When valuing firms you may occasionally have a special case of a company that produces revenues but negative earnings.
These firms are typically start-ups or companies going through a period where operating expenses are high. This leads to a bit of a dilemma for company valuation purposes via discounted cash flow (DCF) given that earnings are a central input into the model when determining cash flow.
Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are calculated as follows:
- FCFF = Net income + Depreciation and amortization – Capital expenditures – Net change in working capital
Earnings represent a term synonymous with net income, which is revenue minus operating expenses, interest paid, depreciation, and taxes.
When earnings are negative, it becomes difficult to value a firm using standard cash flow measures and alternative means must be used in order to determine firm value and fair value for its stock price.
We would in all likelihood obtain a negative value for the firm, which is nonsensical or only truly valid in select circumstances.
Firm value can be reasonably determined in standard cases (positive earnings, positive revenue) by using a combination of cash flow from:
- operating activities
- net income
- earnings before interest and taxes (EBIT)
- tax rate
- capital expenditures
- depreciation
- change in working capital
- total debt
- cash
- CAPM inputs
- beta
- long-term government bond rate
- market-risk premium
- expected growth
But other inputs must be used in the case of a low-earning firm to get a more accurate look at the true valuation of a company. These include:
- EBIT
- Interest expense
- Depreciation and amortization
- Current revenues
- Current capital spending
- Current non-cash working capital
- Book value of debt
- Book value of equity
- Cash and marketable securities
- Non-operating assets
- Net operating loss
- Marginal tax rate
If you’ve been immersed in finance for some reasonable level of time, you might recognize many of these terms and what they signify, but I’ll point out a few that are more likely to be unknown.
Non-cash change in working capital is equal to non-cash current assets minus non-debt current liabilities. Note that this is different from the book value of equity, which is total assets and total liabilities.
The book value of debt is typically equal to notes payable (i.e., a long-term loan) and all long-term debts. The book value of equity, as just mentioned, is equal to the total assets of a company minus its total liabilities. This differs from net working capital, which is current assets minus current liabilities.
Non-operating assets include everything that does not assist in the day-to-day operations of a firm, such as marketable securities. Intangible assets could be considered operating assets in the form of licenses that directly feed into a company’s operations.
Net operating loss (NOL) is not found on the three statements, but may possibly be derived from an earnings report found online. This occurs when a company’s tax deductions exceed its taxable income and consequently provides a negative taxable income. A net operating loss is common in tough-to-value firms as a result of expenses exceeding revenues.
Among other additional inputs, we might need the following:
- Sales to capital ratio
- Expected growth rate (assumed forever)
- Expected debt to capital
- Expected beta
- Expected cost of debt
- Return on capital for the firm
- Number of shares outstanding
- Current stock price
- EV/Sales
To make things easier, a spreadsheet with industry averages is included for many of these inputs (thanks to NYU Stern professor Aswath Damodaran). His website can be found here.
There are two forms of valuation included on his “tough to value” spreadsheet – discounted cash flow and also relative valuation.
In the relative valuation, are using the EV/Sales multiple to determine value as of a particular projected year’s revenue.
If we wanted to value a firm in five years’ time, we would take the revenue projection for that year, assume it’s 100% comprised of sales revenues, and multiply by the EV/Sales multiple to determine enterprise value. (The Sales * EV/Sales calculation causes sales to cancel leaving us with enterprise value.)
Increase in the following variables will tend to increase firm value:
- EBIT
- Revenues
- Interest expense
- Book Value of Debt
- Cash & Marketable securities (small effect)
- Non-operating assets (small effect)
- Net operating loss (small effect)
- Growth rate
- Operating margin (EBIT/Sales)
- Debt to capital ratio
- Return on capital
An increase in the following variables will tend to decrease firm value:
- Marginal tax rate
- CAPM inputs (each would raise cost of equity)
- Cost of debt
- Current cost of borrowing
This type of model will normally be used sparingly when doing valuation analyses.
However, when valuing startups or high operating expense firms, it will be a necessary way to determine company value using discounted cash flow analysis.
