Why founders should avoid overuse of revenue multiple: what it really means in startups’ valuation

Traditional valuation methods rely on a company’s financial statements. If founders use revenue multiples in dealing with potential investors, they should understand the basics of valuation. Otherwise, it might appear as a lack of common sense. Here’s a breakdown of the basic approaches and why revenue multiple was invented.

1.Asset Approach

1-1. Book Value

This simply looks at a company’s cash equivalent assets minus its liabilities. It’s a starting point, but doesn’t consider future earnings potential. So some of assets that have sound earnings can be undervalued by solely asset approach.

2.Income Apporoach

If we simply use asset approach, we will find some of asset value is different in high income generating entities. We should consider the currency also depreciated by time. The time value of money and earning power of assets, present value of future earnings calculations is invented after asset approach.

2-1. DCF(Discounted Cash Flow)

In a basic DCF model, the fair value of a stock is the present value of all its future cash flows. The P/E ratio implicitly assumes that the current level of earnings will continue into the future, and uses a constant discount rate reflected in the P/E multiple.

2.2. Price-to-earnings-ratio(P/E)

P/E comes after DCF principles. We can view the P/E ratio as a kind of shortcut for a DCF valuation. The P/E ratio takes the current stock price and divides it by the company’s earnings per share (EPS).This method takes a company’s past and projected earnings into account.

2.3.Enterprise Value-to-EBITDA-ratio(EV/EBITDA)

The dominant income-based valuation metrics was price-to-earnings (P/E) ratio but if there is R&D asset intensive business, we may ignore investment and growth potential by P/E, because pure Earnings do not show how much the company is earning cash before depreciation and amortization. Earnings Before Interest Taxes Depreciation and Amortization(EBITDA) usually shows real earning power and operating cash flow of R&D intensive businesses. EV/EBITDA comes as an exception to P/E principles.

3.Market Approach

If we select asset approach and income approach to evaluate comapnies, typically future value of R&D intensive investment was underestimated. There was exeptional growth record of Microsoft, Apple, Oracle, Amazon, Google, Facebook, Netflix, Tesla, NVIDIA. Traditional assset approach and income approach cannot properly evaluate these exeptional companies before IPO. Here is why market approach will be used to evaluate high margin, high growth business.

3-1.Public Company Comparables (PCC)

This method compares the target company to publicly traded companies in the same industry. It involves calculating valuation multiples for the public companies and applying them to the target company’s financial data.

3-2. Private Precedent Transactions

This method looks at recent M&A deals involving similar companies. By analyzing the price paid in those deals relative to the financial metrics of the acquired companies, you can derive a benchmark for valuing the target company.

4. Revenue Multiple

Revenue multiple is a different animal. It focuses on a company’s revenue, rather than profits. There are two main types:

4-1. LTM revenue multiple

Latest Twelve Month revenue multiple is usually most reliable indicator of revenue multiple. It takes a company’s revenue over the past twelve months and divides it by its current valuation (market capitalization for public companies, or a funding round valuation for private companies). LTM revenue multiple reflects a company’s historical performance. It shows how much investors are currently willing to pay for every dollar of revenue the company has generated. LTM revenue multiple is a good starting point for valuing early-stage startups that might not be profitable yet. It provides a benchmark for comparing similar companies in the same growth stage.

But you should not forget prerequisite why loss generating startup can raise money, that’s because there is the expectation from investors that the loss making, high growing company will turn into competitive margin business(higher gross margin, higher EBITDA margin, higher income margin than peer group) in 3 to 5 years.

4-2. NTM revenue multiple

Next Twelve Month revenue multiple is totally different from LTM revenue multiple. This metric takes a company’s projected revenue for the next twelve months and divides it by its current valuation.

NTM revenue multiple is not historical record but forward-looking statement, focusing on the company’s growth potential. It reflects founders’ belief in the company’s ability to scale its revenue rapidly.

NTM revenue multiple is more relevant for high-growth startups with a clear path to increasing revenue. It can be used by VCs to assess potential investments in companies that are expected to experience significant revenue growth in the near future.

But don’t forget track record and future expectation is totally different. The likliness of startups to hit NTM revenue that was planned beforehand is less than 10%. And you should not also forget prior condition of revenue multiple formura.

4-3. Prerequisite of revenue multiple

Revenue multiples can be used for companies with certain characteristics:

Hyper-growth

Early-stage or fast-growing companies often have little to no profit yet. Revenue becomes a more relevant metric for their future potential.

High Margin

For companies with a strong business model and higher profit margins than peer groups, revenue can be a good indicator of future cash flow generation. Higher gross margin, higher contribution profit, higher EBITDA is often seen in this type of startup.

Economies of scale

Investment can be done only if the company have economies of scale in selling products or services. If there is no evidence of competitive margin, economies of scale, then revenue multiples is nonsense. You should buy that company by asset approach or income approach. (That is more like distressed or secondary strategy)

4-4. Weakness of revenue multiple

It’s important to understand that revenue multiple has lots of work to do after investment

Unproven profitability

Just because a company has high revenue doesn’t mean it’s profitable or sustainable. The founders should prove if the hypothesis of scale economics in revenue/cost. But its easier to say than to excute. Ecosystem leader, platformer can only earn higher margin than peer group. Connected IoT, SaaS, marketplace tends to show better revenue/ cost model than industry average of S&P 500. Healthy hyper growing companies tends to have >75% gross margin, >50% contribution profits, less than 1x burn multiple(Raised capital/Net New ARR). Asset turnover ratio over 1x.

Fiducialy duty to monitor margin improvement to avoid loss in “time”

Basically, revenue multiple is used for high gross margin business, still generating loss, that may have economies of scale. Therefore, if founders use revenue multiple, there is implicit pledge to investors, to monitor margin improvement. Have to realize clear path to profitability.

But there were many venture capital backed companies that revealed not having economies of scale after several years passed. It is not good situation for both investors and founders not only because money concern but they loss the most valuable asset : time.

5. The hydrologic cycle of the currency

5-1. The hydrologic cycle of seawater

Imagine the ocean as a vast pool of capital, represented by USD. This capital is constantly churning, flowing through different stages like seawater.

5-2. The seawater-to-freshwater cycle

The cycle of seawater evaporating into clouds, forming rain that falls on the ground and soaks into the soil or flows into rivers to become drinkable water:drinkable water is like products or services that can be consumed by people, and finally that consumed water will be returning to the sea(pool of capital).

The continuous circulation of seawater through the Earth’s system is the metopher of the never-ending nature of the monetary cycle and its role in maintaining the Earth’s economic balance.

If you use exceptional theory(revenue multiples) in the nature, you should carefully apply that formula.