| ||||
Has it ever been more difficult for companies to assess new growth opportunities? Roller coaster markets, jittery consumers, and depressed corporate spending all pose challenges to traditional growth valuation methods. In Value Sweep: Mapping Corporate Growth Opportunities, author Martha Amram proposes new tools for the job that allow managers to evaluate projects on a "map" of value.
Amram discussed her work in an e-mail interview with HBS Working Knowledge editor Sean Silverthorne.
Silverthorne: Is there something about the times, be it velocity of change or something else, that makes your book timely now? Would your methods have worked, or would they have been as needed, in the 1970s as today?
Amram: Two forces are at work that make Value Sweep more relevant and useful for 2002 than for 1970.
First, the world of growth projects is more risky. The popular press has picked up that stock market volatility is high for young high-growth companies, but what is less visible is the enormous risk that growth projects bear inside these companies. With short product lives, fast moving technology, and quick price erosion on high-tech consumer goods, growth projects are now more risky than they were thirty years ago.
| Managers involved in growth projects are inherently optimists, so it is no surprise that the most frequent mistake is attempting to place value on vague and unproven business opportunities. |
| — Martha Amram |
Second, we have a more sophisticated set of tools to articulate and measure risk. Value Sweep uses the advances in valuation methods, particularly aspects that account for risk, to provide managers up-to-date tools for the challenges of our time.
Q: For someone already familiar with current growth valuation methods, what is new in your book? What do you bring to the table?
A: Most standard growth valuation models fix or "hardwire" investment schedules, based on a growth projection. Value Sweep shows how to value projects that contain flexible, reactive investment schedules. What is unique about this book is that it shows when and how to use the two most prominent tools for flexible investment—decision analysis and real options—in a way that allows managers to do "back-of-the-envelope" calculations for risky projects.
Q: What mistakes do managers traditionally make when they consider growth options? What do they leave out of their calculations?
A: Managers involved in growth projects are inherently optimists, so it is no surprise that the most frequent mistake is attempting to place value on vague and unproven business opportunities. During the Internet bubble, entrepreneurs were rewarded for the notion that "sometime" we'll make profits. Times have changed. Valuation methods and investors demand a clear depiction of the successful and profitable outcome to a growth project. This is a needed countervailing discipline to the optimism of the managers closely involved in growth projects.
Q: How do you take into account the human side of the growth equation? What if you have an "A" idea, but only a "B" manager to execute it?
A: Venture capitalists have a saying that they fund the team, not the idea. The notion is that ideas will shift and change in response to learning and changes in the market. A good team can navigate these changes.
The issue for valuation analysts is how to quantify the impact of a good team. In Value Sweep, I argue for clearly articulating what a great team could do with the current idea. This is the value of the success payoff. Weaker teams, lack of financing, and so on lead to valuations at discounts to the success payoff. While venture capitalists can decline to invest in a weak team, established companies often don't have this luxury. If they didn't create opportunity for their employees—even the less-than-stellar employees—they could not retain them.
Q: You argue for a "transparent" approach to valuation. Why is transparency particularly important?
A: Key decisions in a growth project are made by a group of people around the table with different backgrounds and agendas. The transparency of the valuation approach enables the diverse group to see the risks and potential rewards. Transparency is critically important to keeping the project on track; too often diverse groups fragment and fall into disarray, killing the growth project with infighting.
|
The transparency of the valuation approach enables the diverse group to see the risks and potential rewards. |
| — Martha Amram |
Another example: Silicon Valley is full of entrepreneurs who are "furious" at their investors. Without transparency, it is difficult for them to see why the extremely low valuations make sense. Instead of seeing a logical, quantifiable, and transparent link to the stock market, the entrepreneurs feel ripped off and abused. Transparency could defuse the tension.
Q: For a dot-com manager in 1999, would your methods have helped in spotting problems ahead?
A: Yes and no. The methods in Value Sweep clearly demonstrate that the growth projects are children and teenagers that grow up to become mature businesses. When the mature business cannot be identified, or does not make a profit, the children are worthless. Thus Value Sweep's methods could have been helpful in sorting between projects that were potential successes and those that were really hot air.
But, Value Sweep also shows how growth project value is tightly linked to stock market valuations. With the high stock market levels of 1999 and early 2000, the valuations and pace of investment in growth projects and startups we saw at that time make a fair amount of sense. The stock market was saying, "Do it!" The hard part is adjusting to the downswing in the stock market, in which it also makes an equal amount of sense to place extremely low valuations on startups and to slow the pace of investment to a crawl.
Q: What project are you working on now?
A: Most recently I've been living the life of growth options as the CEO of a software company in the speech industry. Our software is currently in use in the U.S. Mercedes-Benz product line, where our application provides voice-based personalized traffic reports and connections to the dealer. These are extremely challenging times for a software start-up, and I've found the frameworks I wrote about to be useful in thinking through engineering risks as well as financial issues.
A Look Ahead: Valuing Webvan
| ||||
Using growth evaluation techniques outlined in Value Sweep, Martha Amram uses now-defunct online grocer Webvan as a case study.
To provide a flavor of how a revised valuation process would work in practice, let's walk through an example. In July 2001 Webvan ceased operations. The quick rise and fall of the Internet grocer illustrates many features typical of growth opportunities, as well as the valuation logic behind Internet-fueled growth opportunities. The valuation method used in this example is the subject of later chapters, and a spreadsheet summarizing the calculations is available from www.valuesweep.com.
In the spring of 2001, Webvan was a growth opportunity, a company not yet able to self-fund its business growth. Typical of many e-commerce prospects, it had its feet in both the Internet and physical worlds. Webvan's sales were running at an annualized rate of $300 million, and it promised Wall Street profitability by the second half of 2002. The company also said that an additional $25 million of capital was needed to achieve this milestone. What was the value of Webvan at that time?
Begin the analysis by throwing out the standard valuation tools such as price-earnings ratios, price-earnings-to-growth ratios, and DCF (also known as net present value [NPV]). In all of these methods, value is driven by near-term positive cash flow. But Webvan expected near-term losses! Instead of assuming the issue away, use valuation tools that directly account for value creation while incurring losses.
The first step is to calculate the value of Webvan at maturity when further growth can be sustained by internal funds. What will the business model look like, and what is its value? The mature Webvan might have been somewhere between a grocery store and a delivery business. In spring 2001 the stock market was valuing companies in those markets at one to two times annual sales. Webvan told the financial markets that it would be profitable in three U.S. metropolitan areas by the end of 2001, with annual sales of $300 million. As a rough cut, the value of Webvan in three profitable cities could be put at $600 million (2 x sales).
But there was a significant risk that the firm might not cross the profitability threshold, as it had yet to make a profit in any market. The value of Webvan was less than $600 million, but how much less? One answer is found in the data provided in Chapter 8, which presents a specialized valuation template for valuing venture-funded startups. The template strikes a balance: It is built on the common principles of valuation for growth prospects discussed throughout this book and yet is tailored for the types of firms funded by venture capitalists.
The template shows that the historical venture capital valuation for a firm at the same stage of development (shipping product but not cash flow positive) is about 20 percent of the value of the business once profitable. Webvan's value would then be $120 million (20% x $600 million). Notice how the valuation result is aligned: Webvan's value is expressed as a percent of the current stock market valuation of the mature business. As the market value of the mature business changes, so will the value of the growth opportunity.
What about Webvan's other markets? These are follow-on opportunities that the company may pursue once it has proved its viability in the initial three markets. Assume, in back-of-the envelope mode, that Webvan might double sales by opening up two additional markets. Using the method given in Chapter 7, the value of this follow-on opportunity is shown to be only 15 percent of the current value of the company, or an additional $18 million (15% of $120 million). This result is typical; follow-on opportunities capture our imagination but are seldom large in value.
The total value of Webvan is then about $138 million. This is the value of a company that is currently losing money, but which has a near-term growth opportunity and a follow-on opportunity. The valuation is based on the current stock market value of similar mature businesses.