I was recently listening to the song “Circle of Life” from the movie Lion King, which got me thinking about the parallels between this concept in the natural world and the business world. The song stays in the happy zone for the benefit of the audience and celebrates new beginnings and unlimited potential as a new life enters this world. However, as we all know, in real life the full gamut of the circle of life includes both happy and sad stages. Growing pains, injuries, illnesses, failed relationships and death are as much part of the circle of life as the ever-expanding opportunities to learn, gain experience and grow.
A butterfly goes through several distinct life stages first as an egg, then as a caterpillar, before it forms a chrysalis and undergoes metamorphosis within to emerge as a full-grown butterfly for the remaining duration of its life. Changing seasons also reflect the patterns and continuity of life over a long span of time. Businesses, more or less mirror the circle of life found in nature, and in an open market economy like the U.S., companies are constantly being created, growing, merging, declining, becoming irrelevant, and dying. Broadly, businesses can be classified to be operating in the following stages of their lifecycles1:
- Early-growth stage
- Growth stage
- Mature stage
- Declining stage
Valuing Early-Growth Stage Firms
Companies in different stages of their lifecycle have different factors that drive their value. The potential revenue growth, profit margins and risk factors can differ significantly for companies operating in different stages of their lifecycles. For early-growth stage companies, the current revenue stream may be small or non-existent, even though the revenue growth potential can be very high, and these companies typically sustain heavy operating losses and incur significant capital expenditures in the initial stages. Access to capital is difficult and cash flow shortages are common for many early-stage companies as they try to keep up with operating and capital cash flow requirements.
Survival of the fittest is an underlying theme in nature and in the business world. And just like in nature, companies in their early and declining stages have a lower survival rate than established growing and mature companies. The risk of failure is especially high for small companies in the initial stages, with data from the U.S. Bureau of Labor Statistics indicating that only about 50% of newly-formed small businesses with employees survive beyond the first five years. Early-stage companies may also have significant key person risk, and the exit of key individuals managing the firm could jeopardize the firm’s survival.
From a valuation perspective, within the income approach, the challenges in valuing early-growth stage companies include accurately forecasting the future revenues and stabilized margins and growth rate over the long run for the company being analyzed. Application of valuation methodologies within the market approach, including the guideline transactions method and the guideline public company method is also challenging due to the lack of data regarding transactions of companies in the same industry who are in the same early-growth stage; and in locating comparable publicly-traded companies similar to the company being valued. There could be significant differences in the risk, cash flows and growth profile of the early-growth stage company being valued, and the comparable transaction data or public company multiples being utilized.
It is also important to track relevant metrics and parameters related to the industry for the company being valued. For example, several newly-formed social media platforms and internet companies do not conform to traditional valuation models due to a lack of conventional revenue stream, and often, little or no profitability. These companies often do not charge a subscription fee from their users, but instead raise revenues by running advertisements and placing sponsored content (Facebook, Google and Twitter are well-established companies operating in this space with this type of revenue model). Some of the metrics that are used for valuing social media platforms, apps and internet companies include the number of users, number of page views, revenue per user, cost per click, cost per mille (thousand), click through rate and time spent on page. Companies operating in this space with a subscription-based monetization model can be valued using the discounted cash flow model.
Valuing Growth Stage Firms
Growth companies include new businesses that have survived the first few years in the early growth stage, as well as established companies that have still not reached their market share potential within their existing industry, and established companies that have ventured into a new promising industry or developed new products and services for the marketplace. Even companies with a long history of operations can operate in the growth stage for several years due to the unsaturated market potential for their products and services, industry dynamics and regular product or service innovations.
Growth companies have a volatile trend in revenues and earnings and grow at a faster pace than the overall economy. They may still be operating at a loss or be marginally profitable, but their margins have not yet reached their stabilized levels. Growth companies have value growth potential, but the cash flow projections are still risky and the timing of and success in attaining their full market potential is uncertain. The market landscape is even more uncertain for companies operating in constantly evolving industries such as technology. Due to a longer history of operations and a demonstrable growth trend, it might be easier to raise capital in the growth stage compared with the early-growth stage, but high levels of debt in the capital structure at this stage would increase the risk of financial distress for the company.
For growth-stage companies, within the income approach, the discounted cash flow method that allows for assumptions regarding differing growth rates and margins is a better option than the single-period capitalization method that assumes a constant growth rate and margin for the company being valued. Valuation issues under the income approach include projecting the scale and length of the rapid growth phase. Assumptions have to be made about when the company would reach a stable growth stage, and the differences in the risk profile of the company in these different stages need to be factored in the cost of capital calculation. For the purpose of valuation, working capital and capital reinvestment projections in the business should be commensurate with the projected growth rates of the business in the future.
Using market-based multiples to value growth-stage companies also needs special consideration. Firstly, it is difficult to find comparable guideline companies and transactions with the same kind of growth profile, future growth and earnings prospects and risk profile as the subject company. Secondly, parameters like revenues, EBITDA, EBIT and book value are used to calculate multiples and derive indications of value, but these parameters are subject to vast fluctuations, each year or even quarter, for a growth stage company. Therefore, value indications that are calculated using the current period’s revenues, earnings or book value fails to consider the future growth potential of the growth stage company and may undervalue the company.
Growth companies are often considered attractive targets for acquisition by companies in the mature or declining stages, who are trying to buy the growth potential that is offered by the desired target company. For companies that are not able to generate organic growth, M&A activity enables them to get back to the growth zone by providing access to new products, services, technology and markets; and sometimes by reducing competition. The dynamics of the mating game found in nature also reflects in the business world for attractive target companies, with rivals having to fiercely compete, outbid and provide the right incentives to the target company to be the winning acquirer. It must be noted that merger and acquisition (M&A) activity is cyclical and occurs more frequently when there is greater confidence in the economy.
Valuing Mature Firms
Mature companies include businesses that have reached the growth ceiling with their current product or service offerings and have stabilized revenue growth and profit margins. For mature companies, revenue growth rate typically is similar to the growth rate for the overall economy and industry. However, based on how well a mature company holds on to its competitive advantages and brand value, it can continue to earn excess returns for a long period of time. Other mature firms may see their excess return go to zero or even turn negative when they do not have a strong competitive moat and other firms start competing in their space. The ability to earn and sustain excess earnings thus becomes a determining factor in whether the value of the firm is high or low.
Even for companies in the mature stage of their lifecycle, in many ways, it is a jungle out there. As mentioned previously, apart from the constant fight to maintain their competitive territory, lacking opportunities for organic growth, mature companies often hunt for attractive targets, either to grow or to eliminate competition or avoid being acquired themselves. This is another way to utilize excess cash flows after meeting other priorities. However, there are several real-life examples of companies that have made the transition from the mature or declining stages back to the growth stage by innovative market leadership (e.g., Apple with iPod, iPhone and iPad) and being responsive to the market (Microsoft responding to the movement of the software industry towards cloud and SaaS).
In the mature stage, businesses are expected to be able to fund their working capital and capital expenditures through their ongoing cash flows, and still have excess cash to be able to service debt and make dividend payments or distributions to their shareholders or owners. For businesses operating in this stage of their lifecycle, the decision regarding optimal capital structure using both debt and equity is an important consideration that affects the value of the firm. While interest payments on debt provide the advantage of tax-deductibility, the borrowing company is committed into making periodic interest and principal repayments on its debts. Further, the passing of the Tax Cuts and Jobs Act (TCJA) has made it less tax advantageous for companies to borrow in terms of interest tax deduction, as the highest federal corporate tax rates have been reduced to 21%. Some of the other factors related to increasing leverage of a firm include matching the cash flows on the debt to cash flows of the assets or the project (short-term debt for a short-term project and long-term debt for a long-term project) and ability to fund future projects with debt (it is harder to raise new debt when there already is considerable debt on the books).
An inherent bias that creeps in while valuing mature, stable companies is assuming that the current level of management will continue into perpetuity. If possible, it is beneficial to question that underlying assumption and evaluate whether the current management is running the company efficiently and if a change in management may increase or decrease the value of the mature firm. If a change in management is imminent (e.g., aging or ill CEO/founder, activist investors demanding change in management), it is useful to conduct a scenario analysis based on both the current level of management and under a new management, which may be more or less competent than the current level of management, and calculate a probability-weighted value for the company as of the valuation date.
Valuing privately-held firms, in any of the stages of the business lifecycle, brings in its wake a few additional challenges including lack of reliable data, insufficient publicly available information about other privately-held competitors for benchmarking, lack of buyers for a privately-held company in general, and a non-controlling interest in a privately-held company in particular. Valuing a non-controlling interest in a privately-held company may require application of a discount for lack of control, based on the control attributes of the ownership interest, and a discount for lack of marketability.
Unlike the natural world, advancing chronological age is not an indicator of decline for businesses. C-Corporations have a perpetual life assumption and even other forms of businesses can be run successfully for decades or even centuries as long as they have a good portfolio of product or service offerings, keep up with the demands of the marketplace, are managed efficiently and are able to manage ownership transitions successfully. The following table has a list of some of the oldest continuously operating businesses in the world that are still in business:
|Name of Company||Year Started||Location||Business|
|Nishiyama Onsen Keiunkan||705||Yamanashi, Japan||Hot spring hotel – stayed in the same family for 52 generations|
|Stiftskeller St. Peter||803||Salzburg, Austria||Restaurant located in an abbey|
|Sean’s Bar||900||Athlone, Ireland||Bar|
|Weihenstephan Brewery||1040||Freising, Germany||Brewery located in an abbey|
|Frapin||1270||Segonzac, France||Premium cognac distillery – run by the same family for 20 generations|
|The Shore Porters Society||1498||Aberdeen, Scotland||Removals, haulage and storage company|
|Beretta||1526||Gardone, Italy||Firearms – owned by the same family for almost 500 years|
|Cambridge University Press||1534||Cambridge, England||World’s oldest publishing house|
|Bushmills||1608||County Antrim, Northern Ireland||Whiskey distillery|
|Shirley Plantation||1638||Charles City, Virginia, USA||Plantation – operated by 11 generations of the same family|
|Royal Delft||1653||Delft, Holland||Pottery, earthenware factory|
|Twinings Tea||1706||London, England||Tea|
|Sotheby’s||1744||London, England||Auction house|
Source: Business Insider, Wikipedia
Valuing Declining Firms
The above list of companies has managed to survive over a long span of time despite facing wars, natural disasters, technology and several other disruptors, and have managed management transitions successfully many times over. However, material disruptions can upend entire industries and any company, however big or small, is susceptible to failure. For companies in the declining stage, the important question with respect to valuation becomes whether a turnaround is possible or if the company is more valuable dead than alive (i.e., the value of its assets is greater than the cash flows that can be generated from the use of those assets).
Some of the tell-tale signs of a company operating in the declining stage include falling or stagnant revenues, shrinking margins or losses, asset divestitures, big dividend payouts or stock buybacks, and an inability to repay debt. Certain statistical methods like Altman’s Z-Score, which uses measurable inputs like revenues, working capital, retained earnings, EBIT, total assets, market value of equity (for public companies) and book value of liabilities, to determine the probability of a company going bankrupt. From a valuation perspective, the value of a company in a declining stage may be determined more appropriately through asset-based approaches rather than income or market-based approaches. If a liquidation premise is used to value a declining company, instead of a going-concern premise of value, consideration must be given to the appropriate recovery rate based on whether the assets would be sold as part of an orderly liquidation or a distress sale.
The evolution of the auto industry in the U.S. provides an opportunity to study all the lifecycle stages and also provides examples of companies operating in the declining stage. As the preferred mode of personal transportation moved from horse driven carriages to automobiles in the early twentieth century, a slew of related parts manufacturers (including the oft-mentioned buggy whip manufacturers) were deemed obsolete and irrelevant for the new mode of transportation and went out of business. U.S. automakers maintained their domination in the North American market for several decades, until Japanese companies like Toyota and Honda made headways into the market and earned a reputation for building fuel-efficient cars and cut into the market share of the domestic automobile manufacturers. At the turn of the 21st century, U.S. automakers struggled with both competitive and structural issues like changing consumer preferences with respect to sports utility vehicles, unionized workers and legacy costs in the form of defined benefit pension programs. During the Great Recession, General Motors (GM) and Chrysler (now known as Fiat Chrysler) filed for Chapter 11 restructuring, but have emerged out of the process and are still in operation today. The current players in the U.S. auto industry continue to contend with trends like autonomous vehicles, alternative-fuel vehicles, and changing preferences towards ride-sharing services in cities.
While GM and Fiat Chrysler managed to survive the Great Recession, the financial industry went through a major upheaval during this period, and even well-established firms in the financial industry like the investment banks Bear Stearns (acquired by JPMorgan in a fire sale of $2 per share in March 2008) and Lehman Brothers (filed for Chapter 11 bankruptcy protection in September 2008) went out of business. After Lehman Brothers filed for bankruptcy protection, parts of its North American business operations were acquired by Barclays and parts of its Asia-Pacific and European operations were acquired by Nomura Holdings. This was an especially turbulent period for the financial sector and according to data compiled by Federal Deposit Insurance Corporation (FDIC), more than 500 U.S. banks failed during the years 2008 through 2015.
The changes in the retail industry currently is another example of how market disruptions can change the market landscape and lead to a decline of firms that are unable to innovate and adapt. The decline of brick and mortar stores in the age of Amazon and other digital purchase options, change in consumer purchase preferences, and an inability to service the debt and other overhead costs related to maintaining physical retail spaces have led to a spate of bankruptcy filings by retailers. Some of the prominent brands that either filed for bankruptcy or completely shut down their stores and operations in the year 2018 include Toys R Us, Sears, David’s Bridal, Mattress Firm, Brookstone, Bon-Ton, Claire’s and Nine West.
In nature when an animal is hunted or dies, predators and scavenging animals like vultures, ravens and coyotes consume the remains and over time the remaining carcass decomposes and contributes to nourishing the soil around it. Just as predators and scavengers contribute to keeping their habitats and ecosystems healthy, the firms acquiring the assets of a declining company contribute to the overall health of the economy by ensuring that finite resources are reallocated and put to their best use. The hunted or dead animal contributes to continuing the circle of life, and similarly, even when firms go out of business they contribute by freeing up resources to be used to create value that keeps the economic system moving along.
While all efforts have been made to perform credible research, the author and BeachFleischman PC assume no liability or responsibility for any errors and omissions. Names of certain companies have been used in the article for illustrative purposes and should not be construed as investment advice. Please feel free to contact Srividya with any comments or questions.
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- Broadly based on the classification provided in the book “The little book of valuation: How to value a company, pick a stock and profit”, by Aswath Damodaran