Valuing Young and Unprofitable Companies

The four estimates, and how each one is argued

Market size first, because it is the denominator of everything. A defensible number comes from a bottom-up construction — units times price, customers times spend per customer, or an existing adjacent market that the product is displacing — rather than from a consultant’s top-down figure, which is usually a percentage of GDP with a chart attached. The useful output of this step is a range and a sentence about what has to be true for the top of it. Share second. The honest way to estimate it is to look at what the most concentrated competitor in an adjacent market achieved, and to ask what the company would have to do to get there. A 20% share is a lot in most industries; a 2% share is not. This is also where the competitive question from F7 returns, because the share the company can hold depends on whether anything structural protects it. Mature margin third, and it should be taken from the best comparable business that has already grown up rather than from the company’s current statistics, which are meaningless at small scale. Scale economies are real — a software business at $1bn of revenue has a different cost structure from one at $100m — but so are the costs of the sales force, the discounts and the support that a large customer base demands. Take the mature margin seriously as a constraint: a 25% operating margin is at the upper end of what any industry sustains. Capital fourth, and it is the one most often ignored. Growth consumes cash: working capital, capital expenditure, and the operating losses of the years before scale. That requirement is a forecast in its own right, and because the company has no earnings to fund it, it will be raised as equity, which means the share count you divide by at the end is much larger than the one today. One company, three stories — TAM $40bn, 20% share, 25% margin, $1.5bn raised: the base case · TAM $25bn, 12% share, 20% margin, $2bn raised: the sober case · TAM $60bn, 30% share, 28% margin, $1bn raised: the bull case ← · Weighted by probability: a range, not a price A total addressable market that includes every adjacent opportunity is a marketing number. The market a company can actually sell into this decade is a subset, and the discount for the rest belongs in the share assumption rather than in the story.

Survival, dilution and the option value of waiting

A young company has two kinds of risk that a mature one does not: it might not get the margin, and it might not survive to find out. The second is a binary that a discounted cash flow hides, so the honest treatment is to value the business as if it succeeds, value it in a failure case — often near zero, or the value of the technology and the team — and weight the two. That is what scenario weighting means in practice, and it explains why the same company can be described as worth $5bn and worth $500m by two analysts who agree about the probability of success. Dilution belongs in the same calculation, and it is the number founders and investors most often forget. If the company has to raise $1.5bn and its valuation at that point is $6bn, that is 25% of the equity handed to new investors, on top of further rounds and the option pool. The correct arithmetic applies the future share count to the future value, not the current count to the current price, which is why a per-share value computed on today’s count overstates what a present shareholder will own. Then the most useful discipline of all, which is to wait. A young company’s valuation depends on information that does not exist yet: whether the product retains its customers, whether the market is as large as the story says, whether the margin arrives at scale. Each quarter of evidence narrows the range, and the price does not always rise to meet the news — which is why the option to buy later, at a higher price and a narrower range, is often worth more than the apparent discount available today. That is not a counsel of timidity; it is the recognition that uncertainty is expensive to hold, and that the market pays you for holding it only when the uncertainty resolves in your favour. Watch the unit economics before the growth rate. A young company whose gross margin is structurally low and whose customer acquisition cost is rising is unlikely to reach the mature margin in the story, and the statement that shows it is the cohort retention chart, not the revenue line.

The base rate nobody wants to hear

A probability-weighted valuation for a young company is only as honest as the probabilities in it, and those probabilities are not symmetrical. The academic work on the cross-section of individual stock returns is unusually blunt about the shape of the distribution: over long horizons the aggregate wealth created by the stock market comes from a **small minority of firms**, while a large fraction of individual stocks fail to beat a Treasury bill over their entire listed lives, and many end at zero. That is not an argument against backing young businesses. It is an argument for the probability column in the table being lower than instinct suggests, and for the “goes to zero” branch being a real branch rather than a rounding error. The practical consequence is that the interesting number is not the average outcome but the one that survives the failure case. Value five scenarios and weight them, and the arithmetic usually shows that most of the expected value sits in one or two branches; if the valuation only works because the optimistic branch is given a large probability, the analysis has an assumption where it needs a range. The other consequence is that **losing the whole position** has to be an acceptable loss inside the portfolio’s sizing, because in this category of company it happens often enough to plan for rather than to be shocked by. There is a second-order version of the same point worth stating clearly, because it is where young-company analysis quietly cheats. A venture-style analysis can be right about the business and still lose money, if the growth is funded by issuing more shares. Dilution converts a rising enterprise value into a flat or falling per-share value, and the share count is usually estimated by assuming the company raises at higher and higher prices. That assumption is exactly the one that fails in the branches that matter, which is why the funding schedule is modelled explicitly in this lesson rather than left as a footnote. • A minority of firms creates most of the market’s aggregate return, and a large minority never beats cash. • Weight the failure branch as a real branch; the expected value rarely sits in the most likely single story. • Size the position so a total loss is survivable, since “went to zero” is a normal outcome in the category. • Dilution is the quiet failure: right business, more shares, unchanged per-share value.

Reverse it: the story the price has already accepted

Building a valuation forward from four estimates gives a range; inverting it gives the market’s opinion, and the two together are far more useful than either alone. The inversion starts from the price and solves for the cash flow the price requires, holding the other inputs at defensible levels. Because a young company’s value is dominated by the terminal value, the arithmetic simplifies almost uncomfortably: in the terminal-perpetuity form, value equals the mature cash flow divided by the discount rate less growth, so a price is a claim on a *ratio of cash flow to a rate spread* rather than on a decade of forecasts. Move the growth assumption half a point and the required cash flow moves by several percent, which is why the honest output of an inversion on a young company is a statement about margins and scale rather than about next year. Worked on the same $40bn market, the inversion is what turns a thesis into a testable claim. Suppose the enterprise value implied by the price requires $700m of mature operating profit in the end state. Against a 25% margin that is $2.8bn of revenue, which in a $40bn market is a 7% share — attainable, and the thesis survives. Against a 12% margin it is $5.8bn of revenue and a 14.5% share, a much harder claim that needs a structural reason to be believed. The number the inversion produces is not a target; it is the *minimum* the business has to become for today’s buyer to be level, and that sentence belongs in the note. The second half of the inversion is the share count, and it is the step most learners skip. The mature value has to be divided by the shares that will exist when the value is realised, not the shares outstanding today. If the required $1.5bn of funding is raised at values between $3bn and $8bn, the issuance adds somewhere between half and two-thirds of the current count before any option pool or further round, and the per-share value a present holder is entitled to is correspondingly smaller. Inverting the price on today’s count therefore overstates the claim by exactly the dilution the business plan requires — which turns the exercise into a question about capital intensity rather than only about growth. The inversion is also where the falsifier comes from. If the price requires a 7% share at a 25% margin, then the two observations that would break the thesis are named in the arithmetic already: the share stalling below the level implied, or the gross margin failing to convert into an operating margin at scale. That is the same standard the capstone research note has to meet — a market-implied set of assumptions, a minimum the business must achieve, and an observable that would show it will not. • Invert the price: solve for the mature cash flow the value requires, holding the other inputs defensible. • Convert that cash flow into a required share and margin — the minimum the business has to become. • Divide by the future share count, not today’s, or the per-share claim is overstated by the dilution. • The inversion supplies the falsifier: the share or the margin the price has already assumed. • A range from the forward build and a requirement from the inverse are more useful together than either alone. The lab on the next page does this arithmetic directly, inverting an enterprise value and reading the growth already in the price. Do the forward estimate first, then the inverse, and treat the difference as the thesis.

Sources

• Narrative and numbers: valuing companies without earningsDamodaran, "The Little Book of Valuation"; "Narrative and Numbers" (2017)
• Total addressable market, share capture and the arithmetic of scalingStandard venture and growth-equity practice
• Dilution, runway and the financing path of a growth companyStandard private-markets practice; Damodaran, "Investment Valuation", ch. on young companies
• Scenario weighting and the value of the option to abandonStandard decision-analysis practice; Trigeorgis, "Real Options"