Your valuation is only as good as your assumptions

In the world of technology, achieving a billion-dollar valuation has long been considered the ultimate achievement. But as investors no longer pursue the quest for unicorns with the same level of interest, it may be time to revise valuation strategies as well and look for underlying values rather than inflated expectations.

The rise of unicorn valuations has been in large degree driven by growth metrics above all others, and are at risk of collapsing once growth reach a certain plateau. Companies like Airbnb, Uber, Alibaba, Facebook, Netflix and Snapchat are the fastest-growing companies the world has ever seen. Their growth is exponential, their assets are almost ephemeral, they shun all traditional economic models for valuations. The investments required to scale are almost negligible, their market size often unlimited, their shift from loss-making to profit can be almost immediate. In these very rare cases, traditional valuation methods do not fit the bill.

The problem is that these are not the only ones adopting this approach to valuating their companies. Domino’s is now claiming to be “a tech company that happens to make pizza,” Dell refers to themselves as “the world’s largest startup”. This approach is even more troublesome, as we tend to forget those who were once considered a rising star that no longer has a place in the spotlight.

One example of this is the collapse of Powa Technologies, once estimated to be worth $2,7 billion. One of the fundamental problems for a growth-centric approach to valuations is the risk of stepping in to a self-reinforcing cycle of inflated value. Companies with high growth usually attract high valuations which allow them to raise capital in order to reinvest in growth. This puts pressure at companies to keep growing at all cost, often at the expense of profits and building a sustainable business model and underlying value objects in the company. Google didn’t growth hack. They just provided a service to the internet and build a business around it. This is reflect by the development of valuation multiples, where the highest valued companies of the past were focused on growth at any cost, valuation multiples today favor companies that manage to balance both growth and profits.

Valuating a company for its resilience and sustainability is no straight forward process, and in many cases the purpose of the valuation will lead to biased decisions. Valuating a company for taxation purposes does not always encourage the same result as when raising capital or establishing an employee stock option program.

No matter the reason, the old valuation methods are still valid, but it is more important than ever to understand the underlying assumptions behind the numbers rather than blindly trust the math to be correct.

This is emphasized by Matthew Schubring who recently told Forbes: “A good valuation is 75% art and 25% science because it takes into account the story behind the numbers of a business. Appraisals fall down when there isn’t enough support for the story behind it. It’s based not on just what happened, but on why things happened.” In every case, there are several qualitative considerations that need to be accounted for. A technology company is not a technology company. What industry or market segment is the company addressing? Compliance is not only an issue for corporations in a digital world. Are there regulatory obstacles or possibilities? Not every company has the potential to grow exponentially or to become a successful digital ecosystem. Is the proposed growth hypothesis believable? These are just some examples of questions that should be included in a hypothesis based approach to valuations.

By breaking down the problems in subcategories it should then be possible to identify the validity of each assumption separately. A crucial part in this phase is the ability to separate facts from observations and subjective meanings. In my opinion, understanding the underlying drivers behind the assumptions is always more important than attempting to come up with a perfect single-point view of the world.

After assessing the validity of each assumption, a bottom up approach may serve as a reference point for a valuation. After all, at the end of the day valuations all comes down to a shared belief of future success.