5 steps to value a Tech company

A friend just asked me how to value a video game company. I am not an expert in the industry, but happy to share 5 thoughts that may be helpful, mostly inspired from NYU Professor Aswath Damodaran. These thoughts feed into the main line items of a DCF framework, which enables to value a business based on its expected cash flows and discount rate (described below in more detail as a reminder)

The meat – 5 steps to value a Video Game company

1. Revenue

You need to think of the Total Addressable Market (TAM), how it's going to grow, and how your company can seize a certain market share

It is helpful to understand segments within this TAM, which may behave differently, and see where your company is strong vs. weak + ambitions it may have (for instance, some are focused on Sport Simulation vs. FPS vs. MMORPG vs. Education etc.)

Market share evolution depends on where the company is today, how it compares vs. competitors, switching costs, barriers to entry, etc.

All the above should help you determine the top line (revenue)

2. Cost Structure

Then you need to think of your cost structure. I find extremely helpful to draw plot charts across peers showing historical revenue vs. each of COGS, SG&A, and R&D and see if you can draw some sort of correlation, most likely linear or logarithmic

Caveat on this approach: historical data won't show you how the cost structure will be affected by technological improvements (lower costs) or increased competition for talents (higher costs) or other assumptions that you can make going forward. Besides, if you do it across peers, it disregards company specifics (helpful to look at the r-square of the regression to see if it is meaningful)

3. Investment Needs

For Capex and D&A, I'd build a schedule based on an Adjusted Asset Turnover ratio. I'd look at peers to see how their Adj. Asset Turnover looks like and how it evolved to see if a trend can be inferred. I say Adjusted because I'd retain operating assets that make sense for the business. Here, given the technological nature of the business, I would recommend to capitalize R&D as if it were an addition to Adj. Assets. It would also have to be depreciated at a certain rate. I would include other operating assets as well, but not working cap (separate schedule)

4. Other Assumptions

I'd keep things simple for Working Capital, Tax, Capital Structure (D/E) and WACC, but you may want to put more thoughts into these depending on your objectives

5. Playing with Assumptions

That's where the last point comes into play: as an investor looking to buy, I'd make fairly conservative assumptions and see if the company still looks like a bargain

Another way to look at it is to see what level of assumptions enables the valuation to match the current market price for a listed stock. You can then see how you feel about these assumptions (for example, if you need a 100% growth rate over the next 10 years to match the current price, you may question whether the implied market assumption is realistic)

An analysis that is really interesting is to set a low case and a high case for each assumption, as well as a random case that takes values between the high and low. Then run a a thousand of valuations (data table useful) and see the distribution curve of the implied expected value (basically comes down to a Monte Carlo simulation)

I hope that this will give you some ideas for your next valuation!

If you want more: Highly recommended video of Damodaran talking to Google employees about several topics including how he would value Twitter

Reminder – Valuation Framework – DCF 101

All of the above relies on the DCF method, among the preferred methods to value a business (as opposed to price it) as it enables to take into account its specific features

DCF stands for Discounted Cash Flows. It enables to attach a value to assumptions you'll make on the company's cash flows and discount rate. A standard approach is to value the entire Firm's Value (FV) (as opposed to the sole Equity Value) by summing the Free Cash Flows to the Firm (FCFF) discounted at the Weighted Average Cost of Capital (WACC)

FV = Sum (Discounted Cash Flows) = Sum [ FCFF(i) / ( 1 + WACC)^i ]

(Sum for year i from 1 through N, N being the life of the project)

Free Cash Flows to the Firm?

FCFF = EBIT * (1 – tax rate) + D&A – Capex – Change in Working Capital

EBIT = Revenue – COGS – SG&A – R&D (including allocated D&A)

Weighted Average Cost of Capital?

WACC = Cost of Equity * Equity/Capital + Cost of Debt * (1 – tax rate) * Debt/Capital

Capital = Debt + Equity

Terminal Value?

If you assume Long Term (LT) Cash Flows to grow at a constant Perpetuity Growth Rate (PGR) for ever, you can use the Gordon Growth Model to assess a terminal value:

TV = LT FCFF * (1 + PGR) / (WACC – PGR)

You would then need to discount it back to present to get the present value

Mid-Year Cash Flow Convention?

You can assume that all cash flow happen at the middle of the year instead of the end of the year, and multiply your overall Firm Value by (1 + WACC)^(1/2) account for the gain due to the time value of money

Bridge from Firm Value to Equity Value?

Firm Value as computed by the DCF method is merely the present value of the future cash flows generated by the operating assets of the company. Both shareholders and debt-holders will have claims on these cash flows. Sometimes, other stakeholders may also have claims on these cash flows, such as former employees eligible to pension plans or litigators

So to assess an investment opportunity and get a sense of whether a share price is a bargain, it is necessary to go from the Firm Value (FV) down to the Equity Value (EqV) by subtracting the value of any claims that eligible stakeholders may have, and back the value of non-operating (=non cash flow generating) assets of the company

This is sometimes summarized as:

FV = EqV + Net Debt (Gross Debt – Cash & Cash Equivalent) + Tax Adjusted Pension Deficit + Minority Interests + Expected Litigation Settlement Costs + Other Relevant Debt Like Items – Equity Investments – Other Financial & Relevant Assets

A simpler summary is FV = EqV + Net Debt, but it may miss critical data items

Working Capital Assets and Liabilities are not included as their value is already incorporated in the DCF

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FPS – First-Person Shooter

MMORPG – Massively Multiplayer Online Role-Playing Games

EBIT – Earnings Before Interest & Tax

D&A – Depreciation & Amortization

COGS – Cost of Goods Sold

SG&A – Selling, General & Administrative

R&D – Research & Development

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personal post – does not necessarily reflects the views of my current/past employers