Foundations of New Venture Finance 279For example, large, stable, slow-growth businesses are often capitalized at five to ten
times earnings. Firms expected to grow as much as or slightly better than the overall
economy might have price-earnings ratios in the teens or low twenties. Small firms with
high-growth potential often come to market at IPO at multiples of 30, 40, and 50 times
earnings. Their earnings are valued at higher ratios because certain investors look for the
high-risk/high-reward stock that could be the next Google, Microsoft, Cisco Systems, or
Genentech.
No method of determining the correct price-earnings ratio for any specific new ven-
ture valuation is exact. The best process generates a range of potential values and evalu-
ates outcomes within the range. There are a number of reference points to check in
determining the P-E ratio:
- Look for similar or comparable firms that have recently been valued and employ
that capitalization rate as a base. Unfortunately, there are few “pure plays” available
for comparison.^32 Sometimes private valuations are made by buyers or sellers, but
these are not public information and may be difficult to access. - Estimate the range of the stock market’s overall P-E ratio for the period under
evaluation. If a bull market is expected, P-E ratios will be above the historical aver-
age. In this case, adjust the new venture ratio upward. In a bear market, ratios are
down, and the new venture rate should reflect this. - What are the industry’s prospects? Industries under heavy regulation or competi-
tive pressures are valued lower than those considered “sunrise” industries—that is,
industries just beginning to develop under government protection and with little
competition.
The earnings methods are commonly used because they are relatively efficient (you
need only two reliable numbers) and make for easy comparisons. They are volatile be-
cause any change in future earnings estimates produces a valuation change multiplied by
what may be a very large number. In addition, from an accounting viewpoint, earnings
are designed to minimize tax liability. They seldom represent the amount of cash actual-
ly available for returns to investors and owners. To examine these, we need a cash flow
model of firm value.
Discounted Cash Flow Models
The value of a firm can also be estimated using discounted cash flow (DCF) models.
DCF models were originally developed to estimate returns on specific projects over lim-
ited time horizons in the context of capital budgeting. They were then expanded for use
in valuing publicly held firms traded on major stock exchanges. The application of DCF
models to entrepreneurial opportunities is relatively new and must be applied with some
caution.
Advantages of DCF Valuation. If used appropriately the DCF model of valuation can
provide estimates far superior to those based on assets or earnings. One advantage is that
the DCF model’s valuation is based on the cash-generating capacity of the firm, not on
its accounting earnings. For new ventures, cash is king, and when they are out of cash,