A common way to value a company is to look at the company’s total revenues and then take a some multiple such as “1x” or “2x” in conservative industries, with “10x” as an acceptable standard in the technology industry, and an incredible “100x” as witnessed in Microsoft’s valuation of Facebook. We’ll call this the “Revenue Multiple Approach” (RMA).
What’s interesting to me is that you never read about why we use "revenue" (or a multiple of revenue) to establish a firm’s valuation.
I was considering company valuations last week from an economic perspective - thinking more about how and why companies are valuable and how they fit into the broader economy and less about the plug-and-chug, back-of-the-envelope modeling that is common in finance. It made sense that a firm’s value solely should be based on the benefit that its customers receive from purchasing the firm’s products and services.
The outcome of this explanation is to show how we can generate the value of a firm (“Supplier") based on its sales to its customer(s) (“Purchasing Firm”)
In general economic theory, we know that consumers will consume a good as long as price of good is less than (or equal to) the benefit received by the firm. Consumers consume based on personal utility and firms consume production inputs to minimize cost (or maximize profit). It is possible to calculate the contribution of consuming this input to total profit.
Mathematically, this is means that a transaction to purchase a good or service will occur only if:
What’s interesting to me is that you never read about why we use "revenue" (or a multiple of revenue) to establish a firm’s valuation.
I was considering company valuations last week from an economic perspective - thinking more about how and why companies are valuable and how they fit into the broader economy and less about the plug-and-chug, back-of-the-envelope modeling that is common in finance. It made sense that a firm’s value solely should be based on the benefit that its customers receive from purchasing the firm’s products and services.
The outcome of this explanation is to show how we can generate the value of a firm (“Supplier") based on its sales to its customer(s) (“Purchasing Firm”)
In general economic theory, we know that consumers will consume a good as long as price of good is less than (or equal to) the benefit received by the firm. Consumers consume based on personal utility and firms consume production inputs to minimize cost (or maximize profit). It is possible to calculate the contribution of consuming this input to total profit.
Mathematically, this is means that a transaction to purchase a good or service will occur only if:
Price of a Good ≤ Value
So, if the value of a good is expressed in its price, then the value of a product is equal to the maximum price that the good’s consumer is willing and able to pay.
Total Value of a Good = Max Price Paid by Purchaser
(This sort of reinforces what we said above about a transaction taking place only if the price of a good is less than or equal to its value to the consumer.)
In a perfectly competitive market, firms produce to a point where their marginal cost of producing a product is equal to the marginal benefit gained from its sale. This is represented by the marginal cost/marginal benefit curves, also more commonly known as “Supply” (marginal cost curve) and “Demand” (marginal benefit curve).
If a firm produces to the point where MC = MB, then the costs to the Purchasing Firm for the good will be equal to the revenue of the Supplier. Conversely, the revenue of the Supplier will be equal to the marginal costs of the Purchasing Firm, which happens to be equal to the marginal benefit received by the purchasing firm.
So if we want to determine the Supplier’s value, then we can assume that its value is equal to the total marginal benefit experienced by all Purchasing Firms, which we’ve said happens to be equal to our Supplier firm's revenue.
In a perfectly competitive market, firms produce to a point where their marginal cost of producing a product is equal to the marginal benefit gained from its sale. This is represented by the marginal cost/marginal benefit curves, also more commonly known as “Supply” (marginal cost curve) and “Demand” (marginal benefit curve).
If a firm produces to the point where MC = MB, then the costs to the Purchasing Firm for the good will be equal to the revenue of the Supplier. Conversely, the revenue of the Supplier will be equal to the marginal costs of the Purchasing Firm, which happens to be equal to the marginal benefit received by the purchasing firm.
So if we want to determine the Supplier’s value, then we can assume that its value is equal to the total marginal benefit experienced by all Purchasing Firms, which we’ve said happens to be equal to our Supplier firm's revenue.
Simply put:
Value of a Firm = Total Marginal Benefit Received by its customers = Total Revenue of Firm
Instead of using the Revenue Multiple Approach, we could call our company valuation model method the “Marginal Benefit Valuation” (MBV) because when we’re using revenues to determine a firm’s value, we’re really just calculating the firm’s total marginal benefit to its customers.
Finally, the last step in this process would be to take some reasonable time period, project revenues each year over that time horizon, use a discount rate that correctly assumes risk level or opportunity cost, and calculate a firm's value based on the discounted revenue streams during this time. And there's the basis for firm valuation using revenues to make the determination.
As an extension to the discussion ---
Which multiple to use (1x, 2x, 10x, 100x…)?
Much of that decision is subjective based on brand recognition, future company growth, the industry, and pure subjectivity. (We all remember the dotcoms where business valuations were based on which venture capital firm was willing to bid the highest.) This is another article in itself….
Why use multiples of revenues?
Well, as a part-time academic (I teach Finance at the University of San Francisco), I’ve personally never been able to get my head around using the RMA. If revenues are the choice for determining a company’s value (because they represent the Marginal Benefit received by their customers), it seems that it is far more logical to calculate the present value of future revenues. If one is particularly bullish on a company’s future prospects and would like to reflect this attitude in a company’s value, just adjust the discount rate downward and adjust the growth rate upward to yield higher present value (or higher company value). But of course, then you’re infusing significant subjectivity to the equation, but this approach offers a more sound theoretical modeling technique.
As an extension to the discussion ---
Which multiple to use (1x, 2x, 10x, 100x…)?
Much of that decision is subjective based on brand recognition, future company growth, the industry, and pure subjectivity. (We all remember the dotcoms where business valuations were based on which venture capital firm was willing to bid the highest.) This is another article in itself….
Why use multiples of revenues?
Well, as a part-time academic (I teach Finance at the University of San Francisco), I’ve personally never been able to get my head around using the RMA. If revenues are the choice for determining a company’s value (because they represent the Marginal Benefit received by their customers), it seems that it is far more logical to calculate the present value of future revenues. If one is particularly bullish on a company’s future prospects and would like to reflect this attitude in a company’s value, just adjust the discount rate downward and adjust the growth rate upward to yield higher present value (or higher company value). But of course, then you’re infusing significant subjectivity to the equation, but this approach offers a more sound theoretical modeling technique.
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