No Revenue, Profit or Free Cash Flow? Now what?

Posted on February 12, 2008

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In my recent post, I discussed how a firm’s value could be determined simply by discounting the total revenue of the firm over a reasonable time period using an appropriate discount rate – the “Discounted Revenue Valuation Model” (DRVM)- because a firm’s revenue represents the total benefit received by its customers.

DVRM focuses more on the economic, or intrinsic, value of a firm, not the market value of a firm. Financial markets and investors have shown a propensity to ignore economic valuations, instead valuing firms at artifically higher levels, creating a “market value” that exceeds true “economic value.” This is the fundamental issue that I am addressing in these series of posts.

While I think DVRM a good starting point to begin to alter the way we think about firm valuation, practical challenges emerge with using this approach.

From a financial and accounting standpoint, it is possible for a firm’s expenses to exceed its revenues. If a firm under evaluation has this condition, then the firm would not be a sustainable enterprise over the long run (assuming no change in the growth rates of revenues relative to expenses over time). So it seems that revenue alone cannot serve as the only indicator or proxy for determining firm value.

Arguably, it would be more responsible to take into account what’s left from a firm’s revenue after deducting all expenses. This is commonly known as “income” or “profit.” Instead of using revenue, one could project a firm’s annual income over a reasonable time horizon, determine a discount rate that fairly represents the risk level or opporunity cost of capital for the firm, and reach a new value for the firm. Using this method, there is the implicit correction for expenses incurred by the firm to achieve their revenue.

Even so, there are still problems with using a “Discounted Income Valuation Model.” Primarily, accounting rules allow for a firm to claim expenses and revenues that are non-cash events, such as Depreciaton and Amortization on the expense side of things and Accounts Receivable on the revenue side. Therefore, accounting rules show that a firm may show an accounting profit, but may not have positive cash flows.

Cash is king, and anyone who’s every been without money when they need will certainly attest to this. This leads us to using annual Free Cash Flows (FCF) to determine a firm’s value. Just as we did with our Revenue Valuation Model and Income Valuation Model, we just forecast FCFs through a reasonable time period, discount them back using an appropriate discount rate, and now we have the true “value” of a firm.

Every textbook in basic finance espouses this method for properly determining a firm’s value. This line of reasoning – starting with revenues, then using profits, and then using FCF to determine a firm’s value – is exactly why textbooks and academics argue that the Discounted FCF Method is the proper technique to value an asset (or firm in this case).

But, here’s the big problem –

Most start-ups generally have no FCF, Revenue, or Profit. And if this is the case with Facebook (which does have some revenue, though very little relatively speaking), how can you logically use some variation of the Revenue or FCF Valuation Models to accurately determine the true intrinsic or economic value of a firm?

I would argue that you can’t. Throwing out valuations such as 10x revenues or 100x revenues to determine a firm’s valuation is an economically unsound practice. There must be a better way to calculate firm valuation outside of some variation from the Revenue or FCF Models.


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