Tech Company Valuations: How to Value a Technology Business and Win the M&A Game

Valuing a technology company is different from traditional valuation methods due to the unique nature of the industry.

Several key differences separate technology companies from other businesses:

• High growth rate of many firms
• Negative earnings at the early stage.
• A significant share of intangible assets not reflected in the financial statements, such as patents, customer data, and others

How to Value a Tech Company

Traditionally, valuation methods have been divided into income-based, market-based, and asset-based.

1. Income-based approach. Performing a discounted cash flow analysis based on financial projections
2. Market-based approach. Benchmarking to comparable public companies and precedent transactions
3. Asset-based approach. Estimating the fair value of the company’s assets and liabilities

Most technology companies have very few tangible assets, while years of investment in technology are rarely reflected on the balance sheet. That is why income-based and market-based approaches are more suitable for technology company valuation.

In this article, we briefly summarize these two standard methods and their peculiarities when applied to tech companies.

Discounted Cash Flow (DCF) in tech company valuations

A discounted cash flow valuation is a business valuation method that estimates a company’s value based on its expected future cash flows.

The expected future cash flows are modeled based on the financial projections for the company, which include assumptions for revenue growth, operating expenses, CAPEX, and working capital. Detailed financial results are usually modeled for 3 to 5 years, after which a stable cash flow growth rate is assumed.

The discount rate used in the valuation is typically the cost of capital for the asset, which reflects the riskiness of the cash flows. It can also be the required return rate for the investor performing the valuation. It is usually higher for tech companies than traditional businesses and exceptionally high for riskier early-stage businesses.

The present value of the projected cash flows is then determined by discounting them at the discount rate. A sensitivity analysis that estimates the valuation depending on the changes in critical assumptions is commonly used to see how robust the valuation is.

With numerous assumptions and detailed calculations, DCF valuation is considered the most precise, as it is deeply rooted in financial theory. Yet the number of inputs and difficulty in interpreting makes this method cumbersome in tech company valuation.

Many tech startups are operating in highly uncertain environments, so predicting revenue and earnings far into the future is difficult. At the same time, slight changes to the terminal growth rate and discount rate significantly affect the final value, rendering the method of little use.

The model can be helpful for mature technology companies with stable growth and predictable profitability. Still, even in such cases, investors prefer a more straightforward multiples method and will express the DCF valuation result as a multiple of Revenue or EBITDA.

Additionally, DCF can be a useful tool to understand the drivers of the valuation: playing with revenue growth rate, profitability or other assumptions may give a good idea of what metrics affect the valuation the most.

Revenue or Earnings multiples

The most common method for valuing technology companies is using a multiple of revenue or earnings.

The revenue multiple is used when the earnings multiple cannot be calculated, as there are no earnings. It is prevalent for technology companies, such as SaaS businesses that invest aggressively in customer acquisition and growth. While not directly related to cash flows, using revenue multiple can still be a useful benchmark when an earnings multiple cannot be applied.

Earnings multiples are typically used for mature tech companies with a history of positive earnings. The earnings multiples method is, in effect, a simplification of the DCF valuation method, as the higher value of the multiple corresponds to lower risk and higher growth of the company.

One of the most commonly used valuation multiples for technology companies is EV/EBITDA.

EV is an abbreviation of Enterprise Value, a comprehensive measure of company valuation that accounts for equity value and its financial debts net of cash. It allows to value a company’s operations irrespective of how the company is financed (by debt or equity).

EBITDA stands for Earnings before interest, taxes, depreciation, and amortization and is considered a good proxy for the company’s cash flow. For calculating multiples, it is advisable to ensure EBITDA is normalized: cleared of one-off items and owner’s costs to show the true earnings potential of the company.

As EBITDA is a proxy for cash attributable to both equity holders and debt holders (the interest is added back), the numerator of the EBITDA multiple is Enterprise Value.

The second input in earnings valuation is the multiple itself. The two most common sources of comparable multiples are publicly traded companies and precedent transactions.

Public comparables

Publicly listed companies are traded on stock exchanges daily and are required to report financial results quarterly. Therefore, it is easy to calculate the multiples implied by the investors for any company using the current stock price and most recently reported Revenue or EBITDA.

To benchmark a company to public comparables, it is essential to select a proper peer group: the companies that operate in the same industry and have similar growth rates and risk profiles. The peer group is never perfect, so the practice is to include more companies in the comparison and provide a range of multiples.

It is important to note that publicly traded companies typically enjoy a higher valuation than their private peers. First, public companies have lower risks due to having audited financials and corporate governance. Second, their shares are liquid, which provides significant value to the holder.

Precedent transactions

While listed companies are multi-billion dollar companies with liquid shares, private M&A transactions happen among companies of all sizes. Benchmarking a company to precedent transactions would typically yield a more accurate result.

The challenge here is to collect a large enough number of comparable transactions. The deal values in private transactions are rarely disclosed, and the transactions themselves are difficult to find. Therefore you need access to large datasets of past M&A deals to build a relevant peer group.

It is possible to calculate the multiples used in the precedent transactions by searching for press releases announcing the acquisitions. M&A advisors typically have access to specialized databases, which can create the precedent transaction analysis for you.