Understanding tech investment: A how-to guide

Quarterly global financing trends to private technology companies (US$ billions)

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Source: Venture Pulse, Q3'16, Global Analysis of Venture Funding, KPMG International and CB Insights (data provided by CB Insights) October 13th, 2016.

How organic growth creates value

Andrew Macken, Portfolio Manager, Montgomery Global Investment Management

The most common mistake that investors make when valuing technology companies, in my view, is the failure to appreciate the power of organic growth on value creation. When a more traditional company grows, it typically needs to invest in new capacity to grow supply to meet the increased demand. If a business can earn high returns on each increment of invested capital, then this is a high-quality business. But even better is a scenario in which the business does not need to invest much at all to meet the incremental demand – as is the case with some technology companies. This is called organic growth – and it is very powerful. For example, if your business can generate 15% annual earnings growth organically for just ten years, then a 30x price-to-earnings ratio is likely entirely reasonable.

Picking the right tool for the job

Delian Entchev & Nick Cameron, Investment Analysts, Watermark Funds

EV/Sales is a good relative valuation metric for tech companies generating revenues and in high growth phases of their life cycle. EV/Sales also works well for tech companies transitioning from rapid growth infancy phases to adolescence where the majority of the investment cycle has been completed.

For those with positive FCF (free  cashflow) generation, EV/FCF works well too as it captures capitalised  R&D costs/intangibles that are common with tech companies. EV/FCF for the maturing, fully matured,  and sunset companies. It works very well as tech companies in these stages have typically turned to returning a higher percentage of FCF to shareholders.  More mature tech companies are also valued using PE multiples, but we prefer EV/FCF for reasons outlined above.

Our preferred and more comprehensive valuation method is to perform a DCF (discounted  cashflow) valuation of a discrete period of FCFs and then use a terminal year multiple (take-out multiple) such as EV/FCF or EV/Sales as opposed to a perpetuity model.

The number 1 priority is being number 1

Nick Griffin, Head of Investments, Munro Partners

For many technology companies, particularly hardware companies, the P/E ratio is still appropriate. Rather, it is the internet and digital companies where we look differently. Most digital / internet companies we look at generally evolve towards a ‘winner takes all’ or ‘winner takes most’ outcome. Google is probably the best example as it is now the world’s dominant search engine and that is now very hard to take that away from them, giving Google unique pricing power and market dominance.

Consequently, taking into account multiple analysis for digital / internet companies and whether they are number one or have a strong chance of being number one, is very important for modeling earnings. Google is number one in Search and has a market  capitalisation  of $549 bn. Yahoo is the number two player in search, and it was recently sold for just US$4.8bn. If a digital / internet company has a strong chance of being number one we will usually use aggressive assumptions and value with a DCF or  a five years  out multiple. If a digital / internet company is less likely to be number one, it is likely to get caught continuously overspending on customer acquisition. In this case, a DCF will still work, but our earnings and  cashflow  assumptions will be much lower.

Further reading

Investing in technology-based companies requires a whole new set of knowledge and different way of thinking. For ‘first-timers,’ this can no doubt be intimidating. To help readers better understand the intricacies of technology investing, we asked our three investors for their recommended resources.

Nick Griffin, Head of Investments, Munro Partners

Recommendation: ‘The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies’ by Erik Brynjolfsson and Andrew McAfee. (VIEW LINK)

What he said:

“(The book is) a continuation of their book Race Against the Machine. It provides a good description of such concepts as ‘Network Effects’, ‘Moore’s Law’ and ‘Artificial Intelligence’, which important to understand why digital / internet companies are generally ‘winner takes all’ or ‘winner takes most’, thereby disrupting the concepts of traditional economics and hence technology businesses cannot be analysed in the same way as a traditional business. The book also provides some helpful tips on how to educate one’s children to deal with a world where most menial tasks will be automated. “ 

Andrew Macken, Portfolio Manager, Montgomery Global Investment Management

Recommendations:

KPCB - (VIEW LINK)

Andreessen Horowitz - (VIEW LINK)

Follow Venture Capitalists on Twitter - (VIEW LINK)

What he said:

“There are a number of helpful resources out there to learn about investing in technology companies. Naturally, some of the best technology investors in the world are based in Silicon Valley; and many of these firms publish educational content that can be very insightful. Furthermore, by following various venture capital investors on Twitter, one can learn a great deal from the insights and commentary that are posted on a daily basis. “

Glossary

Capitalised R&D – Research and development that is held on the balance sheet as an asset and then depreciated over its useful lifespan. The alternative is expensing R&D, which means the cost appears on the income statement as an expense in the year it’s incurred.

Discounted cashflow (DCF) – The process of valuation undertaken by most analysts and fund managers. It involved forecasting future cashflows and ‘discounting’ them back to today’s rate at an appropriate hurdle rate, discount rate. Learn more here: (VIEW LINK)

EV/Sales – Enterprise value is the market capitalisation of the company plus the market value of any debt or hybrids. This is divided by the sales of the company as a relative pricing measure, usually when earnings are negative or very low.

EV/FCF – Similar to the above ratio, however instead of sales, free cashflow is used.

Out multiple or take-out multiple – A multiple that is applied at the end of the forecast period for

Sunset companies – A company nearing the end of its lifecycle.