1. Firm Life Cycle
Let's look at a firm's typical life cycle and see how that relates
to the multiples that are used to value the company.
So on this chart, starting on the left side, we've got the inception
of the business all the way through its early growth phase,
acceleration and slowing growth, maturity, late maturity and eventual decline.
Let's think about the metrics that correspond with these sections of a business
life cycle. The first is sales. At the inception of a company,
sales are zero, but that ramps up over time,
but profit lags. So you'll see what this means is that the P
E ratio, for example, cannot be used with an early stage company that
has negative earnings, but an EV to sales multiple could be used instead.
So you'll see EV to sales with earlier stage companies.
Finally, you see that cash flow even lags profits,
and the reason that this happens is that capital investment is spent upfront
and is slowly depreciated through the income statement. So in the early
stage, that means profit is often higher than cash flow,
but at a later stage of a company's life cycle, the cash flow
can be higher than profit as the company re invests less cash in
the business. So basically, as the company moves from inception towards
maturity, we'll use enterprise value to sales, then probably enterprise
value to EBITDA and then price to earnings or cash flows.
2. Let's practice!