Valuating an IT Company – Important parameters, concepts, and method

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Valuation of software IT company

Valuation is a tricky business, so many methods, so many different parameters, and one thing that means something, means altogether something else the moment you change the underlying business. Confused? Read on.

Asset of a company for a banking stock could mean a loan book. But, if you take a mining company, then looking at asset is whole together a different thing. Mining companies include left-over mine capacities in asset sections, and if you know this already, you’d look at assets differently for a banking stock, and differently for a mining stock.

Now, coming to valuating an IT Company, what all goes into this valuation? What are some of the tricks that we must be aware of, or else, we are set for a faulty valuation.

If I were to turn bookish, I’d tell you most common valuation methods are –

  1. Income based
  2. Assets based
  3. Market based

But, what you’d miss is seeing through & reading between the lines, and that is my I am not going to talk about any of these above 3 valuation methods. Instead, I am going to take a path less traveled.

No Moat

Remember, starting an IT company is no longer an uphill task. Anybody with skill, and a few resources can start a company in garage. So, first and the most important point to understand is – There are very low entry barriers, and hence, if an IT business is new & operates in services domain, unless they are offering extremely niche services, it is going to be a ZERO moat business.

No Moat –> Over Crowded Market –> Lot of Competition –> Limited Scalability –> Certainty of Changing Business Dynamics –> Small change in market sentiments could be large impact on sales & revenues.

Limited Tangible Assets

Usually, IT Companies have very limited tangible assets. All they own is hardware & some licenses. What value do these things have if you were to go public? Zilch. Nothing!

However, there is one extremely important, but intangible asset that these companies own – Its people. You cannot value someone’s worth in numbers and add up that to find a valuations. Intangible assets mean a lot more for an IT company. But, how to read & understand what does intangible assets really mean when you are doing a valuation?

A few important points to start with

  • Find out if your company is into IP/Products segment. If yes, find out the size of the IP/Product team
  • Then find out the segment-wise revenue & profits for IP/Products
  • Find out the number of licenses sold during a year, and determine the phase that product is into using bell curve analysis

product lifecycle

When the IP/Product is launched, sales revenue is low, capital utilization is low, and cash flow is mostly negative. This is because an IP or Product needs high investment in inception phase. The customer may be hesitant to buy an unproven product and a heavy advertising is required to create awareness.

Next, in the growth phase, if product has gained some ground, sales will start increasing, and there will be high capital expense, and once sales start to increase, cash flows turn around, and you start noticing a positive cash flow.

At maturity of the product, it is observed that sales slows down & sales growth is low. Profits falls & usually company starts cutting down on the price as well.

During the terminal stage of the product, sales are at their lowest levels. R&D Costs are minimal, and it is sign to look for alternative product.

What does above data mean?

It simply means how to link intangible assets with the product sales, capex, R&D Costs, and Profitability. If the product is offered in a niche & highly demanding domain, you’d notice a very high R&D Cost, and most of the profitability comes from fewer licenses, but product consulting, implementation, maintenance, and upgrade brings in a lot of revenue for the company. If you notice the revenue coming in steadily for years for a given product, you should know that for this IT company, its people is worth everything! The most important asset perhaps is its people. 

Always discount future cash flow

Usually, when a company is new or has limited history, there is uncertainty about sales. If it is a product company, product lifespan may not be determined precisely. and if there are PE Investors in the company, then it is safe to assume those PE investors would want a very high return on investment and you will have to significantly discount future cash flows.

In addition, if you notice that product may not have a very long lifespan, then you also have to cut short the time frame considered while doing FCF Calculations.

Contract Negotiations

Usually mid-size IT Companies tend not to invest heavily into product development. Especially if it is high capital consuming product. For e.g. Persistent Systems joined hands with IBM to develop a cloud platform product called as IBM Watson IoT. It was both prudent & safe for Persistent not to develop a similar product by its own. However, the contract with IBM was such that the revenue realization would take some time. So, while doing valuations for Persistent, it was essential to understand contract negotiations with IBM.

Some companies face difficulties in revenue realization, especially if they are new & small, but work for a large organization or a government institution. In such cases, these IT companies would require to put in lot of upfront money into product development, implementation, and sign off, but revenue from the vendor or a customer may not be realized immediately. In such cases, company’s Top & Bottom line takes significant hit, but that does not mean company is going in junks. It is important to know how sooner revenue will be realized. Reducing trades receivable is a great method to keep track of how company is getting to negotiate contracts more into its favor.

Valuating Data

As data is new oil, understanding how much data would be worth for the company can actually change entire valuation metric upside down. According to survey made by a company called Wester Digital, people think that their personal data is worth £3,241. That is huge! Tempted to do valuations for Google/Apple/Amazon/Facebook?

Other important factors

I’d list down a few other important factors that you can use to evaluate a software business or an IT company.

Industry – Essential as it sets the tone for valuation. IT company operating into highly critical domain worth a lot more than just another IT Services company

  • Net Profits
  • Growth Rate – Both Revenue & Profits
  • Last 12 moth sales
  • Management Salary – Both Absolute & as a % of net profits
  • Management salary as a % of dividends paid to investors
  • Years since operation
  • Niche/Competitors/Assets
  • Intangible Assets
  • Any trademarks, IP, Brands owned
  • Real estate & office space owned
  • Patents & Royalty fee as a % of profits
  • Customer List – Should be growing
  • Management – Ethical, clean management, should preferably have salary less than 20% of the profit, variable compensation is not counted for as it is linked to growth

 

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