As the warm and fuzzy memories of summertime fade into the distant past, it is once again time to start setting the alarm clocks, buying new textbooks, and catching up with our friends we have not seen over the break. In other words, it is back to school time.

While I used to think that the year starts on January the first, I have now come to the realization that much like the English Premier League, the year really starts in late August and goes with a frantic and exciting pace all the way to the next summer. So welcome to the 2022 – 2023 season! I hope that it will be one filled with excitement, lots of goals, and most importantly, fair play.

As we think back to the second half of the 2021 – 2022 fintech season that we left behind, the defining feature was of course a momentous shift in company valuations. On the public side, there was no hiding from this painful reality, whereas on the private side it seems like many people are still coming to terms with it. Our more practical minded Swedish friends such as Klarna seem to have accepted the fact, dealt with it, and moved on, while others that are living in a sort of denial can still be found.

Lots of good pieces have subsequently been written on valuation over the summer, some dealing with the relationship between EBITDA and revenue, and translating revenue multiples into the context of future growth expectations, etc.

Those have all been good to read, but in the spirit of back to school time, it would be good to look at company valuations from a very rudimentary perspective. Specifically, let’s look at four simple principles that can be used to create a valuation framework for companies – profits, time value of money, growth, and risk.

Let’s start with profits. To put it very simply, companies are ultimately only valuable if they can generate net income that can then be distributed back to investors as a dividend. If I told you that I had a company that will never generate a single dollar of profit in its lifetime, or there was one where all pre-tax profits would be swept up by an evil troll (no, I am not talking about the IRS here) at the end of the day such that they can never dividend out any profits, the answer to what those companies are worth would be very simple. Zero.

Now that we know we need profits (one would hope we really didn’t need a reminder), let’s look at a way to value those future profits. This takes us to our second principle, the time value of money. Stated simply, this principle tells us that a dollar today is worth more than a dollar tomorrow. The current inflationary environment illustrates this fact very clearly. If a tomato costs $1.00 today, but will cost $1.25 next year, my $10.00 buys me ten tomatoes today, but only eight tomatoes next year.

Hence, $10.00 to be received next year is only worth $8.00 today if measured in tomatoes. The rate at which we discount the future cash flows (25% in our tomato example) is denoted as “r” in finance, and is called the discount rate, interest rate, or cost of capital depending on the context. Hence, $1 in the next period is only worth 1/(1+r) today which is one of the three key formulas you’ll ever need in finance.

The second formula you’ll need (and with these two you can derive other more complex looking formulas) is a mechanism for valuing an annuity. An annuity is a constant but perpetual cash flow, and is the other basic building block for valuing cash flows over time.

For example, let’s assume we have a company that will generate exactly $100 million of dividendable net income per year, from now until the end of time. What is this company worth? I will give you a hint – it is not infinite!

To answer the question, let’s assume that the cost of capital, or “r” from above, is 10% – in other words, investors can put their money in an equally risky venture and earn a 10% return. So what is the answer?

While many people get this question wrong, the simple answer is that it is a unicorn – worth $1 billion! The formula for valuing an annuity is simply to multiply the annuity (in this case the $100 million) with 1/r. Put simply, 1/10% = 1/0.10 = 10, so multiplying $100 million by 10, we get to a billion.

A convenient way to keep this formula in mind (and also to prove it to be correct mathematically) is to ask the reverse question. If I could earn a 10% annual return on my capital in perpetuity, how much would I need to set aside today to generate $100 million year after year? The answer is $1 billion – just put it to work and clip that 10% coupon – not a bad way to earn $100 million per year!

While these two formulas are all you need to derive other time value related formulas in finance, they leave out one important fact we in the venture capital world care dearly about – growth. A cash flow that grows is obviously worth more than a cash flow that does not, and our annuity example above related to a zero growth, constant cash flow.

So how does the growth rate, usually denoted as “g”, impact the value of an annuity? The answer is that the value of an annuity becomes 1/(r-g), so if we assume a 5% perpetual growth rate, the unicorn in our prior example suddenly doubles its value to become worth $2 billion ($100mn/(10%-5%) = 100mn/5% = 100mn/.05 = $2bn).

*[A note to those who want to geek out a little bit: As promised, this seemingly new formula is derived from the prior two formulas under time value of money. Follow the proof & derivation from this link: https://en.wikipedia.org/wiki/Dividend_discount_model*

However, there is one more important insight around growth that we need to keep in mind while valuing companies. In the long run, nothing can grow faster than GDP. Think of this as the speed limit of the universe – nothing can travel faster than the speed of light. Taking Apple as an example, after they have produced billions and billions of phones and computers, at some point they will have saturated their addressable market, and their growth will be bound by how fast GDP can grow. If this were not the case, at some point Apple would literally take over the world.

So if you want to value Apple, one way to do it would be to model out the growth in profits year by year until they reach that “end state”, then come up with a terminal value based on the constant growth annuity formula from above, and then time value all those cash flows into the present. Sounds simple, right? No wonder stock prices can be volatile!

But the point is that the problem is not one of lacking the necessary math – it is actually one around the difficulty of forecasting how fast exactly Apple will grow, what their competitors and regulators will do, etc.

Which finally brings us to our fourth and last principle, risk. In simple terms, the more difficult it is to forecast and rely on those future cash flows, the higher the risk, which in turn means the higher the “r” you need to use to discount your cash flows. And vice versa.

To summarize, our unicorn from above, that has $100 million in net profits, and will grow at 5% until eternity, is worth $2 billion if our cost of capital is 10%. If they manage to grow faster, they will be worth more, but they cannot grow faster than GDP in perpetuity. If our cost of capital (i.e. risk) goes up beyond 10%, they will be worth less.

So sharpen your pencils, take out your calculators, and get to work – there are many companies to value out there, and don’t worry about running out of interesting subjects – we’re creating new ones every day!