Investors should take either a bottoms-up or a top-down approach as the initial step to valuation. Value investors typically use a bottoms-up approach when looking for companies trading at a discount to book value or low multiple of cash flow. Momentum investors looking for earnings growth expansion based on improving prospects of an industry usually use a top-down approach. Industry trends, competition and a company’s business model are relevant factors that need to be assessed before determining the fair valuation for a company. This insight helps us determine the metrics and multiple ranges that are appropriate. Limited information can play havoc on the valuation exercise.
The best valuation metric is cash flow. One can also use earnings, net asset value and, as a last resort, revenue multiples, depending on the situation (i.e., no earnings). In addition, gross margin, sales network structure, balance sheet strength, backlog, days sales outstanding and management are reviewed as differentiators between companies. The final step is the incorporation of market psychology. This can be a major wild card in the valuation process. Negative market sentiment can weigh heavily on an industry and especially a stock. In the end, valuation can differ from individual to individual, hence the opportunity to capitalize on deviations from the efficient market theory as all opinions are aggregated over time. A look into the conferencing sector provides insight into how valuation can differ within a sector.
The conferencing sector has been top of mind since the Sept. 11 tragedy cut business travel and prompted the use of Web and phone conferencing. Companies such at ACT, Centra, Genesys, Raindance and WebEx were expected to benefit from this shift. These expectations pushed the stocks and valuations higher based on future earnings upside. With strong industry dynamics, analysts have been focusing on individual business models to gauge appropriate valuation (i.e., client base, competitive positioning, pricing power, etc.).
The sector has three business models—traditional phone conferencing, integrated phone and Web and pure Web conferencing. The traditional model has the lowest margins and the least pricing power as opposed to the Web conferencing model. Applying these business model characteristics to valuation of individual companies, the market has placed the highest multiple on WebEx based on its proprietary offering and positioning (Web-based), growth opportunity, cash flow and industry-leading margins. On the other hand, traditional teleconferencing companies have received lower valuation due to pricing pressure among competitors and subsequently lower margins. Raindance, an integrated solution provider, finds itself in the middle in terms of valuation as the company continues to try to improve its margins as it alters its revenue mix and leverages its cost structure.
Pure Web conferencing companies have gross margins in the range of 75 to 85 percent and expectations of solid earnings growth, whereas the traditional providers generate lower margins of 50 to 60 percent and moderate EPS growth based on economic and competitive pressure. Thus, the Web providers have traded and will trade at a premium Total Enterprise Value (TEV) to EBITDA multiple versus the traditional audio providers. TEV to EBITDA is the valuation metric most appropriate for the industry based on our analysis. It enables us to make an apples-to-apples comparison of all the providers, which in several cases don’t or will not have earnings in the near future.
Peter L. Martin, CFA, is an author and consultant, providing in-depth coverage of the knowledge services industry.