Plain Vanilla Unicorns

From the Wikipedia:

Plain vanilla is an adjective describing the simplest version of something, without any optional extras, basic or ordinary. In analogy with the common ice cream flavour vanilla, which became widely and cheaply available with the development of artificial vanillin flavour. Certain financial instruments, such as put options or call options, are often described as plain vanilla options. The opposite of plain vanilla options are exotic options.

Everyone knows that a unicorn is a company valued over $1B, but not many understand anymore what a $1B valuation implies in terms of cash generation. I can safely state that after these last 5+ years working in tech.

Most of the unicorns we read every day about bleed red. They are often many years away — some of them forever — from generating free cash flow for their shareholders. They are often young, high-growth, uncertain companies for which forecasting cash flows is an exercise of sorcery. A DCF model is an even more mythical creature than the unicorn itself, and not without problems of its own. Let’s add to that the fact that valuations in venture-backed companies are often nothing else but a number which results from dividing the money raised by the desired dilution for the existing shareholders. The most sophisticated thing you would do as a venture investor is to use a revenue multiple.

The result? We no longer understand what those valuations actually mean in terms of cash generation. Because, from a financial perspective, that’s what companies are about, aren’t they?

And that’s exactly what I am trying to provide here: a visual image of what the most basic unicorn — the plain vanilla unicorn — might look like.

Perhaps you might find useful to have that image in your mind.

Bear with me.

The simples equity valuation model

The simplest equity valuation models are the dividend discount models, and, among those, the simplest is the Gordon Growth Model (GGM).

Under the assumption of perpetual constant growth, the present value of an infinite stream of dividends (or cash flows) can be calculated as:

V0 = D1 / (r — g)

The formula states that the value of a company today (V0) is equal to the dividend the company will distribute the next year (D1) divided by the difference between the required equity return (r) and the perpetual growth rate (g).

We are trying to solve for D1, i.e. the free cash flow for the equity holders that a company has to generate in year 1 — and from then until infinity growing at a constant rate g — to be valued at $1B, because that’s the image that I would like to have in my mind.

Solving from the previous formula:

D1 = V0 x (r — g)

V0 is known. It’s $1,000,000,000. So, to calculate D1, we need to assign values to r and g.

Let’s start with g, the constant growth rate.

Dealing with infinity is no joke, and g is no exception. Since no firm can grow forever at a rate higher than the growth rate of the economy, the constant growth rate cannot be greater than the overall growth rate of the economy. Let’s set g at 5%, which is a very high constant growth rate (usually g doesn’t exceed 2–3%). It implies that the company will double in value every ~14 years…FOREVER.

Now let’s move to r, the required return to equity.

The required return to equity is a discount factor which should compensate the investor for the riskiness of the investment as compared to other investments (this particular stock vs. the broad equity market, and stocks vs. risk-free assets such as sovereign bonds). This is the discount factor used in a DCF model.

Let’s use a formula from CAPM, the most widely used (and hated) model in the industry.

According to CAPM:

r = RF + (Beta x ERP)

where,

• RF, the risk-free rate is the yield of long-term government-issued bonds. I will use a value of 2,70% (source)
• Beta is a measure of the extra riskiness — measured by its volatility — of a particular stock vs. the broad equity market (if the volatility of a stock is higher/lower than the volatility of the market, its beta is greater/less than one). I will use a value of 1,32 (source)
• ERP, the equity risk premium, is the extra return equity investors need in order be compensated for the higher riskiness of the asset class (as compared to risk-free assets). I will use a value of 5,60% (source)

Combining all three:

r = 2,70% + (1,32 x 5,60%) = 10%

This means that, a rational investor, considering the riskiness of equity investments in general plus the extra riskiness of this stock in particular, would demand a 10% yearly return. This is not far away from the historical returns of the stock market, which gives us some confort. It also tells us that this value most likely on the lower part of the acceptable range for a risky high growth tech stock. In an early-stage venture investment, r can be as high as 50–60%.

Before moving on, let me clarify that, for our purposes, using a low value for r and a high value for g — as we are going to do — is conservative, in the sense that it lowers the cash flow needed to arrive at a $1B valuation (see D1 formula above).

[Another way to see this is that the value today (V0) is 1/(r — g) = 1 / (10% — 5%) = 20x D1, the free cash flow to the equity of Y1. Now you understand where that multiple comes from!]

The final picture

We have already all the ingredients required to calculate D1:

D1 = $1,000,000,000 x (10% — 5%) = $50,000,000

Combining all ingredients together, we can conclude that a plan vanilla unicorn — the simplest instance of the class unicorn, under all assumptions considered — is a company which generates $50M in free cash flow for the equity next year, and grows that cash flow at a 5% rate per year forever.

This is what the first 15 years would look like:

Closing remarks

Needless to say that this model is surely not the most appropriate one to value high growth tech stocks and that, even for this extremely simple model, an infinite number of scenarios (other values of r, g or timing of the cash flows) are not only possible, but highly advisable.

Now that you have this reference point, I leave you with the task of thinking what would happen if we changed r, g or the timing of the cash flows. What would happen if the company lived only for 20 years? If we are valuing a company at a 10x revenue multiple, what are the underlying assumptions for r, g and D1?

Remember, the only purpose of this post was to give you some hints about what a simple unicorn — if it generated cash — might look like.

Now it is your turn to spot them in the wild!

Thanks,

Samuel