As an Investor, You Can’t Afford to Not Understand This

As an Investor, You Can’t Afford to Not Understand This

Mr. Wonderful here –

There’s an old saying that bull markets are born in doubt and die in euphoria. Well, last year’s bull market went to slaughter with a near unprecedented 39x P/E multiple on the Nasdaq 100 index. Today, that multiple is down by nearly half, and it took out a lot of investors who were too naive to see warning signs in the valuations.

You may not like it, but investing is a cutthroat business. And whether you’re trading public securities or backing startups on platforms like StartEngine – if you don’t want to get wiped out, you need to understand valuation.

How much is what I’m buying really worth?

When a founder gets in front of me and says, “I want $200k in exchange for 5% of my company,” my first step is to work out the market capitalization. Basically, if 5% will cost me $200k, how much is the whole kit and caboodle? Well, 5% is a twentieth of the entire pie, so $200k X 20 = $4M post-money or including the value of my investment.

Ok, great – now I need to know why? Why is this idea they’re sitting on worth $4M? This is where smart investors start doing their homework. Don’t kid yourself, though – there’s no silver bullet for assessing valuation, but generally you want to look at some combination of the following factors:

• What’s the market cap? How many shares are outstanding and what’s the price per share? (Companies raising on StartEngine will list this in their offering circular).

• What are the revenue and market multiples? How many times greater is the valuation than revenues in say the past year – or projected revenues? How does this line up with other recent exits in the industry?

• How wide is the moat, and what’s the cost to duplicate? How expensive would it be for me to recreate this company from the ground up? What’s the value of their IP and other assets?

Now, you have to take into account where a company is in its life – especially in startup investing. Roughly speaking, nowadays a business in its Series A will have a valuation that’s about four times higher than in the Seed Round. So if a brand new company comes to me with a great pitch and terrific IP, I’ll listen – after all, I’m nothing if not reasonable. But if they claim they’re worth $60M (the average pre-money valuation of a Series A from the most recent reporting) with nothing to show for it, you can bet I’ll put them in hell in perpetuity.

Don’t be a sheep – lower valuations = more equity.

Here’s where a lot of investors go wrong: Today stock prices on public exchanges and valuations in private markets are generally down across the board. Many will sit on the sidelines and wait for the next market euphoria (and we know what happens then). But smart investors will see opportunity to seize equity – and that’s how you grow from a minnow to a shark.

Kevin O’Leary is a paid spokesperson for StartEngine. View the details here.