“A paperclip can be a wondrous thing. More times than I can remember one of these has gotten me out of a tight spot.” – Angus MacGyver
How to value a business can feel like a MacGyver scenario at times given the constraints. Investors and companies are dealing with incomplete information, limited resources, little time, and future uncertainty. Finding a solution is part art, part science, and part circumstance. Given all these constraints, many lean on their swiss army knife of valuation frameworks- like revenue multiple or company comparison – to “MacGyver” the quickest, most efficient valuation solution.
While these methods are useful and have their place in the valuation toolbox, there are circumstances when using such approaches can meaningfully misvalue the long-term opportunity of a business. In these situations, it sometimes makes sense to value a company using its total addressable market as a reference point.
No single valuation method is perfect, but certain situations will favor some valuation approaches over others. It is my hope that by the end of this overview you will not only learn and understand how to value a business using market size but also recognize appropriate situations to apply it.
I have also evaluated Airbnb’s valuation opportunity using addressable market as a case study for using the methodology. So if you’re ever mysteriously locked in an Airbnb rental with only a paperclip and magnifying glass you’ll at least have an interesting framework for valuing the company.
- Using market size to value a business is more about trying to understand and frame a company’s opportunity than actually valuing it.
- The method is especially useful when attempting to value emerging technology platforms or products that have immature, unproven financials but are pursuing mature, proven addressable market opportunities.
- In hindsight the scale and magnitude of Airbnb’s valuation opportunity was apparent when assessing the total addressable market, but still required speculative conviction that the shift from hotels to homes would scale beyond the early couch surfing adopters and Airbnb was the team to execute that vision.
- The total addressable market can be huge, but execution is everything when it comes to actually achieving huge valuation outcomes.
- Companies with escape velocity growth and network effects are some of the most misunderstood and mis-valued investment opportunities in the market given the disruptiveness of their presence in the market and the difficulty of quantifying the impact of that disruption.
How To Value A Business Using Market Size: Overview
Illustrative Example & Steps
- Estimate total addressable revenue opportunity: Total Units x Revenue per Unit
- Estimate the industry’s after-tax profits: Revenue x Margin x (1-Tax Rate)
- Apply a valuation multiple on the profits to estimate the total addressable value of the market: (1 + Growth) / (Discount Rate – Growth)
- Alternatively a revenue multiple could be applied to estimate the total addressable value of the market
- Apply a current – or anticipated – market share to estimate the value of the business.
The goal of using market size to value a business is to approximate a company’s valuation when other methodologies may misvalue a company’s addressable opportunity. I’ve found this method especially useful when attempting to value emerging technology platforms or products that have immature, unproven financials but are pursuing mature, proven addressable market opportunities. As Fred Wilson astutely points out, 20x revenues is a huge number, but every once in a while, a company actually deserves it. On the flip side, a company may not deserve its valuation multiple based on addressable market analysis, leaving an investor to ponder whether the company is a short opportunity or if they are missing an important piece of the valuation puzzle.
Utilizing market size based valuation is more about trying to understand and frame a company’s opportunity than actually valuing it.
When is it appropriate to use total addressable market valuation?
- Company financials are nascent or unknown, but want to assess what the potential valuation opportunity is longer-term.
- The current valuation multiple is aggressive and want to evaluate if the currently known addressable market can bear the valuation.
- Want to frame the big picture investment thesis, narrow down the key assumptions, and try to understand what needs to be believed to justify a valuation.
- To estimate the valuation impact of an industry undergoing innovator’s dilemma or technology driven inflection.
What are the pitfalls of using total addressable market valuation?
- Like many valuation methodologies, total addressable market requires a lot of estimates and bad assumptions can have garbage in, garbage out consequences on valuation.
- Does not work well for markets that are emerging and don’t have established spending patterns.
- Markets undergoing technology disruption can shrink near-term before outgrowing the legacy market due to broader adoption. It can be very difficult trying to properly value and time this transition.
- The theoretical market value can be substantially different from the aggregate value of public market comps.
- Applying a market multiple to a disruptor that’s gaining market share can undervalue the company while concurrently overvaluing an incumbent that’s losing market share.
How To Value A Business Using Market Size: Airbnb Case Study
Preface & Warning
There are several thoughtful posts online assessing Airbnb’s current and future valuation prospects that also provide comparisons to other players in the market. This case study is going to take a slightly different approach and look at Airbnb’s valuation opportunity from an addressable market perspective. The assumptions I use are very rough guesstimates and based on what I feel are reasonable based on my own personal experiences and could clash with publicly stated revenue and margin targets. Don’t take these valuations at literal face value. My goal is to feature Airbnb as a means to highlight how to value a business using addressable market and identify key issues in the process.
Valuing Airbnb Using Arena Venture’s Airbnb Pitch Deck
“In the earliest days, metrics will mislead you or simply lack the cumulative data to give you a real answer (to give you the certainty about product-market fit that you will never find at this stage). Metrics are mainly useful for understanding how the founders themselves think about them — but they don’t mean much on their own. Focus your time understanding the people building a company, not its charts and spreadsheets.” – Paige Craig, Arena Ventures
Airbnb is quite possibly one of the most popular names mentioned by VCs when discussing investment misses (rejection letters, Fred Wilson, Paul Graham). Of these write-ups, my favorite is probably Paige Craig’s $1 billion lesson discussing how he discovered Airbnb and the lessons learned from not investing in the company. The most interesting part of the post is the accompanying pitch deck he provides laying out how Airbnb sized their opportunity.
A recurring theme of the Airbnb early investment story is many investors:
- Loved the team and their ability to execute
- Were not entirely convinced the market would embrace their business model
- Were skeptical of the addressable market opportunity
I have the benefit of hindsight, but few would dispute #1 and #2 was a legitimate concern at the time despite positive, early proof points. #3 was also difficult to discern, but if you believed the team could execute their business model then a huge addressable opportunity was in play. Or, if you were like Paige Craig and had an investment thesis that #2 would or needed to exist in the future, you knew the addressable market was huge and needed to find the right team capable of executing the vision.
All that said, evaluating metrics and addressable market size before product-market fit can lead to misleading conclusions but they are nonetheless helpful in framing how founders think about their opportunity set and what they are internally executing towards. So when we look at Airbnb’s original deck, we see a team who believed there was a huge addressable opportunity in front of them.
If an addressable market valuation was applied using these numbers, there are interesting – and noisy – insights.
On first pass, the addressable market approach estimates Airbnb would be worth approximately $12.5 billion on $2 billion in revenue in 2011. In reality if the company could scale to $2 billion by 2011 a more plausible valuation would be -by my guess – closer to $40 billion to account for the reality that the company has achieved dominant network effects and will be a major market share gainer for the foreseeable future. The $12.5 billion valuation, on the other hand, assumes stable mix and market share. It does not account for material changes in addressable market size or major market share shifts that almost always occurs when a disruptive platform like Airbnb enters and reaches scale in the market. While this valuation is a theoretical exercise and not helpful in isolation, it does provide a glimpse to just how big the opportunity could be if the company can execute towards their vision and scale it.
A More Conservative Approach to Airbnb’s Valuation
While $12.5 billion was not the valuation achieved in 2011, the company did raise over $100m at a $1.3 billion valuation driven by strong growth and execution. I don’t know how Airbnb was actually valued but BusinessInsider posted an Airbnb deck that may provide a glimpse to investor thinking. What was really interesting to see in Business Insider’s versions of the the deck is the company applied much more conservative market share and revenue targets of 2% and $200 million respectively when compared to the Arena Ventures deck. Coincidentally, if the same addressable market methodology from the previous example was applied to these more conservative targets, the value the company would have at been approximately $1.2 billion or $1.3 billion if you included $100 million in cash from investors.
Based on this analysis, it is likely investors believed $200m in revenue – or 2% market share – was very achievable in the near future and were willing to pay 6x forward revenue to invest. The multiple on actual revenue would have likely looked aggressive, but when framed in the context of a rapidly growing platform with network effects, valuing the company based on achieving at least 2% market share looked like a great investment opportunity.
Airbnb’s $24 Billion Valuation & 2020 Vision
Fast forward to late 2015 and Airbnb is now valued at $24 billion and on track to hit $900 million in revenue. The company is also forecasted to generate $10 billion in revenue by 2020. If the company can hit that growth target, Airbnb will potentially be worth $60+ billion dollars possibly generate 20%+ annualized returns for investors who participated in the most recent round. Obviously a lot needs to happen in order to maintain growth momentum and achieve $10 billion revenue by 2020, but by using the market size framework we can at least try to understand how plausible that target is instead of making passing judgements on the company’s valuation strictly based on financial multiple or peer comparisons. Growth doesn’t occur in a vacuum and it’s important to try and understand where it’s coming from and which markets will potentially be disrupted.
There are several core fundamental assumptions within the market size framework investors must believe to hit $10 billion including the assumption the company can continue to take meaningful market share (by my rough estimates achieve at least 30% share of the serviceable market) and the serviceable market (Budget & Online) must continue to shift away from hotels to Airbnb type rentals while simultaneously seeing the total bookings pie for Budget & Online grow in size. Given how other markets have reacted to platforms like Airbnb entering the market and achieving escape velocity it’s not out of the question these assumptions can happen (predicting timing and magnitude is a different matter). Overall there’s a lot of moving parts and who knows how the legal and regulatory environment will impact the market transition, but it’s clear Airbnb has done a historic job executing on their vision and capturing a meaningful part of the travel market as a result.
How To Value A Business Using Market Size: Things To Consider For Key Assumptions [Optional Reading]
There’s no right answer to what are the best assumptions to use to value a business, but a way to reasonably manage assumptions and avoid inflating the valuation is to be conservative. Again, the key is to try and frame the opportunity and not find an exact valuation. Once a company achieves escape velocity and network effects, more ambitious assumptions be entertained.
Interestingly the best way to establish reasonable top-down market assumptions is to spend a lot of time and effort understanding the bottoms up unit economics – such as customer lifetime value and customer acquisition costs – of the underlying business. This ensures the assumptions being used are grounded in reality.
Total Addressable Revenue Opportunity
- Estimating the total revenue pie can be difficult and third-party estimates sometimes be unrealistic when looking under the hood and assessing their core assumptions.
- Don’t be afraid to use third-party estimates but be mindful of their underlying assumptions.
- Publicly traded competitors will have their own estimates on the market and are worth evaluating.
- A key factor to evaluate for tech companies is the pace and timing of revenue shifting from legacy models (on-premise, off-line, etc.) to emerging models (SaaS, on-line, mobile, etc.). How quickly can existing behaviors be repurposed to new models?
Margin and Tax Rate
- Bottoms up unit economics can be a good way of determining a normalized margin to use.
- Using publicly traded financials can also help but be mindful that companies are spending money on all sorts of initiatives that may obscure the true underlying margins of a market.
- Tech companies are notorious for paying low cash taxes.
- It’s ok to be conservative and use a fully loaded cash tax rate.
Long-term Growth and Discount Rate
- Most investors generally keep long-term growth rate in the low single digit range (3% to 5%) and discount rate around 10%.
- Remember the growth rate is for an entire market in perpetuity.
- For tech companies, a key factor to evaluate is market share vs. total revenue opportunity and market share vs. addressable revenue opportunity (i.e. total digital revenue)
- Some tech companies may only have single digit % total market share, but dominate their addressable revenue.
- Understanding the pace and timing of market share shifts is more important than the estimated market share.
Note: These are my opinions. If this post didn’t answer your question, feel free to leave a comment and I’ll try to answer it. If you disagree with something, feel free to let me know. These are my personal views and debate is an important part of the investment process. I might end up agreeing with you.