Pros and cons of the peers multiple method to value Tech Companies

Valuing tech companies can be a complex task, particularly given the rapid pace of innovation and the often intangible nature of their assets. One of the widely used methods in the venture capital (VC) world is the peers multiple method. This approach compares a target company's financial metrics to those of similar companies to determine its value. While this method has its advantages, it also comes with notable drawbacks. Here, we will explore the pros and cons of using the peers multiple method for valuing tech companies.

Pros

• Simplicity and accessibility: One of the main attractions of the peers multiple method is its simplicity. It is relatively straightforward to apply, making it a favored initial valuation tool for many VC investors. By examining the valuation multiples (such as EV to Revenue or EV to EBITDA) of comparable companies, investors can quickly estimate a target company's value before conducting a more detailed analysis.
• Market dynamics reflection: This method provides a benchmark against similar companies, which helps investors understand where the target company stands within its industry. By reflecting current market dynamics and trends, it enables investors to take a snapshot of how the market values comparable companies, which is crucial for making informed investment decisions.
• Relevance in similar business models: When the peer companies have similar business models and cost structures, the peers multiple method is highly effective. It makes logical sense to compare companies operating under comparable conditions, as their financial metrics will likely provide meaningful insights into each other's valuation.

Cons

• Negative EBITDA challenge: A significant limitation of this method is its reliance on financial metrics that may not be applicable to many tech companies. For instance, most tech startups have negative EBITDA, which renders multiples like EV to EBITDA unusable. Consequently, investors may resort to revenue multiples, which do not value profitability metrics, margins, or cost structures.
• Penalisation of asset-heavy and R&D-intense companies: Tech companies that are asset-heavy or have substantial R&D expenditures are often penalised by this approach. Their value is not always proportional to their revenue levels, leading to potentially undervalued assessments. This method may fail to capture the future potential and innovative capabilities that such investments represent.
• Inapplicability to pre-revenue companies: The peers multiple method is not suitable for pre-revenue companies, which is a common stage for many tech startups. Furthermore, according to ScaleX Invest's methodology, the method loses consistency below a certain revenue threshold (around €200k). This limitation makes it less useful for early-stage investors looking to value nascent tech companies.
• Market mispricing risk: Another risk is that the method relies on the current market pricing of comparable companies, which might be mispriced. If the market is experiencing a bubble or a downturn, the multiples derived from comparable companies could lead to inaccurate valuations.

Conclusion and recommendations

The peers multiple method offers a quick and accessible way to estimate the value of a tech company, particularly useful in the early stages of the investment process. Its strength lies in its ability to benchmark against similar companies and reflect market dynamics. However, its limitations - such as its inapplicability to pre-revenue companies, and potential to undervalue DeepTech firms - must be carefully considered.

For tech investors, it is advisable to use the peers multiple method as an initial step rather than a definitive valuation tool. Combining this approach with other valuation methods can provide a more comprehensive assessment. Additionally, investors should remain aware of market conditions and the specific characteristics of the companies they are evaluating to mitigate the method's inherent risks.

By acknowledging both the pros and cons, investors can better navigate the complexities of valuing tech companies and make more informed investment decisions.

ScaleX Invest platform assists tech investors in valuing their target and portfolio companies. It leverages data from over 8,000 scored companies and employs a combination of five valuation methods, each weighted according to its relevance on a case-by-case basis.