What Gets You Better Valuations?

In a recent examination of publicly traded stocks using MorningStar screens, we noticed that even in these depressed market conditions there are at least three dozen healthy domestic stocks with market capitalizations greater than $500 million trading at a greater than 6 price to sales (P/S). Google had a much better P/S multiple than Yahoo; Visa topped out MasterCard; Alnylam topped out all other siRNA therapeutics companies; Dolby Technologies topped out its peers like DTS Inc., First Solar topped out other semiconductor companies; RedHat topped out its open source counterparts; QualComm topped out other wireless equipment manufacturers. What makes these companies tick? Our first observation was the market shares. Companies with the largest market share and with proven barriers to entry tended to be rewarded more. Holding unsurpassable intellectual property was also greatly rewarded.

Google has a 62% market share in the paid-search market compared to Yahoo, which has just 13% - a distant second. Visa's logos are carried on about 63% of the worldwide credit and debit cards, while MasterCard's share is only 31%. Alnylam holds the rights to nobel-prize winning technology and licenses that to several siRNA therapeutics companies. Alnylam's IP allows the firm to create an entirely new class of therapeutics for tough-to-treat diseases.Similarly, Dolby's technologies continue to be included as new digital broadcasting standards are rolled out internationally.First Solar is the undisputed leader in cost-per-watt solar cell production with its competitors a distant second.Red Hat has more experience distributing and supporting Linux than any other company does. Again, in the IP leadership area, Qualcomm's patents are central to the CDMA technology for 3G mobile communications.

It is important to note that strong market leadership and unsurpassable barriers to entry - be it branding or holding central intellectual property that is sessential for the growth and development of a whole market - is what attracts P/S multiples in excess of 6.0. Unless your business model is designed to make your company the overhwelming leader in market share or IP rights, there is very little chance that the market will value your firm at 6.0+ P/S multiple.

When we come across small companies that request us to classify them under this 6.0+ leadership category, we calmly tell them what it takes to get there. When starting out, it is important for entrepreneurs to understand their return on investment 8 to 10 years down the line, so they can structure their external financing requirements in a way that optimizes their RoI. Entrepreneurs need to have a good understanding of what their exit multiples are likely to be to align the financial risk/reward system better within the company.