Xero valuation – the final(ish) chapter

Lets just recap where we’re at. We’ve got a spreadsheet (see the last blog post) which projects revenue, customer numbers and EBIT. Sweet. So what more is there?

Well, the point of these posts is to do a discounted cash flow(DCF) valuation on Xero. And a DCF valuation needs cash flows, and EBIT is not cash flows. Net profit isn’t cash flow either, so theres a bit more digging to be done.

So what is cash flow? And why is it different to net profit? And who really cares, just tell me what I should pay for a Xero share!

Net profit is revenue – expenses – tax – depn – interest. So that all makes sense right? Money coming in, costs of doing business (including depreciation) and interest on any loans. And of course, the inevitable tax consequences.

Its an interesting number. Kind of. In a “mm, thats very interesting, whats on TV?” kind of way.

But as owners of a company, we’re much more interested in cash. Cold, hard, cash. Or, not cold, flappy paper cash. Any kind of cash. More = better. This cash is what we get in the bank at the end of the year, which lets us buy cool stuff. Like iPads. And food. Net profit is a more… airy definition, and you definitely can’t eat it.

So we turn to Cash Flow. Cash flow is intended to take the net profit, and work out how many iPads you can actually buy at the end of the year. The most interesting cash flow number is free-cash-flow-to-the-firm (FCFF). What this says is, sure, you’ve got some operating cash flows, but I want to know how many damn iPads I can actually buy at the end of the year! Dammit! FCFF in particular deals with capital expenditures.

And Xero has nearly 2 million per year of capital expenditure, mainly capitalised development costs. So it is pretty significant to them.

The idea with capital expenditure is it is what you are reinvesting in the firm in order to grow it in the future. So next years revenues depend on previous years capital expenditure. So how much will Xero have to reinvest in order to grow like the previous posts predictions?

Actually, thats a big question, so should be in bold:  how much will Xero have to reinvest in order to grow like the previous posts predictions? its big, because it is hard to tell. Theres not much data, so its very unclear.

So, another guess, the sales to capital ratio. How much do sales improve by reinvesting a dollar in capital expenditure? My guess looks like:

Xero Terminal year (2018) 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008
Revenue from operations $684,768 $570,640 $475,533 $317,022 $158,511 $66,046 $25,402 $8,467 $2,851 $959 $134
EBIT $171,191.92 $142,659.93 $118,883.28 $57,063.97 $23,776.66 $7,925.55 $1,016.10 $0 -8450 -6751 -4310
Change in revenue $95,107 $158,511 $158,511 $92,465 $40,644 $16,935 $5,616 $1,892 $825
sales to capital ratio 1.60 1.80 2.00 2.50 2.00 1.75 1.50 1.08 0.59
Reinvestment (capitalised development costs) $59,442 $88,062 $79,256 $36,986 $20,322 $9,677 $3,744 $1,749 $1,397
Reinvestment (as percentage of revenue – interest only) 10.42% 18.52% 25.00% 23.33% 30.77% 38.10% 44.22% 61.35% 145.67%

The important line is the Sales To Capital Ratio line. This reflects my thoughts that SaaS systems take a chunk of capital expenditure, particularly when moving into new markets (eg: US), and that this will continue for the next 8 years. Putting these values up, ie, for every dollar of capital reinvestment, you get X dollars back in revenue in the next year, will obviously make Xeros valuation higher.

I’ve also estimated a stable reinvestment rate as a percentage of revenue of 10%, which is more or less in line with other internet companies. If anything, I think this number will be higher.

Theres a couple of other numbers that are needed before the final valuation. Beta, or the measure of the firms risk. I have started at 2.5 to reflect the significant risk with Xero initially, and decreased to 1.4 in 2017. It sounds about right. Risk free rate of 5.5% and a equity risk premium of 5%. Sounds pretty reasonable to me, but more guesses!

Ok. Phew. Damn this is a lot of work. Cutting a long story short, finally, how much is a Xero share worth, right now?!?

And, according to me, thats a reasonably sunny outlook. Not blow you away stunning, but reasonably optimistic. I’ll put the spreadsheet up on google apps now, so you can have a play.

Xero valuation – the final(ish) chapter

3 thoughts on “Xero valuation – the final(ish) chapter

  1. I wonder if your beta estimate is a bit severe. In theoretical finance theory, there is no premium for firm specific risk since it is assumed that all investors have well-diversified portfolios. It is hard to estimate the systematic risk but there are a couple of assumptions we can make. First, tech companies often have a beta greater than 1. Second, tech companies that sell consumer products tend to be the companies with high betas while tech companies that supply business customers tend to have lower betas. For example:

    IBM beta=0.72
    Oracle beta=0.97
    SAP beta=1.07
    MSFT beta=1.08

    These are much lower beta values than consumer focused tech-firms that are affected more by the swings of the economy.

    The cost-of-capital assumption is going to significantly affect the valuation. I think that assuming a beta of 2.50 with an equity-risk premium of 5.5% is pretty harsh.

    1. Hey Kelvin, I noticed I made a large error in the terminal value calculation, which I revised. I also revised the betas down a little, starting at 2, and ending up at 1.1 although betas seem to be all over the place depending on whose estimation you use.

      Estimates of B2B type firms vary greatly, yahoo finance has salesforce at 1.66, Taleo at 1.56 etc, which are much bigger companies than Xero. My thinking with a high beta was that Xero was in the ‘early start up’ group of businesses, which most investors will put funds in when they have discretionary funds to invest. Also, I thought that Xero would be a relatively illiquid stock. So my expectation was that Xero would go up significantly on good news, and drop significantly on bad news.

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