When analyzing an asset issued by a publicly traded company, there are some consistent considerations that will always be looked at. What is the capital structure? What is the revenue, the costs, and the earnings? What are the growth rates of those three numbers, and what competitive advantages could affect those numbers if the market changes? While each investor has a different approach, and different institutions will set different guidelines in their approaches to assets, there are some baseline considerations that make for several agreed-upon standard operating procedures. Thus things like discounted cash flows and setting price targets become standard parts of the job.
In private equity, things can be very different–although maybe not always so. If a company is private but well established, the approach may not differ all that much from analyzing a public company, although the form of the capital structure will be very different and often much more complicated. But at the end of the day, a focus on future revenues and earnings in the context of market changes will drive the investment recommendation.
It’s when the company is early-stage or a startup that PE looks wildly different from more conventional forms of finance. DCFs are rarely used in the VC world, particularly on the west coast, where a focus on the growth of a particular technology drives investment decisions. Furthermore, aggressive startup investors will fund not only companies with no earnings, but companies with no revenue. In such a case extrapolations of future earnings are so far removed from reality that conventional investing principles are misleading at best, which is in part why growth and value investing as philosophies have become increasingly at odds in certain parts of the investment world.
Does this mean that the startup-focused private equity world has no need for financial acumen? Of course not. Issues such as ownership and ownership control are extremely important in mapping out the future of a company. Furthermore, analyzing monetization opportunities and limitations remains a financial exercise; while a highly technical product such as a b2b SaaS solution will require a deep understanding of the technology involved, it takes a financial analysis to determine the top potential total addressable market of that technology and what strategy will be needed to take the tech to market and to its maximum monetization potential. Then of course there are the various methods in which a capital structure can be formed in a company that remains early stage; this can result in significant creative financial engineering to maximize the potential payoff of the company for all parties considered.
How do analysts change their approach when working in private equity? For one, a more flexible mindset and a more diverse range of tools is essential, but a focus on creating a variety of scenarios for a variety of outcomes and having those at the ready as the company evolves is crucial. One cannot simply make a multi-billion dollar valuation on a hot name and call it a day–Softbank learned that lesson with WeWork. Instead, one has to be ready to completely abandon an analysis entirely and use a backup analysis instead, sticking with the company but taking a new approach when an old one works. This is different from analyzing a publicly traded company, where the market can allow you to just sell the stock when your model fails. Unable to do that, private equity investments are much more deeply committed, resulting in much greater risk–but also much, much greater reward.