Modeling the Deal
Transcript August 1, 2008

Host: Okay, the second half the training is about to begin. So first of all let me, just allow me the honor to introduce Steven Huang. And he represents Shipston Group Limited. So he has made himself available to talk about valuation. So if you have any questions he’s the person to ask.

Steven Huang: Thank you. First of all, I’m going to use English, so if any of you have problems understanding or need me to clarify just let me know and I’ll do my best in Chinese to explain. But I think most of you can understand English, is that right? Okay. Let me actually give you a little bit of background on my company, which is called Shipston Group.

The founder of my company is actually one of the sponsors of the Dingman Center for Entrepreneurship, which is our company’s relationship with the University of Maryland. We are actually a private equity firm, which is a little bit different from venture capital, largely because we generally invested in larger, more developed companies. You know generally the deal size that we look at are probably $100 to $500 million dollars U.S. Venture capital companies generally will look at much smaller deals, you know five, ten, 15 million dollars.

But regardless of that I think that a lot of the basic investment principles are the same, especially when they’re related to evaluation of your company. And I think that Mr. Zhao actually he was a great speaker. I think he brought up a lot of very important things that are going to be important for you guys as entrepreneurs to think about. And I think that it’s actually a good balance because from his side you can learn about what the entrepreneur went through and from my side what I’ll try to explain to you is how an investor looks at your company. Okay?

So you’ll be able to sort of look at both sides. And hopefully after this little workshop you’ll have a better idea of how you can better position yourself to get investments. Okay? So this is what I had originally planned, but I think because of time and because of the people here what I’m going to do is I’m going to actually going to go through a lot of these slides very quickly and then I’m going to leave more time for questions in case any of you have specific things that you want to ask about your company or your fundraising situation. Okay?

The first thing I wanted to explain to everyone is this whole concept of valuation. And I think this gentleman in the back actually brought up a very good point when he was talking about his company trying to raise venture capital investments. The concept of valuation is not fixed. Many different people looking at the same company will have different valuations on that company. Okay? And there are different ways to do that valuation and each different method will come out with a different answer.

So the first thing that you need to realize is that there’s no right answer for what the valuation is. Okay? The valuation of your company is determined by supply and demand in the market. For example, I know in the late 1900s in the United States when a lot of Internet companies were looking for investors they were able to get very high valuation from venture capital companies largely because there was an excess as far as capital and not enough ideas. But right now it’s a much tighter capital market. Okay? So right now investors are able to get much better valuations on the same companies. Okay.

So the first thing is I just want to go through a few sort of my tips for you guys on how to raise this money. And I think Mr. Zhao talked about a lot of these things, but I’m going to go into a little bit more detail from the investor’s perspective. The first thing is raise your capital before you need it. Okay? And I think that Mr. Zhao spoke about this very well in that they were able to raise $400 million U.S. on a fairly good valuation because their company was already cash flow positive.

They didn’t need the capital to continue operating. They needed the money to expand. Okay? And I’ll tell you from my experience very often I come across companies that are looking to raise money but they are already close to running out of money. Okay? And that actually puts them in a very bad position because me as the investor time is on my side. The longer I wait, the more desperate they become. Okay? So you need to be very careful about how much money you have on hand, how much money you’re generating and how much money you earn each month. Okay?

In the industry this is something called burn rate. Okay? So you need to have a very good forecast on how long your company can sustain itself without external money. Okay? And in general the investment process can take anywhere from six months or nine months. Okay? So you need to plan for this, right? From an investor’s perspective one of the things I hate to hear the most is when I talk to the CEO of a company and they say, and I say when do you want this money, and they say as soon as possible.

As an investor I just say I can’t do it as soon as possible because I still need to go through the due diligence and all the legal process. And when I hear that it’s not even worth my time. Okay? It means that the entrepreneur is not good in planning his business. Okay?

The second thing is raise only as much money as you need. And this is very because the reason I think most of the people in this room are entrepreneurs, the reason that most of you are looking to raise money is that obviously you want to make a lot of money. Okay? And by raising more money than you need what that does is, and this gentleman in the back he brought up a very good point, it’s about control of your company. As an entrepreneur you want to obviously retain as much control as possible. Okay? And so there’s a fine balance between raising as much money as you need to reach your target, but not too much more. Okay.

The third is also very important, the right type of investor. And Mr. Zhao also talked about this. I remember the gentleman in the back when Mr. Zhao asked what kind of investor this is. And if it’s a very reputable investor a lot of times you’re going to be willing to raise money at a lower valuation because this person is a value added investor. Okay? And in the industry there is something called stupid money and smart money. Okay?

Stupid money are investors that basically they put money in your company and let you operate it. And sometimes that’s good. Sometimes if you have a very strong management team, if you have a very good business plan and you don’t need a lot of help. That’s actually very good, because they won’t bother with your operations. They’ll check in every quarter or every year to make sure that you’re operating well. Okay?

In my experience, especially in China it is actually a great help to have value added investors. Okay? And these are basically investors that by becoming your investors that adds value to your company. If you’re talking about investors like Intel Capital or Kleiner Perkins or Steamboat, okay, these are all very reputable investors and once they become shareholders in your company they will attract more business partners and more investors to help you. Okay?

So this is something that you need to consider, which is the amount of equity in your company that you’re willing to give up to an investor. And you need to understand what value this type of investor brings. Okay? For example, as a private equity investor we are actually a value added investor, because as an investor not only do we bring you know the $10 or $50 million dollars of investment capital, we actually have a team of operators that will come back and will help you re-organize your entire company. Okay?

And the last point is also very important in my opinion. From the investor’s perspective, okay, each of you as entrepreneurs naturally believe in your own company. If you didn’t believe in your company you wouldn’t be doing it as a living. Okay? And for me personally one of the things I like to see the least is the very beginning of a business plan, it’s like the market for my product is huge and it’s growing, because that’s a very subjective description, you know? And every entrepreneur thinks that their company is the best in the industry and the industry is growing. Okay?

And again I think that Mr. Zhao highlighted on that a lot, which is you need to not only explain how your company is going to become a ten million dollar enterprise, but step by step how it’s going to reach that, and not just say the market is really big and therefore my company will do very well. Okay? But those are really four of the key tips I can give you from the investor’s perspective.

But I think the focus of this workshop is that you are going to be going through a few of the valuation techniques that you should be familiar with, both for use in your own company and just so you have an expectation of what the investor will be looking at when they’re deciding to invest or not. Okay?

There are a number of valuation methods. These, actually up here is just six that I’ve listed, and actually the first one asset valuation is something that you probably aren’t going to encounter a lot in venture capital, in entrepreneurial companies, but it’s something that’s very common in China, especially for large companies such as state owned enterprises, which is that they derive valuation based off their balance sheet net assets. Okay. As an entrepreneurial start up you probably don’t have a lot of assets and therefore you’ll use one of these other methods. Okay? But I actually wanted to explain that to you.

Okay. I’m going to skip assets. Okay. The venture capital method is something that an investor will calculate in five or ten minutes just to know whether he wants to continue reading your business plan or not. Okay? And part of this goes to what Mr. Zhao as explaining in terms of the investor’s return. Okay? VCs are very often looking for the ten times or 100 times return. And I’ll actually talk about that a little bit later that what a venture capital method does is it says okay, as a VC how much equity do I need to take in your company to make it worth my while? Okay?

And here’s how to look at that. So let’s say your company right now is, it’s growing, and you expect it to generate four thousand dollars net income in ten year’s time. Okay? And you put that in your business plan. What the venture capitalist will do is they’ll apply what is called a multiple, a comparable and they’ll say okay, a company in your industry that’s publicly listed generally trades around 25 times of your price earning ratio. Okay? So that’s a thing called PE.

What price earning ratio is it’s the ratio of the valuation of your company to the net income of your company. Okay? And just knowing that I put 25 here. This is probably pretty representative for high tech internet companies. But of course if varies from industry to industry. Okay? And again as a VC they’ll have a certain target return rate. Okay? And I just said 40 percent here.

So what this means, what the venture capital valuation method means is it goes to calculation here. It says that if your firm is able to reach a target of four thousand dollars in ten years time and you have a 25 time price earnings ratio that means that in ten years time your company should be worth $100,000. Okay? And if they didn’t count that as their expected return, so that’s what this 0.4. So the 0.4 is 40 percent. Okay? So this is what the investor is expecting to earn on his investment. It’s saying that okay, if your company is worth $100,000 in ten years time that means that today it’s only worth three and a half thousand dollars. Okay?

And I realize that’s a big difference, but now what the investor says is okay, if the company is only worth three and a half thousand dollars now how much equity do I want to take in it? Do I want to take a minority position? Okay? And if you cannot accept this valuation it’s very difficult for the investor to move forward. Okay? And that’s what I used before. I chose this price of 40 percent rate of return. So this is actually something that’s very typical for venture capital investors.

And again Mr. Zhao talked about this before. He used something called a big multiple, so basically a multiple on investment capital. But at least in the United States this is a more common return gauge, which is IRR. What IRR stands for is the internal rate of return. Okay? So this is basically amount of return that the investor expects to make every year that they hold the investment. Okay? And again different types of investors, different types of VCs will have different return rates.

And what you see here is that early stage VCs or seed investors they generally want a very high rate of return. And as the company develops more and more their expectations come lower and lower. Okay? And there’s actually a very good reason for this. The reason is because as a company develops and reaches more and more of its development milestones the company is less at risk to fail. Okay? It’s as simple as that.

If I am an early stage or seed investor in a company and the company has only been operating for one year’s time there’s a very high chance that the company will not do well. Right? But if the company’s already been operating for four or five years, has already got a stable income, it’s already got a developed marketplace then there’s less risk for me to fail as the investor and therefore I can accept a lower return. Okay?

And this is also very important. This relates to a lot of things. This relates to, for example, series A round finance. This gentleman’s education company he says that he’s raising series A right now. And so the type of investors he’s talking to, the needs to make sure that they are the series A early stage investors. And if they are this is probably the type of return that they’re looking to get. Okay?

Now a lot of you might be wondering is it reasonable for these VCs to expect such high rates of return? And the reason that they do is because if you look at the way an investors makes his investments, it’s like this, okay? Generally if a VC firm has a $50 million fund, okay, they’re going to look at spread that $50 million around 10 to 15 companies, okay, which means that each company will probably raise probably around three to five million dollars. Okay?

And this is a principle basically called diversification. He’s saying, okay, if I make ten investments I expect any two of them to do what? I might expect six of them to just break even, meaning that I don’t lose my money but I don’t really make much back. Okay? And I expect maybe two of them to lose that money altogether. Okay?

So under this type of scenario if only two out of the companies ten investments do well, in the aggregate this investor is only generating 12 and a half percent on the portfolio. Okay? But I think that what this slide demonstrates more importantly is as an entrepreneur even if you raise venture capital your odds of becoming a huge success are not that great. Okay?

Everybody hears about the big ITO stories, the Google’s, in China the Sina’s. Everybody hears about the big success stories, but the problem is that very few people hear about the companies that don’t do well, okay, the companies that fail even. Okay? So this is the reason why you need to have a very realistic expectation of how your company can grow. And at the same time this will help you understand why a VC needs to make ten times or 100 times their investment. Okay?

Alright, the next method is something that’s very common. And again it’s also a very quick method to do valuation, it’s something called comparable or it’s also called a multiple. And the basis for this valuation method is basically comparing your company versus publicly listed companies. Okay? And obviously you want to find a company out there that’s most similar to yours. Okay? For example, the gentleman in the back he has an education company.

So probably for a comparable if you want to look at listed companies. But the point is that you want to look at publicly listed companies that are at least in your sector, if not having the same type of business model. Because what this does is it gives you a benchmark, it gives you a reasonable comparison to look at what your company might eventually become and how much valuation might be attached to it. Okay?

And again in terms of looking at these comparable valuations there are many ways to do this. Okay. The most common one that you’ll see is the one that we talked about before which is the price earnings ratio. Again price earnings, it varies very significantly depending on the industry that you’re in, the size of your company, but for investors and for you yourself as entrepreneurs you want to have a gauge of your company’s potential.

So there are a lot of good … you know Sina Finance or Google Finance … that provides a lot of this information at your fingertips. You just search for the company’s name and they’ll tell you what that company’s price earnings ratio is. Okay? And much as you did before once you have a comparable company price earnings ratio and you know your own current earnings you can get a very good sense of how much your company is worth right now. Okay? And again there are also, there are many different types of comparables, types of books, types of sales.

This one that is very useful for a lot of starter companies, because most starter companies, especially in the start up phase they won’t be generating a lot of income. They’ll only have in come cases very limited revenue. So in most cases it’s useful to have a price of sales ratio. Okay? And again after we go through this presentation if you have specific questions on how to use it or how to apply it we’ll address it then.

Q: (Inaudible.)

Steven Huang: Well, you would collect comparable data from publicly listed companies, okay? So if you look at … in fact, I’ll show you right now. If you see right here what does it tell you, that multi capitalization or the valuation of Google is 148 billion dollars.

Q: (Inaudible.)

Steven Huang: Well, this is how it’s applicable. But it also tells you right here that the price earnings is 31.4. Now what this means is that this valuation is 31 times Google’s earnings. Okay. So if you take 148 and divide it by 31, you’ll get roughly what? Like $4.2 billion. So this means that in the last year Google generating $4.2 billon income. Okay? Now if you are a privately listed company you know what your own net income is. Right? So what you do is you multiple that by this ratio to come up with an estimated valuation.

Q: (Inaudible.)

Steven Huang: Well, this is for one company. There are two ways of doing this. One is if you have one company that is basically exactly the same as your company except that it’s listed you can choose to use just that one company’s price earnings ratio. But the better method is generally to take an average of comparable companies. So for this I would take the Google’s 31.14 and then I would also look at Sina, right? So Sina’s estimating at 41 and a half and I might look up also Baidu.

Q: (Inaudible.)

Steven Huang: Exactly. So Baidu here is 100. So the reason you want to take an average is because you will always have statistical outliers. Okay? A 100 times PE is pretty ridiculous. Okay? So I don’t care how good a company it is it’s not going to be worth 100 times earnings. But that’s why you want to take an average. Okay? So that’s how you use this multiple. But again the price earnings is the most comparable one. But again for most start up companies you might have to use things like price of sales. And a lot of those you have to calculate yourself.

But again it will depend on the industry that you’re in. I’ve seen cases, for example, pharmaceutical companies, and pharmaceutical companies using actually a price to Ph.D. ratio, okay? And the reason they do that is because the business of pharmaceuticals is hugely driven by research. And they found that the more Ph.D.s a pharmaceutical company has the more money it’s making. Okay? So it says I have a price to the number of Ph.D.s on staff ratio.

So what you need to do is you need to really think about your business and what are the key business drivers. Okay? Actually another good example of this is back in the Internet bubble in the late 1990s a lot of investors were using something called price per eyeballs. Which is basically a valuation based on the number of unique visitors per day or per month. It turned out that that was a very bad measure of value, but it just goes to show you that there are many ways to do comparable valuations.

So again these are some of the reasons why a comparable valuation is not very good. We talked about first like we just saw when looking at an entire industry and when you look at an entire industry there are so many different companies in so many different countries and so many different investors that it’s going to be hard to come up with a representative multiple. As we just saw Google’s multiple price earnings of 31 and Sina’s was 41, the value was at 100. And you could argue that Baidu and Google should be much closer to each other, but they’re obviously not.

So again like this particular method is actually only good as a reference point. It gives you an idea of when you go and sit down and talk to an investor you say here’s what I think is a fair valuation and this is why. Okay? Now I’ve been doing finance right now for nine years. I was originally at CitiGroup and then I was working at (inaudible) and now I’m at Shipston Group. But in these nine years even though I’ve see many, many valuation methods the so-called gold standard, okay, which is the standard in the industry is still discounted cash flow.

And this is something called DCS for short. And the reason why this is the most popular and most commonly used method is because it is very analytical. There’s a reason for everything. There are a lot of flaws in this method. It still requires a lot of assumptions to be made but at least every single thing that you know about your company can be modeled. And what I’m going to show you actually is a DCS I was working on this morning.

So this is a company that we’re actually looking at right now. And I can’t tell you the company by name right now, but what this shows you is the level of complexity for this model. This is actually a company that I’m looking at right now, actually has six different plants in six different countries around the world. And so they’re dealing with multiple currencies and they’re dealing with literally hundreds of customers.

So what I’ve done, okay, so this is a look at all their customers and all their contracts. And this is the level of complexity that they often go into a DCS model. But at the end of the day is you come out with this. So my valuation puts this company as a little bit more than $80 million. But obviously it took three weeks of work to build this model. But the reason this is a very important tool in valuation is that I can track every single assumption that I made to get to this valuation.

And what it comes from is it comes from basically a financial forecast. I know how this company performed in 2008 and I’m forecasting how it’s going to perform for the next five years. Okay? I don’t expect to teach you how to do a DCS model because we just don’t have enough time, but …

Q: (Inaudible)

Steven Huang: So this worksheet. I just need to make sure … This right here is the discount rate that you’re talking about, right?

Q:(Inaudible)

Steven Huang: It does change but in this particular case this is actually an acquisition. So we’re actually looking to buy this company outright. And therefore what’s most important to me right now is what the discount is right now. But for different models you might want to model in different discount rates depending on the company’s capital structure as it’s changed over time. But I don’t know how much finance background you guys have, but, for example, I’ll talk about this a little bit later…  In fact, I’ll come back there and we’ll talk about it.

So again the gold standard in the industry is still the DCS. But again as we said it’s not perfect. There are still a lot of problems with the DCS. The first is something that you guys are probably going to run into a lot, which is that as entrepreneurial companies, as starter companies, you don’t have a very good gauge of how much money or how quickly your company will grow.

When Mr. Zhao was here speaking he was talking about if he can, the entire market is this big and if only one percent of customers actually are booking reservations and he gets five percent of the market, that’s a very good cost down estimate. But it’s hard to say how quickly you will get to that target. He might get to that target in five year’s time, he might get to that target in ten year’s time. But those different scenarios will cause very different valuations.

This I’m going to jump over now. These other methods are basically doing probability analysis, okay? I’m not going to get too much into that or this. So like I said the most important thing that you guys need to think about right now when coming up with valuation is that there are a lot of methods out there. The two that I would recommend you guys to focus on would be the VC method and the comparable method. And if you have a very strong CFO you should have him or her do a DCS also, because more likely than not the investor is doing a DCS on your company.

Because what the investor wants to know is how much money they can make from your company. And so even if you don’t do it they probably will do a DCS, but they won’t share it with you. So what I’m going to do probably for the next 10 to 15 minutes is I’m going to go into a little bit more detail on a DCS, and again if you have any specific questions we can talk about that later. Okay?

The concept behind the DCS is exactly what the name says it’s a discounted cash flow. Okay? When an investor is looking at a business it is most important to look at how much cash that company is generating year on year. All forecasts about revenues and net income is a very good indicator, but it’s not as good as cash, because at the end of the day a company is worth as much cash as it’s generating. Okay? So what this is saying right here, this is a basic rationale behind a DCS is that it takes all a company’s future forecasted cash flows and discounts them back.

Now for those of you who don’t have a lot of finance experience when I say discount what this means is very simple is that you would rather have a dollar today than a dollar one year from now. And the reason is because if you have a dollar today you can begin using it. And if you have to wait one year there is something called an opportunity cost. So what this is doing is saying that okay, you would rather have a dollar now more than a dollar in one year. But would you rather have a dollar now or a dollar fifty in one year?

And every person is a little bit different, because every person will have a different expectation of the term. Okay? And that’s what discounting is all about. And that gentleman in the back when he talks about discount rates that’s really what (unintelligible) is about, it’s about how much you are expecting (unintelligible) how much is the investor is expecting to earn on his investment. Okay?

In the previous example that I showed you what this is saying is that as an investor I want to earn no less than 12 percent a year on this investment. I obviously would like to make more but I cannot make less than 12 percent. So this is my discount rate. So what this says is that if I had a choice between one dollar today or actually let me use, if I had a choice between 100 RNV (ph.) today versus 112 RNV one year from now I would be indifferent (ph.) between the two. Okay?

But if I had a choice between 100 RNV today or 113 RNV in one year from now I would choose to take the money one year from now. Did that make sense? If not, we can talk about it. Now the important part of a DCS is going from what we talked about net income to a cash flow. And the reason is for those of you who are accountants here the net income is basically an accounting number. It takes into things such as depreciation, which is a non-cash expense. Depreciation is something that basically you can write down your debt obligation but doesn’t change the fundamental cash nature of your business.

Your net income also doesn’t take into account things like working capital, the amount of capital that your company needs on a cyclical basis just to continue running. It doesn’t take into consideration things like capital expenditures. And in terms of starter companies, especially internet, this is going to be important in terms of buying computers or servers. And so the key is this is a very simple way to get from a company’s net income to cash flow.

And so they talked about you add that depreciation and the reason is because depreciation is a cash outflow but that’s not recorded on the net income statements and (unintelligible) and working capital. This we talked about. Okay. Working capital. I actually want to talk a little bit more about this because working capital is the life blood of a company. And I say this because very often I see very good companies. They’re in a very good market, they have very strong management team, but they are not managing their working capital properly.

And what working capital is are things like inventory, how much inventory you’re keeping in your company. If you are an Internet company that might not apply as much. But you would need to think about things like receivables. What receivables are is the amount of days or the amount of times between when a customer is obliged to pay you versus when they actually put cash in your pocket. And this in my experience especially in China it’s a very big problem.

And it’s a very big problem because Chinese companies notoriously have problems collecting cash from their customers. And this is true whether it’s an internet company or whether it’s a manufacturing company. And I’ve seen a lot of companies, in fact a lot of companies that we turn down investments in because we weren’t confident that the company would be able to collect money from its customers in a timely basis. Okay?

And the same thing is in terms of payables. And just the rule of thumb is you want to be able to collect cash from your customers as quickly as possible, but you want to pay your own suppliers cash as late as possible. And again I think that Mr. Zhao’s statement of if you can lease it, don’t buy it and if you can buy it, don’t lease it, if you can steal it, don’t buy it. That’s great and you should all live by that, okay, which is save as much money as you can.

And you have to be very careful about when you’re paying cash. If you cannot pay a supplier for one more month and not hurt the relationship with that supplier than do it, because that additional month of working capital is going to mean something as your company grows bigger and bigger. And one other thing is actually very important. And what this is the terminal value. And I’m going to go back to my model again for this.

Now what I’ve done here is in this role this model that I forecast the cash profile is something to be. And what this means is that in this current year, 2008, I’m actually expecting this company to lose $1 million of cash. And in the next year I expect them to lose $40 million of cash. So looking at those numbers alone this might look like a really bad investment. But what I am counting on is that in the future there’s going to be a very large payout at the end. And this number has a very large impact on what your company will ultimately be worth.

Now getting back to your question about a discount rate. In this model I calculated a 12 percent discount rate. But at 12 percent discount rate it works out basically to an $80 million valuation. Now just to show you how big of a difference this makes, if I change this to eight percent it increases the valuation from $80 million to $211 million. So this is obviously a huge, huge gap. But the reason I’m showing you this is because you need to understand that even minor differences, even small changes to something like a DCS can have a huge impact on your valuation. Okay?

But the value of doing it this way is that I have a very logical reason here to saying why I’m using a 12 percent discount rate as opposed to eight percent. And I actually was going through this model with my colleague this morning and you know it’s again when you’re a DCS whether you’re doing it for your own company or whether you are reviewing an investor’s model, the two things you need to focus on most are what this discount rate is and what the terminal value is. Because those two factors will have a huge impact on what the valuation becomes.

So this again, this is just one way of calculating terminal value. I don’t want to go through all the equations right now just because it’s not necessary. If you want come talk to me afterwards and I can send you lists and lists of equations. Okay? And I think this particular slide is going to be really relevant to you guys too, which is growth patterns. As entrepreneurs you need to really think about how your company’s going to grow over time. Most often I see business plans that forecast basically an exponential growth rate. Basically starts from one dollar, next year it’s ten, the year after it’s 200.

And while that is great to forecast it’s most likely not going to be true. And you as entrepreneurs you need to think about how quickly can I grow my company and most importantly what are the constraints because some of the investors back there what I want to know is why your company can’t grow at that rate. Okay? Is your company not able to grow faster because the market’s too competitive? Is it because you don’t have enough good employees or you can’t hire enough employees? Is it because you don’t have enough marketing expenditures?

Because as an investor I actually want your company to grow as quickly as it can and if I can understand your reasons for limiting growth maybe those are things that as an investor my money can help to fix. This next part is actually going to be very detailed, so what I’m going to do is I’m actually going to stop here because I don’t think you guys need to go into the details of how to do a DCS.

And I’m going to actually open it up to questions if you guys have specific things about your companies that you want to ask about, whether it’s how do you find the right investors, how do you negotiate with them, what’s the profit, how long does it take? And if you want to use Chinese to ask questions, that’s fine too. My listening is much better than my speaking.

Q: How do you value the intangible? Like the technology and the expertise?

Steven Huang: That’s something that’s actually very important. And for an entrepreneurial starter company that’s actually probably even more important. That is best answered by first thinking about how you’re going to value the company. If you are looking at a valuation based on comparables then those factors are already taken into consideration, because companies that are similar to yours will also have a great amount of intangible assets and intellectual properties. And those are already factored into their valuation. Now on a DCS basis it’s much harder to do. But in general these intangible assets should be reflected in how quickly the company’s able to grow. Any other questions?

Host: No more questions?

Q: (Inaudible)

Steven Huang: So debt is something that’s very important. Let me actually answer your question in two parts. For an entrepreneurial company it’s virtually impossible to raise any debt, because banks aren’t going to lend to you because you don’t have enough a stable cash flow. So for I think most of the people in this room this question is not going to directly apply to you. But once your company is established and is generating regular and consistent cash flows it’s much easier to raise debt capital.

And you’re right one of the advantages of debt is that it acts as a tax shield, because basically your interest payments are tax deductible. Now this gets into a much more complicated area. This is something called your capital structure, which is to say that … let me go back to this. I need to delete a name, this is confidential. Okay. What I’m doing here for this company is I’m calculating its capital structure, right? So in this particular case this is a (unintelligible) company which is 1.7 billion R&D on the equity market and it has roughly 1.3 billion of debt on the books, right?

What I am saying here is that you can see here, right, this, call to capital, okay? This, call to capital is actually calculated as a ratio of your debt to equity. And so by changing your debt to equity ratio you can change your call to capital, right?  And by changing your call to capital as we just saw you can have big impact on your valuation.

So the way, this is an area called corporate finance. And it’s basically the CFOs job to tune their capital structure to minimize the company’s call to capital. And why? Because with a lower call to capital the company has a higher valuation. Does that answer your question? But the process is much more complicated. I mean, if you want we can talk about it after this workshop. But I think for the rest of the people it won’t be as important.

Q: (Inaudible)

Steven Huang: No, let me be clear about this. In that slide that 25 percent … you’re talking about this one, right? The PE is 25, right. But we have to go back to what we just talked about in terms of how you find what is comparable. So you have to define or you have to identify what are the publicly listed companies that are most similar to yours. Like we said if you are running an internet search engine your comparables would become companies like Google or Sina or Baidu. If you’re looking at education companies your comparables would be you know (unintelligible). If you’re looking at an automotive company your comparables would be Ford and GM and (unintelligible).

So this one, this 25 PE is just, it’s an example. In my experience I think that internet companies, high tech, high growth companies that’s a pretty reasonable estimate. But as we just saw when we look on the Google finance there are a lot of variations. But for other more established industries, for example, an automotive industry a very good PE is 78.

Q: (Inaudible)

Steven Huang: That’s a very good question. In general, PE ratios for industry will be constant. They might change but nobody knows how it will change. But that’s why this was a very rough estimate. That’s a very good point, you’re right. Where in this method you’re basically assuming that the price earning ratio stays constant in ten years, and it might not. But as far as we know right now it’s a good measurement.

Q: (Inaudible) 

Steven Huang: I have seen adjustment models, but the problem is that nobody knows what’s going to happen in the future. In general, PE ratios will tend to trend downwards, right? And so the adjustment models that I’ve seen, what they generally do is they forecast a downward trending PE depending on companies becoming more mature. In general you will see higher principle earning ratios for high growth companies.

So in the finance world there’s also a thing called a peg ratio. I think it’s on here too. No. The peg ratio is basically the price to earnings to growth ratio. So what the growth ratio measures is how quickly this company is growing year after year. And the reason why investors will do this is because they want to understand how good of a value they’re getting depending on what they’re buying at. Yeah, peg ratio. Okay?

On here this is Yahoo Finance, but what this is saying is that it’s taking the ratio of Yahoo’s PE, which is also, it’s like Google’s PE, 31, to their growth. So what this is saying is that for the next five years Google is expecting to grow roughly what 24 times per year, which is pretty high. Anyway, so there are ways to model adjustments in the PE but it’s very rarely done, because nobody can really know what will happen.

Host: Any more questions? Thank you.  As you can tell these are very technical stuff in the financial world. You have to know something this technical to be able to talk on the same level, otherwise you are at a disadvantage. Thank you again for coming today. Have a nice weekend everybody.