Fundamental Analysis – Does it Work for Start ups?

By Welch Capital Partners on
May 25, 2021
Having graduated from the B.Comm program at the University of Ottawa, I started my Chartered Financial Analyst (CFA) designation in the late 1990s.

Immersed in finance theory, my cohorts and I analyzed numerous public companies, performed financial analysis on their reported financials, and prepared valuation models using discounted cash flow (DCF) methodologies to find the intrinsic valuation of these companies. We then, with great confidence (and in hindsight, with great naivety), told the world whether the price of the stock was overvalued or undervalued.

We were kings of Fundamental Analysis (FA). We viewed trendy valuation methodologies at the time (such as ‘value per engineer’) as pure gobbledegook. According to Investopedia, fundamental analysis is a method of measuring a security's intrinsic value by examining related economic and financial factors. Fundamental analysts study anything that can affect the security's value, from macroeconomic factors, such as the state of the economy and industry conditions, to microeconomic factors like the effectiveness of the company's management. We drank the FA Kool-Aid.

Jacked up on Pizza Pizza and chocolate milk, we attempted to find trends and key insights that the reported financial statements didn’t show, ever expanding our mastery of MS Excel. The bliss we experienced when a macro we created actually worked, or found a new way to analyze disparate pieces of data through, was almost as great as the births of my children (well, almost).

Similarly, when I was studying for my Chartered Business Valuator (CBV) designation, there were endless opportunities to value companies with positive cash flows, stable and consistent revenue growth, and optimal capital structures. Again, we believed that ALL companies were like this.

My journey to enlightenment began when I was working as a part-time CFO for a start up medical devices company. It continued as I acted in the same capacity for a technology start up. Money was raised at a relatively generous price per share, but something was awry – these companies were pre-revenue! The horror…

To make things worse, these companies had no assets other than IP. Sacré bleu!

And finally, to my disbelief, management didn’t expect to be profitable (let alone generate positive after-tax cash flow) for at least 5 years (what world am I living in?).

How could third party, sophisticated investors see any value in these companies? How was capital relatively easy to secure?

I was immobilized. What was a valuation purist to do?

I couldn’t perform any fundamental analysis without sales, EBITDA, working capital, assets, etc. I had no ability to analyze trends, as there was limited company history. What was I missing all these years? Was my training all wrong?

Cue the Enlightenment Music…

As I spent time understanding these companies, I resisted my desire to force projections and DCF models onto the management teams. I fought my instinct to discount non-financial milestones that were achieved, preferring only to see importance in financial metrics. After some time, I soon realized something very important – that fundamental analysis isn’t solely about pre-defined financial metrics that are derived from audited statements of public companies or large private companies. True fundamental analysis is the analysis of the company’s measures of success, quantitative and qualitative. It is important to understand the story behind the numbers. Metrics such as sales growth, asset utilization, profitability and liquidity ratios, etc. are lagging indicators of the company’s ability to execute on its business plan, and execute on a consistent basis.

I soon began to understand that you can apply fundamental analysis to company-specific metrics that make sense for the stage the company is at, and the art of fundamental analysis will evolve over time as the company grows and financial data points become more prevalent.

Instead of focusing on traditional financial ratios, we began to measure the following:

  1. Sales cycle, and whether the sales cycle continued to shorten as management refined its pitch, its responsiveness to prospective customer needs, and through perpetual learning from customers, suppliers, staff and advisors;
  2. Whether the incremental cost to acquire a customer declined over time (even if there are only a few customers). We measured spend per customer (travel costs, team time running demos, marketing spend for proposals and pitches and supporting overhead, etc.);
  3. Management’s ability to hit milestone targets, many of which were qualitative in nature - Has management’s ability to execute on its targets, no matter how small, improved over time? Are they exceeding targets or simply meeting them? Each milestone achievement was measured, and the targets became more challenging as management’s confidence grew; and
  4. Is the company a good steward of investors’ capital? Are they finding ways to increase the runway if sales targets are being missed or delayed? How frequently are capital injections required? Is the management team understanding the big picture in terms of financial management and cash flow?

According to the New York Times Bestseller Measure What Matters, by John Doerr, objectives define what we seek to achieve and key results are how those top-priority goals will be attained with specific, measurable actions and within a set time frame. These objectives and key results (OKRs) highlight an organization’s most important work and focus effort and foster coordination throughout its teams. In other words, getting a key sense on how management and their teams are executing on the key objectives they set for themselves is a real driver of a company’s value. The financial metrics that come after are a direct result of the company’s decision making and performance execution.

Consequently, if a company is executing on its plan, risk is lower in the eyes of an investor. The lower the perceived risk, the lower the expected rate of return and the higher the value. Investors saw value in these start ups, and so did I.

Don’t get me wrong. I still like building pro forma and valuation models and I do a little dance when my pro forma balance sheet balances. However, I have been delighted to discover that fundamental analysis, of a different sort, can be applied to the world of start ups.

Adam Nihmey, CFA, CBV
Managing Director, Valuations

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