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How to Value Internet Firms Effectively?

Prof. Partha S. Mohanram
Tuesday, December 1, 2009
Prof. Partha S. Mohanram
Why is valuing Internet firms inherently difficult?

Firstly, most Internet firms do not have much of a history, as they have been in existence for a very short time. It is extremely difficult to extrapolate into the future as there is not much of a track record to go on for the firm as well as for the industry, often. Secondly, the financial statements of Internet firms rarely represent an accurate picture of either the past performance, present condition, or future prospects of the firm. Thirdly, the applicability of traditional valuation methods in such settings is suspect. Essentially valuation is about extrapolation of the present fundamentals into the future, and such extrapolation becomes problematic in this setting.

How Internet firms are typically valued?

Multiples based valuation: The most common method to value Internet firms is on the basis of multiples. Typically, the most commonly used fundamentals are earnings (Price and Earnings), revenues (Price and Sales), and book values (Price and Book). Earnings multiples follow naturally from the finance theory that views the value of a firm as the capitalized value of expected future earnings. However, earnings multiples are typically not very useful for valuing early stage Internet firms, as a vast majority of them are loss making. They can also be extremely volatile, as earnings see-saw from period to period. Revenue multiples can be viewed as an extension of earnings multiples. They are more stable than earnings multiples, however, assuming that all revenues will eventually generate profit may not be correct. Book value multiples can also be used to value Internet firms. Such firms have understated book values as their value lies in unrecorded intangible assets representing their intellectual capital. However, one can compensate for this by assigning higher multiples.

Multiples based valuation method has the advantage of being simple, but it can often merely be simplistic. Firstly, finding an appropriate peer firm is difficult, as no two firms will be similar in their future earnings and growth prospects as well as their risk profiles. Secondly, multiples are often used in an extremely ad-hoc fashion, with adjustments being made to the underlying multiple without any formal justification. Thirdly, multiples can propagate misevaluation. If the comparable firm is undervalued or overvalued, the misevaluation carries over to the target firm being analyzed. Fourthly, using different multiples can give different valuations without any guidance as to which is the appropriate or correct valuation.

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