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How-to-Value-Internet-Firms-Effectively?
Prof. Partha S. Mohanram
Tuesday, December 1, 2009
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.

Finally, a major problem with multiples based valuation is that it assumes that a dollar of sales, earnings, or book value of Firm A is the same as a dollar of sales, earnings, and book value of Firm B. Differences in accounting standards as well as the manner in which individual firms apply them can lead to substantial differences. Consider the firm Priceline. When one buys a $200 hotel room from Priceline, for which the hotel chain probably gets $180 and Priceline gets $20, what do you think Priceline’s revenue is? It is $200 or $20? Priceline argues that it is $200 and accounts for it as $200 of revenue and $180 cost of service. An alternative treatment would be to say that Priceline earns $20 of commission revenue on the transaction. Irrespective of the merits of the argument, it is crucial to know what the basis of Priceline’s revenue is. Otherwise, a mechanical application of a revenue multiple to Priceline’s sales figures can lead to a bloated valuation estimate – especially if the peer firms are using more conservative accounting.

Formal valuation methodologies: The other technique to value Internet firms is to use formal methods such as the discounted cash flow method. This involves forecasting future financials to infer free cash flows, picking a discount rate, and making a terminal value assumption. Forecasting future financials should involve formal forecasts of future income statements and balance sheets. The latter is particularly important – as if one ignores balance sheets, one ignores the assets a firm needs to achieve its expected growth. The choice of discount rate is problematic for Internet firms, as one needs to make assumptions about a firm’s systematic risk (?) without any stock market information. Remember that these are risky firms, and so one should use high discount rates.

The most important step is the terminal value assumption. Often, valuations are done with a terminal multiple – like an EBITDA multiple. Remember that EBITDA is an inflated number – as it excludes real expenses like interest and depreciation – and so an EBITDA multiple of 20 might actually be a free cash flow multiple of 30. Alternatively, a terminal value is calculated using a perpetuity formula, with a terminal growth assumption. Remember that this is a terminal growth assumption i.e. growth until year infinity, not just long-term growth. A terminal growth assumption of anything substantially more than the economy’s GDP nominal growth rate should make you uncomfortable (4-5 percent).

How to value Internet firms appropriately?

Valuing Internet firms is extremely challenging. However, with some simple guidelines in place, one can be less prone to making obvious errors.

* Understand who is behind the valuation. An entrepreneur is obviously going to present a rosy view of the future, while a VC has the opposite observation.

* Focus on the underlying business. See how well the assumptions in the forecasts and valuation are tied in to the economics of the segment that the firm operates in.

* Understand the accounting. This is critical as the Priceline example mentioned above should indicate.

* Try not to reverse engineer the valuation.

* Avoid ad-hoc adjustments. To adjust multiples, understand how differences in profitability, growth prospects, and risk profiles are likely to impact future earnings and cash flows.

* Try to infer the inherent assumptions in any valuation. If the assumptions are unrealistic (terminal growth rate assumption too high, risk assumption too low), stay away or demand a lower valuation.

* Test the robustness of the valuation to changes in assumptions. Sensitivities to alternate economic scenarios is crucial ? e.g. What will happen if market penetration is lower, or online shopping grows at a lower rate?

* Be afraid of any jargon you do not understand. Phrases like ‘new paradigm’ really mean ‘I don’t like the valuation from traditional methods, so I’m making my own stuff up’. Similarly, be wary of ‘pro-forma’ numbers. That’s essentially the same as above – making up your own financials.

* Avoid self fulfilling prophecies. Relative valuations are obviously important, but think about the absolute valuation as well as in “I know that everyone seems to be valuing these firms as X, but does this X make any sense?”

Conclusions

Valuing technology firms in general and Internet firms in particular is difficult. It is critical to appreciate the context of the valuation. Understand the firm, the industry, and its prospects. Be aware of how accounting standards impact key financial indicators such as revenues, earnings, and book values. Learn how to deconstruct a valuation to realize what the key assumptions are and then critically analyze these assumptions. Doing this will ensure that one does not fall victim to any self fulfilling prophecies.

The author is Phillip H. Geier Associate Professor, Columbia Business School
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