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Tuesday, February 22, 2011

Valuations like it's 1999?

from Megan Jones





Zynga is reported to be raising $500 million at a $10 billion valuation. Twitter recently raised $200 million at a $3.75 billion valuation, and turned down a rumored offer of $5 billion from Facebook. Facebook is valued at $50 billion. Demand Media's market cap is close to $2 billion. Groupon turned down a reputed offer of $6 billion. LinkedIn, Pandora, and on, and on.

Most of the above financings are being done by sophisticated investors – either through direct investments with the company or in million dollar blocks on the new secondary exchanges (also limited to certain types of accredited or institutional investors). They are also potentially company to company transactions in an M&A concept; in that case the deal is usually heavily weighted to stock and not cash offers. The number of shares and companies is limited. Demand Media, being the only public company listed above, is the exception.

But as these companies start going public will these “high” valuations have a larger impact? Are we facing a new bubble?

The short answer is probably. But let's delve deeper.

One of my first projects as a young investment banker was to value a client whose legacy business was dying out quickly but their new product lines (totally different from their old product lines) weren't quite done being developed. Typically, one starts a valuation by looking at the company's numbers. Revenue, margins, earnings or EBITDA, ongoing investment requirements and such. Thus valuing the existing, though dying, business was easy as it had financial results. The new one – with no finished product and a new market but no existing presence? Not so simple. We made up numbers (called projections and actually based more on data than simple guess work)

How did we do it? First, we asked management for their projections and the support behind them. Then we did some estimating of our own. We looked at their industry and related industry projections. We looked at the total market size and comparable company multiples in like industries. High growth industries with similar dynamics were studied; as were ground breaking companies. We came up with a variety of projections and used traditional valuation methods such as DCF and comparable company models. We guessed, used some common sense and numerous footnotes and came up with a valuation. Judgment, based on past experience, was key.

Fast forward some years to the late 1990s and the dot com explosion. I pitched and worked on a number of deals in that heated sector and always looked back to my earlier project for common sense approaches to valuing companies that were creating industries. The Internet was new to most of the world then. I also learned a new variable – the company reputation among its industry. Sometimes no one can better evaluate a company than their competitors who hear the customer feedback, know the space and understand the product or service.

The Internet isn't new anymore. I'll even argue that social networking isn't new. The companies listed above have survived a few ups and downs. Groupon is only about a year and a half old but the others have more tenure. These companies aren't concepts – they are actual running entities, and generally profitable. Twitter is a totally different situation from Pets.com or Toys.com. These management teams have held on longer and raised more private money than did those earlier dotcoms. They have more users and potentially huge global markets. They are more than a footprint.

So do these valuations make sense? Using traditional metrics the answer really depends on whether they execute and grow as the market (investors) is/are expecting them to. Using historical numbers and comparing them to as “like” or similar companies (tough) the valuations are very rich. So the answer is maybe. But their growth rates are as high as the expectations. While lofty valuations leave them little room to under execute some of them will exceed these expectations. Remember the naysayers who said Google's valuation was too high at the IPO? Take a risk on such companies if you can afford it but realize that you are walking on a tight rope with them. If they are public and disappoint their shares will dive.

And note, these valuations and multiples have mostly being afforded to the top tier companies. What worries me more is that the concept has started trickling down, leading to heady valuations for less game changing or successful companies. That trend – to me – is more worrisome than a few high profile and well run companies getting a diamond valuation.

Lately, I've heard too many institutional investors say that they are now happy with more certain – though with less potential upside - returns. I cringe. Then again, as the last ten years have shown us, even "sophisticated" investors can lose (lots) of money. My point? Nothing is certain and hopping on yesterday's trend, or today's over priced trend, is dangerous.

The public markets are now double their lows of less than two years ago and around their highs from before the crash. I'm still a huge believer in equities for a number of reasons – which I've written about earlier. But evaluate a company and not the market. No one can predict the market (which is why the statement is such a cliche) but good companies will find ways of growing, adapting and making money. Traditional valuation metrics should never be ignored as market multiples do play a large role in company values.

Megan Lisa Jones is an investment banker who works primarily with companies in the digital media, technology, gaming and other emerging industries. Her experience includes time with Lazard Freres, Needham & Company and Merrill Lynch. Her investment banking blog is at www.ibla.us; and she released a novel, Captive, in late 2010 (www.meganlisajones.com). This was originally published at her blog.



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