Are Twitterers worth more than Googlers?

Following up with an additional thought on the Twitter/Facebook saga... In yesterday's article, I approached Twitter's valuation from a "per twitterer" basis - arriving at an estimated value of $45 per twitterer based on Facebook's $500 million which is really worth $150 million using the "Henry Blodget Facebook valuation discount factor."

To put the $45 per user valuation in some perspective, Google's market cap is about $90 billion based on today's opening share price. Public estimates out there show that there are approximately 1.4 billion people in the world on the Internet. Let's discount that to 1.0 billion just in case that includes people that can access once a week or month, or people that can access email and aren't able to regularly use search. At about 70% market share in the search business, that comes to abut 700 million people.

$90,000,000,000 / 700,000,000 = $128 per Googler

If one assume that Facebook's $500 million offer was indeed a legitimate $500 million and not an $500 million in inflated currency, the price per twitterer that Facebook is $150 per user, which would mean that Facebook is valuing Twitter's users more than the market values Google's users. Twitter doesn't have a revenue model. I think Google does...

(Interesting side note - the first search result for the term - "how many people use google everyday" - is a forum post on answers.yahoo.com from May 31, 2006. Still some room for improvement and not surprising that problems like this crop up from time to time...)

"No Thanks!" in 140 Characters or less

Maybe the message was something like:

Twitter: @Facebook "No can do. Thx 4 the offer."

It's common knowledge now that Twitter declined Facebook's "$500 million" offer. Running some numbers yields some interesting results on the offer and valuations of both companies. (We'll come back to the quotes around the $500 million shortly...)

Back in April, Michael Arrington wrote that Twitter was worth between $60-$150 million just before it closed it’s $15 million venture round at the end of May.

TwitDir shows that there are “3,328,420 twitterers we know!” as of the time of this article. Using the $500 million offered by Facebook for Twitter and some simple math, this would equate to a valuation of approximately $150 per twitterer. Not sure if I’m buying that (pun intended….).

Henry Blodget did some interesting analysis on the real value of the Facebook offer, since the $500 million is “overvalued Facebook stock” based on the $15 billion valuation. There are lots of ways to slice and dice Facebook's valuation (including my own perspective based on the "Facebook Multiplier"). Blodget estimates that Facebook’s correct valuation is closer to $5 billion, thus decreasing the real value of Facebook’s offer down to $150 million, or $45 per twitterer.

At $45 per twitterer, which is probably a more realistic number to use, two questions:

1. How would Facebook earn back the $45 per twitterer in future value terms?
2. What does Twitter have planned that makes them think they can do better than $150 million.

Just my opinion, but:

1. I'd guess that Facebook isn't quite sure what it'd do - sort of feels like Yahoo! in a way. Good on eyeballs and users, not so good with the whole revenue thing.
2. Twitter isn't so sure either, but knows that there's a better deal out there than $500 million in monopoly money. Just because they turned down this deal doesn't mean they turn down the same amount or less from another enterprise.

Locking in on LinkedIn

I read about the recent $53 mln Bain Capital investment to LinkedIn and I was prepared to write an article again questioning the valuation of another social/business networking site. Like many, I'm not particularly enamoured with the current $15 billion valuation of Facebook, so my initial reaction to the $1.035 billion valuation of LinkedIn was - "here we go again..."

Because LinkedIn is a private company, their financials and revenue sources aren't available. I did some scouting on the site and they make money in a few ways:

1. Advertising via their Large Budget and LinkedIn Direct Ads to provide targeted advertising to its members.
2. Subscriptions to Premium Services that allow the user to directly contact people out of their network with "InMail" and send "Requests for Introduction" emails. These services range from $20-$200/month.
3. Perhaps some others such as data analytics based on membership statistics and activity (though this is only my conjecture...).

Johnathan Richards wrote an article following the June 2008 venture investment and estimates LinkIn revenues to be around $80-100 million, with "about a quarter" of the revenues coming from subscription services. At first, I was a bit surprised to read that subscription fees could be so high, until I considered the number of recruiters that have contacted me via LinkedIn, as well as my own activity. (I personally subscribed to their $20/month plan when searching for a job a while back, and was able to link up with a great recruiter at Russell Stephens as a direct result of an InMail.)

With the current $1 billion valuation based on revenues of $100 mln, that's 10x revenue valuation, without any knowledge of their profit margins. The News Corp acquisition of MySpace for $580 million back in 2005 supplies some relativity to the $1 bln valution. Though a social site, not a business site, MySpace does parallel LinkedIn in terms of its ability to focus on a large market segment, it's networking component, and the fact that the business world has placed a valuation on it. Since the acquisition, MySpace has reportedly been a boon to the New Corp's Fox Interactive Media Group. (According to the most recent 8K report from June 2008, News Corp reports that Fox Interactive Media grew revenues 57% and increased "operating profits five-fold on strength of advertising and search revenue growth at MySpace.") Two years after the aquisition, things seem to be looking rosy for New Corp according Murdoch in this Wired Magazine article.

Considering the virtual aspect to LinkedIn's product and the scalability of subscription services, I suspect that their profit margins are healthy and growing as LinkedIn acheives a greater lock-in effect with users - becoming the main destination site for business networking. The caveat to acheiving this lock-in effect will be the quality of service and networking effects. However, by providing the ability to remove connections and requiring a subscription for the ability to directly contacts individuals outside of one's network, LinkedIn drastically removes the diluation and spam factor to their networking functions. Additionally, LinkedIn boasts (as they should) that their audience has an average household income of $109,000, about 2.5x's the median US household income of $48,200 according to the 2007 US Census (though I'd like to know the median LinkedIn income to see how much top executives on LinkedIn skews this average figure).

Looking LinkedIn's development, they've taken a deliberate and apparently successful approach so far - develop a user base, find a way to quickly monetize activity with premium subscription services, and then analyze the user base to leverage it for targeted advertisers. From this perspective, LinkedIn is now completing the foundation of its business with the Series A, B, C financing of about $30 mln, while this most recent $53 mln should be intended to move the company into a mature state with specific long-term goals for continued rapid growth.

The most compelling part of LinkedIn's situation is its $1 bln valuation based on $100 mln in revenue. It's high, but justifiable given the apparent success of others in the networking space, and the unique niche of its business and professional membership base. Like everyone, I'm interested to see how quickly it can convert the valuation to practice, or to see if it can utilize its valuation to grow by:

1. Acquisition of higher-end job sites such as TheLadders.com or Vault.com
2. Targeted content partnerships such as their recent NY Times agreement
3. Integration of specific industry content and membership groups such as BAFT, VCExperts, or others to serve as a clearinghouse of industry information for its users.

So here I am at the article's end, completely reversing my initial reaction to the valuation - seems to be okay after all...

CBS - The CNET Acquisition

The acquisition of CNET by CBS – let’s take a quick look at the numbers.

I began by checking out the Balance Sheet, and as a content and media company, one would expect what I saw – relatively low base of assets and liabilities. Pretty tough to determine the value of CNET based on assets on the books.

Then moving to the Income Statement, annual Revenues have been growing modestly each of the last three years (from Yahoo! Finance):

2005 = $354 mln.
2006 = $387 mln.
2007 = $406 mln

But the bottom line income tally reveals the results of some interesting accounting activity:

Total Income 2005 = $19.6 mln
Total Income 2006 = $6.8 mln
Total Income 2007 = $176 mln

The jump in 2007 looks impressive, until you see that CNET accounts for a $178.8 mln “Income Tax Expense,” thus propping up the overall bottom line income for the year.

Looking at the Cash Flow Statement, nothing here seems terribly appealing.

Change in Cash Flow 2005 = $26.3 mln
Change in Cash Flow 2006 = ($24.5) mln (CNET paid off $125 mln from convertible notes issued in 2004.)
Change in Cash Flow 2007 = $57.3 mln

Aside from debt retirement, it seems that cash flow situation seems is fairly stable as you look at cash flow from operations. But, nothing seems particularly compelling or attractice here from an acquisition standpoint.

So what does all of this mean in terms of the $1.8 billion price paid by CBS for CNET? The $1.8 billion represents a premium price per share of $3+. It also represents about 4 times revenue, slightly less than the price Microsoft offered for Yahoo! (which was 6 times revenue). CBS isn't in a situation where top line revenues really matter, so to acquire CNET simply to add to top-line revenues probably isn't a valid reason for the acquisition.

Total annual income is unimpressive, and the annual changes in cash flow are appealing but don't provide the case for the acquisition either. Overall, as seems to be the case when old media companies are attempting to keep with consumer demand for innovative content, the $1.8 seems to be an overpayment. CBS is obviously buying the CNET brands in hopes (yes, hopes) in evoling these brand names to consumer mindshare.

The bigger question is whether or not CBS can convert and integrate the acquisition into a positive gain to justify the price. I’m guessing not.

Google Valuation - Decidely Undecided

In early April when Google stock was trading at the mid-$400s, I started thinking about its market valuation and price per share. Maybe it was a good buying opportunity since coming down from its all-time highs in the $700+ range late last year.

In the spirit of the analysis I’ve done in previous articles with valuations Facebook, Starbucks, Bear Stearns, and Yahoo!, I jumped into Google’s financial statements to see what I could find. Happily, I discovered mystery, love, and intrigue – certainly enough for a good story.

I’m drawn to an elemental approach that looks at intrinsic value, even with dynamic technology companies like Google. In taking this approach, I focused my research on the growth of Google’s assets, and more specifically, on the growth of Google’s shareholders' equity. Because shareholders' equity is what’s left after subtracting a company’s liabilities from its assets, it provides a clear of what is left for shareholders after debts are retired from a company’s assets (thus the term “shareholders' equity”).

Starting with the 2003 year-end reporting through 2007, the growth of Google’s shareholder equity has declined fairly rapidly –

From their financial statements, Google’s Total Shareholder Equity (in 000s) over the past five years –

2003: $602,641
2004: $2,929,056 (an increase of 386% from 2003)
2005: $9,418,957 (an increase of 221% from 2004, but a 42% lower growth rate)
2006: $17,039,840 (an increase of 80% from 2004, but a 63% lower growth rate)
2007: $22,689,679 (an increase of 33% from 2004, but a 58% lower growth rate)

Notice the trend? Of course, maintaining triple-digit shareholder equity growth isn’t realistic, but it does show the effects of Google’s increasing company size and asset base.

There are about 313 million shares outstanding. If we divide the current shareholder equity of $22,689,679,000 equally among each shareholder, that comes to about $72/share. So if Google liquidates today and pays off its liabilities in full, there will be $72/share to distribute.

Google isn’t going out of business today, so looking at this number in comparison to a $450-550 share price probably isn’t the best option in determining the true value per share. Another option is to consider current and future Cash Flow/Share (CFS), with future cash flows discounted back to today using a reasonable required rate of return. Google’s Beta is 2.01 and the US Treasury 10-year bond yield is about 3.75%. Using the CAPM, that calculates to a 12.25% required rate of return. To account for the current economic downturn and innovation risk, let’s call it 15%.

Google’s CFS was $17.66 in 2007. If we assume a 10% growth rate per year for 10 years, how does that shake out in valuing its shares after discounting future cash flows to today? With a 15% required rate of return as the discount rate, the sum of the discounted CFS for the next ten years is $101.91. Again, not quite close to the recent $450-550/share trading range.

Extend this 10% growth rate in Cash Flows into perpetuity with the same 15% required rate of return and we get a value of $353/share. But is a 10% growth into perpetuity realistic? Probably not, but it’s hard to argue against it given their Quarter 1 results for 2008. Their ability to innovate is the wild card.

All in all, I’m still undecided about what to decide… I first contemplated this about two weeks ago when the price/share was in the mid-$400s. Now in the mid-$500s, I don’t have any better answers as to whether or not the valuation feels right. It seems a bit high based on fundamental research and intrinsic valuation.

There's a nice article that looks at Google's valuation in a similar, but different way using a "scenario approach." It's worth a read.

It’s clear that investors are flocking to the stock after selling off in recent months. But is in investing or speculating? That’s the part I can’t figure out…

Yahoo!'s Valuation - Goodwill leads to Goodwill

Recent word is that Microsoft has no plans to raise its $44.6 billion bid for Yahoo! Inc. $44.6 billion got me wondering how this matched up to Yahoo's value based on its balance sheet. I found one item to be particularly interesting - "goodwill" - which seems to be indicative of Yahoo! Inc.'s problems, and could be leading the company to Goodwill Industries very soon. How about a new logo?

As defined on Investopedia - "goodwill appears on the balance sheet of the acquirer in the amount by which the purchase price exceeds the net tangible assets of the acquired company." In other words, goodwill is the extra that you pay for after accounting for the actual company assets.

Keep in mind that I don't know what the media industry norms are with regard to the goodwill-to-acquisition price ratios, but looking at the Yahoo! Inc.'s 2007 Annual Report, it seems to me that they're pretty good at throwing cash into the goodwill bucket for acquisitions without getting much of a tangible return.

A few examples from Yahoo! Inc.'s 2007 10-K to illustrate (this info is found around page 70-85 of the report...):

1. Purchase of SOFTBANK, a firm with which Yahoo! had a couple of joint ventures (2005)

Total purchase price = $500 million in cash
Amount of purchase price allocated to Goodwill = $388 million

2. Purchase of Right Media (2007):

Price = $526 million ($246 in cash, $237 in equity)
Amount of purchase price allocated to Goodwill = $440 million

3. Purchase of Zimbra (2007):

Price = $302 million ($290 in cash)
Amount of purchase price allocated to Goodwill = $241 million

4. Purchase of Blue Lithium (2007):

Price = $255 million ($245 in cash)
Amount of purchase price allocated to Goodwill = $221 million

5. Alibaba (2005):

Price of 46% of shares = $1 billion in cash
Amount of purchase price allocated to Goodwill in 2007 = $443 million

Like I said, I don't know what the normal allocation to goodwill as a percentage of total purchase prices in the media business, but when I look at these transactions, I see a significant trend -

Yahoo! likes to take cash from its pockets and exchange it for an accounting asset called "goodwill" that you can't touch or see. These investments are not all-inclusive of all of the deals on Yahoo! Inc.'s books, but just up the cash spent on these five examples and you get nearly $2.3 billion.

I'd like to think that the brain trust at Yahoo! Inc. would like to have that $2.3 billion to spend on projects developed internally to produce organic company and product growth. Perhaps these actions are a microcosm of what's happened to the Yahoo! brand. A company that led the Web 1.0 revolution is now becoming a sideline watcher in the Web 2.0 and Web 3.0 evolution.

To put some perspective Microsoft's $44 billion offer - Yahoo! generated $6.9 billion in revenue in 2007, putting Microsoft's offer at a bit more than 6x revenues. Compare that to Microsoft's valuation of Facebook at $15 billion, estimated to be 500x revenues.

Illustrating Market Value vs. Intrinsic Value with Starbucks

Starbucks is favorite company of mine to use in various finance and business strategy lectures, (and to get a jolt before our Sunday strategy meetings at Altos Research). Over the past decade, Starbucks enjoyed a steady rise up, initiated aggressive international expansions plans, and with their recent reappointment of Harold Schultz as CEO, is now working to repair some erosion of their brand and product quality.

Most recently, I’ve been watching the Starbucks’ market valuation plummet over the past year with great intrigue. The current share price movement provides another great illustration of the difference between "market value” of a firm and the actual “intrinsic value” of a firm

In early January 2007, SBUX traded at about $35/share, yielding a market capitalization of over $25 billion (=$35/share x 725 million shares outstanding). At Friday’s market close, SBUX traded at $17.05/share, yielding a market valuation of only $12.36 billion.

While the company is focusing itself on re-establishing its brand, quality, service, and products, there certainly haven’t been any fundamental shifts in the demand for coffee. It doesn’t appear that Starbucks customers are flocking to Peet’s Coffee & Tea or Caribou Coffee to get their daily caffeine fix. Share prices at Peet’s are down about 20% since last year, and shares of Caribou have fallen from about $7/share to $2.75 in the same period. McDonald’s is rolling out a plan to compete in the specialized coffee business and their stock is up from $45/share to $55/share over the past year, but can they really take significant market share from Starbucks? Probably not.

So have operations at SBUX really taken such a negative turn that the company is now worth less than half of its value from early 2007? Clearly stock market thinks so, but this is why there is a difference between market value and intrinsic value.

When SBUX traded north of $30/share, that run up was based on increased demand for the market supply of shares (the 725 million outstanding). Strangely, in the middle of this run-up, the stock had a 2:1 split which changed the supply from about 362 million shares to the current 725 million shares outstanding. Supply doubled and the demand continued to force the market price per share to the $40/share range. The change in price reflects increased demand for shares, not necessarily a change in the intrinsic value per share of Starbucks.

According to Starbucks’ financial statements, the company increased its net income over 33% and increased their assets by over 50% in this two-year period. Let’s look at the market price per share during this same period.

In January 2005, SBUX traded at about $30/share. Taking into account the 2 for 1 stock split in October 2005, this means that the shares trading at nearly $40/share in April 2006 were really trading at $80/share. From at the same time that SBUX increased net income by 33% and increased their company assets by 50%, individual shares (actual pieces of ownership of the company) increased in value by over 250%. This means that the market value of a share of SBUX was increasing at a pace much faster than the actual value of the Starbucks.

Remember, market value ≠ intrinsic value.

Read the financial statements. Look at the assets and cash before making a decision on any company’s value – public or private. This isn’t my own idea, Ben Graham and David Dodd wrote about this in Security Analysis and this has long been the mantra of Warren Buffett.

More on the Bear Stearns Valuation

At market close on Thursday, Bear Stearns was trading at nearly $6/share, yielding a market capitalization of just over $800 million, nearly a tripling of the publicly-announced offer of $2/share ($236 million) from last weekend.

The general consensus indicates that the real estate owned by Bear Stearns in New York City is worth about $1 - 1.3 billion. On March 16, Paul Kedrosky wrote that that this real estate asset would account for a large portion of the sale price.

If this is the case, some things still don't add up to -

1. At the original sale price of $2/share ($236 million), it seems that JP Morgan was buying a $1 billion real estate asset for about 25% of market value. There are proponents of the $236 million price tag that argue that JP Morgan is "buying the stock, not the assets." In the simplest terms however, when you own a stock, you own a share of the company. When you own a share of a company, you own a share of all of its assets. This is the basis of intrinsic valuation.

This is my fundamental position againt the low valuation. I agree that Bear Stearns is not worth the $20+ billion when BSC share traded at $170, but their largest underlying real estate asset is worth more than $236 million.

2. What about the human capital at Bear Stearns? The company paid $3.4 billion in compensation in 2007 (according to their 10K). Assuming that anyone worth their salt has left the company by now, you can probably estimate that the remaining human capital still with the firm by the time this shakes out is worth some value of what they were paid in 2007. Let's call it 10%, which provides a current human capital value of about $340 million.

By these estimates, assuming all other assets in the company are worthless:

Real Estate + Remaining Human Capital = Total Current Value of Bear Stearns

So:

$1 bln + $0.340 bln = $1.340 billion, which calculates to $11.35/share. Given the risk profile of BSC right now, JP Morgan could justify a discount, a "risk incentive" to take the shares at a price slightly below this level.

So with a share price at the $6/share area and a secondary market valuation of about $800 million, we're getting warmer. But it's not surprising to see current shareholders balk at the $2/share originally proposed.

The first Internet IPO "Gold Rush" - in retrospect

I found an interesting spot on the PBS website - dot.con - that was aired and published back in 2002. Now that we're starting to get some perspective on the first Internet rush, reading these pieces in retrospect offers some valuable lessons going forward.

Venture Capital Investment Trends since 1995 (Deal Sizes)

Another snapshot of data provided by PWCMoneyTree.showing the size per venture capital per deal in companies of various stages since 1995.

The magnitude of the upward spike for Expansion and Late State companies is rather startling, but not surprising in retrospect, with the quick upslope from 1998 through 2000. Of course, this was the heydey of the first Internet boom, only to be followed by the impending crash in 2000-2001. One can only surmise that this free flow of capital into later stage companies is the 3rd, 4th, 5th round financings to get the original dotcoms to IPO.

To go from $7 mln/deal to nearly $25/mln deal provides some perspective on where the Internet IPOs took the imagination of venture capitalists and Wall Street alike, and where the imagination of venture capitalists and Wall Street took the Internet IPOs.

$236 million? Bear Stearns, Valuations, and Train Wrecks

An astonishing train wreck. That’s all that comes to mind in reading about Bear Stearns’ collapse and J.P. Morgan’s purchase of the Wall Street mainstay since 1923.

According to the Wall Street Journal – “J.P. Morgan Rescues Bear Stearns.” "Rescues?" Seems more like Cousin Vinny bailing out the “two youts” somewhere in Alabama after being charged for murder…

Part of me feels like the $236 million price tag might still subject J.P. Morgan to the “winner’s curse,” but seeing that no other bidders were evident, I guess not...

To put the $236 million number into perspective, the latest Bear Stearns balance sheet is showing over $600 million in Plant, Property, and Equipment, so at least J.P. Morgan can have a sidewalk sale to liquidate the remaining office equipment and cover the legal fees associated with the acquisition. And the $236 million would have been pocket change for the LBO equity firm about a year ago.

Or if you started with $200,000 in 1923, earning the market return of 8.66% per year would have yielded you $232 million by now.

The latest venture capital investment-based valuation of Yelp is somewhere around $200 million. So Web 2.0 companies with revenues at $10 million a year are worth more than Bear Stearns in its current state?

When I introduce the concept of fundamental analysis to my finance students at the University of San Francisco, we do an exercise to illustrate the difference between “market value” and “intrinsic value” of a firm. Guess I have a new company to use for next semester’s lecture.

The Facebook Multiplier: Economic vs. Market Valuation

I get the social part of it. I just found a friend of mine from high school, spent 10 minutes with my wife perusing pictures to put on my profile, and even reviewed 20 results for “Sambucci” including two in London, one in Glasgow, and one in Ecuador. I don’t get the 100x revenues to determine its $15 billion valuation.

Facebook’s foray into tracking member purchases went awry. Advertising dollars reach their ceiling quickly unless you’re Google.

The Facebook marketplace is less than overwhelming. There are 2598 items for sale in Silicon Valley, CA at the time of this posting. When I click “For Sale", the first page results include a 5"x5" cheese cake for $50, Oracle SQL/DBA Training for $360, and a 2007 Hybrid Ford Escape 4WD for $26,000.

Huh?

A marketplace is a place of aggregation where economic activity transpires. On the Internet, eBay is the typical example - an established marketplace with buyers and sellers. Defining the market more loosely, the same occurs when someone uses Google or another search engine to find a product that they eventually purchase. Members join Facebook for social networking, not to directly engage in economic activity.

With no indications that Facebook’s revenues are rising exponentially, it’s likely that direct revenues Facebook will generate for itself will remain relatively low compared to the true online marketplaces like eBay (~ $7 bln in 2007) and Google (~$15+ bln in 2007).

If this is indeed true, they why use Facebook’s revenues as the metric for valuing the company (currently at 100x revenues according to Microsoft’s recent investment)? Maybe there’s a more accurate way…

Let’s assume that because I’m a Facebook member, I meet up with a long lost high school friend in New York City and have dinner. It’s fair to assume that this happens frequently with many Facebook members – connecting with friends either directly or in part because of Facebook – which results in economic activity of some sort taking place (a $100 dinner in this case).

By taking this approach, we can then begin to connect a certain amount of economic activity attributable to Facebook. Some members are “power” users and others are more cursory like me. But overall, there is likely some average amount of economic activity per member that can be measured. Economists use “mulipliers” to calculate these “down line effects” of some event or activity. (In fact, the consumption multiplier is the rationale for the recent tax cuts approved by Congress and President Bush.)

If we can quantify these economic activities per Facebook member, then why not use a “Facebook Multiplier” to determine the firm’s value? This multiplier is not related to the revenues of Facebook. Instead, the newly-created revenues of other market participants as a result of Facebook existing become the determining factor to establish Facebook’s economic value to the market. Using the multiplier establishes a true intrinsic value for the firm, not an arbitrary market value as was done with Microsoft’s investment in Facebook.

This proposed multiplier may indeed show that Facebook’s firm value is indeed 100x revenues, but not because we use Facebook’s revenues as a basis for arriving at the valuation. Instead, Facebook is valued based on its contribution of total economic activity. This multiplier can be justified going forward because of the lock-in effect of Facebook, and possibly the growth of the multiplier as Facebook members utilize Facebook more frequently.

This creates a clear divide between Facebook’s economic value (its contribution to the economy as a whole) and its shareholder value (market value). To the displeasure to future Facebook shareholders, the multiplier approach values Facebook on the total revenues that it creates in the general economic, not revenues that it collects as a participant in the market.

The result? Facebook’s economic value is different than its market value. In fact, its economic value is greater than its market value. We assume that shareholders value a firm based on future earnings due to them as a part owner of the company. Shareholders that purchase shares of Facebook based on the market valuation of $15 billion established by Microsoft will be sorely disappointed if the firm’s personal revenue growth of Facebook remains at its current level.

In the end, I’m not contesting that Facebook is worth $15 billion. It could be even more than that. I just disagree that Facebook’s market value is $15 billion. The firm may hold an economic value of $15 billion with the resulting multiplier effect, with the market value falling far short of this number.

(Also consider that perhaps Microsoft established a $15 billion market valuation for Facebook to artificially inflate the market price to other would-be suitors…)

Caveat emptor.

No Revenue, Profit or Free Cash Flow? Now what?

In my recent post, I discussed how a firm's value could be determined simply by discounting the total revenue of the firm over a reasonable time period using an appropriate discount rate - the "Discounted Revenue Valuation Model" (DRVM)- because a firm's revenue represents the total benefit received by its customers.

DVRM focuses more on the economic, or intrinsic, value of a firm, not the market value of a firm. Financial markets and investors have shown a propensity to ignore economic valuations, instead valuing firms at artifically higher levels, creating a "market value" that exceeds true "economic value." This is the fundamental issue that I am addressing in these series of posts.

While I think DVRM a good starting point to begin to alter the way we think about firm valuation, practical challenges emerge with using this approach.

From a financial and accounting standpoint, it is possible for a firm's expenses to exceed its revenues. If a firm under evaluation has this condition, then the firm would not be a sustainable enterprise over the long run (assuming no change in the growth rates of revenues relative to expenses over time). So it seems that revenue alone cannot serve as the only indicator or proxy for determining firm value.

Arguably, it would be more responsible to take into account what's left from a firm's revenue after deducting all expenses. This is commonly known as "income" or "profit." Instead of using revenue, one could project a firm's annual income over a reasonable time horizon, determine a discount rate that fairly represents the risk level or opporunity cost of capital for the firm, and reach a new value for the firm. Using this method, there is the implicit correction for expenses incurred by the firm to achieve their revenue.

Even so, there are still problems with using a "Discounted Income Valuation Model." Primarily, accounting rules allow for a firm to claim expenses and revenues that are non-cash events, such as Depreciaton and Amortization on the expense side of things and Accounts Receivable on the revenue side. Therefore, accounting rules show that a firm may show an accounting profit, but may not have positive cash flows.

Cash is king, and anyone who's every been without money when they need will certainly attest to this. This leads us to using annual Free Cash Flows (FCF) to determine a firm's value. Just as we did with our Revenue Valuation Model and Income Valuation Model, we just forecast FCFs through a reasonable time period, discount them back using an appropriate discount rate, and now we have the true "value" of a firm.

Every textbook in basic finance espouses this method for properly determining a firm's value. This line of reasoning - starting with revenues, then using profits, and then using FCF to determine a firm's value - is exactly why textbooks and academics argue that the Discounted FCF Method is the proper technique to value an asset (or firm in this case).

But, here's the big problem -

Most start-ups generally have no FCF, Revenue, or Profit. And if this is the case with Facebook (which does have some revenue, though very little relatively speaking), how can you logically use some variation of the Revenue or FCF Valuation Models to accurately determine the true intrinsic or economic value of a firm?

I would argue that you can't. Throwing out valuations such as 10x revenues or 100x revenues to determine a firm's valuation is an economically unsound practice. There must be a better way to calculate firm valuation outside of some variation from the Revenue or FCF Models.

Company Value = Benefit to Customers

A common way to value a company is to look at the company’s total revenues and then take a some multiple such as “1x” or “2x” in conservative industries, with “10x” as an acceptable standard in the technology industry, and an incredible “100x” as witnessed in Microsoft’s valuation of Facebook. We’ll call this the “Revenue Multiple Approach” (RMA).

What’s interesting to me is that you never read about why we use "revenue" (or a multiple of revenue) to establish a firm’s valuation.

I was considering company valuations last week from an economic perspective - thinking more about how and why companies are valuable and how they fit into the broader economy and less about the plug-and-chug, back-of-the-envelope modeling that is common in finance. It made sense that a firm’s value solely should be based on the benefit that its customers receive from purchasing the firm’s products and services.

The outcome of this explanation is to show how we can generate the value of a firm (“Supplier") based on its sales to its customer(s) (“Purchasing Firm”)

In general economic theory, we know that consumers will consume a good as long as price of good is less than (or equal to) the benefit received by the firm. Consumers consume based on personal utility and firms consume production inputs to minimize cost (or maximize profit). It is possible to calculate the contribution of consuming this input to total profit.

Mathematically, this is means that a transaction to purchase a good or service will occur only if:

Price of a Good ≤ Value

So, if the value of a good is expressed in its price, then the value of a product is equal to the maximum price that the good’s consumer is willing and able to pay.

Total Value of a Good = Max Price Paid by Purchaser

(This sort of reinforces what we said above about a transaction taking place only if the price of a good is less than or equal to its value to the consumer.)

In a perfectly competitive market, firms produce to a point where their marginal cost of producing a product is equal to the marginal benefit gained from its sale. This is represented by the marginal cost/marginal benefit curves, also more commonly known as “Supply” (marginal cost curve) and “Demand” (marginal benefit curve).

If a firm produces to the point where MC = MB, then the costs to the Purchasing Firm for the good will be equal to the revenue of the Supplier. Conversely, the revenue of the Supplier will be equal to the marginal costs of the Purchasing Firm, which happens to be equal to the marginal benefit received by the purchasing firm.

So if we want to determine the Supplier’s value, then we can assume that its value is equal to the total marginal benefit experienced by all Purchasing Firms, which we’ve said happens to be equal to our Supplier firm's revenue.

Simply put:

Value of a Firm = Total Marginal Benefit Received by its customers = Total Revenue of Firm

Instead of using the Revenue Multiple Approach, we could call our company valuation model method the “Marginal Benefit Valuation” (MBV) because when we’re using revenues to determine a firm’s value, we’re really just calculating the firm’s total marginal benefit to its customers.

Finally, the last step in this process would be to take some reasonable time period, project revenues each year over that time horizon, use a discount rate that correctly assumes risk level or opportunity cost, and calculate a firm's value based on the discounted revenue streams during this time. And there's the basis for firm valuation using revenues to make the determination.

As an extension to the discussion ---

Which multiple to use (1x, 2x, 10x, 100x…)?

Much of that decision is subjective based on brand recognition, future company growth, the industry, and pure subjectivity. (We all remember the dotcoms where business valuations were based on which venture capital firm was willing to bid the highest.) This is another article in itself….

Why use multiples of revenues?

Well, as a part-time academic (I teach Finance at the University of San Francisco), I’ve personally never been able to get my head around using the RMA. If revenues are the choice for determining a company’s value (because they represent the Marginal Benefit received by their customers), it seems that it is far more logical to calculate the present value of future revenues. If one is particularly bullish on a company’s future prospects and would like to reflect this attitude in a company’s value, just adjust the discount rate downward and adjust the growth rate upward to yield higher present value (or higher company value). But of course, then you’re infusing significant subjectivity to the equation, but this approach offers a more sound theoretical modeling technique.

Market Value vs. Intrinsic Value

I'd like to tackle the issue of firm valuation. Determining a firm's value is especially important for start-up firms under consideration for venture funding. Establishing, maintaining, and increasing a start-up's value is central to the reason the firm was founded and for utilizing venture capital and investment provided to it.

This introduces an item that requires further clarification - the definition of "value." Value can be generally defined as "a fair price" or as "utility" or "worth" (courtesy of the American Heritage Dictionary...).

In the financial world, it's common to differentiate among types of "value." Specifically, there is a difference between an asset's "market value" and its "intrinsic value." Market value is the value that someone else places on an asset - what that asset is worth to some other market participant. Intrinsic value is the actual value or worth of a firm.

This fundamental difference in values supports the argument that the true value of a company is not necessarily reflected in the market valuations given to them by other market participants. The case I referred to was Microsoft's $15 billion valuation of Facebook. Valuations generated by venture capitalists or other related suitors nearly always tend to be market values, and not a reflection of a firm's intrinsic value.

If a VC values a company at $100 mln, and makes a $10 mln investment, that means that they have purchased 10% of the company. That initial $10 mln investment may be (or at least should be) entirely necessary for the target company to propel itself for product development, sales, and eventually profit. However, given that VCs are wrong on their company valuations 90% of the time, the $100 mln valuation is solely based on the market value - what the VCs are willing and able to pay for some asset.

In this case, they are willing and able to pay $10 mln for 10% of the company. Surely they would be willing to pay less that $10 mlm for 10% of the company, and alternately, the company owner would surely be willing to sell less than 10% of the company for $10 mln. But assuming that the VC and the company operate in a competitive market, this $10 mln investment for 10% of the company represents the market equilibrium price for the asset (the asset being 10% of the start-up).

This market price doesn't necessarily mean, and in most cases, does not mean that the intrinsic value of the start-up is $100 mln, only that the market value of the start-up is $100 mln. In fact, with the 90% failure rate of the VC industry, it stands to reason that the market valuation of the company is quite overpriced, but because there is a willing buyer and seller, a market for the 10% of the company is created.

With a couple of fundamentals definitions, we can begin to see how the market valuations for start-ups and new media companies may be incorrect a high percentage of the time, with these errors tending to overvalue a firm rather than undervalue a firm.

It's a point of frustration to see artificially high market values placed on firms (whether they be start-ups or publicly-traded) when it is clear the economic or intrinsic value of a firm can be clearly argued to be much lower.

Private Equity & the Publishing Industry

Apax acquired Thomson Learning for over $7+ billion - nearly the same sale price as Chrysler!

Pearson plc recently acquired eCollege for approximately $500 mln., despite Pearson’s strategic partnership with Blackboard, Inc., a direct competitor to eCollege. Additionally, this price reflects a value nearly equal to eight times revenue and 20 times EBITDA.

I am closely monitoring the current and proposed transactions in the publishing industry. With over seven years of experience in this industry, I believe that there are significant inefficiencies that exist within the market participants. The major publishing houses maintain internal brand and production silos within their organizations, often duplicating product development, sales, and distribution services. In these cases, there are opportunities to divest these brand silos individually, with the sum of parts worth more than the whole and thus providing an opportunity for an experienced private equity fund to execute these transactions profitably.

In addition, traditional publishing companies have been challenged by an increasing number of distribution competitors, such as used books sellers overseas and new technology companies offering customizable, user-generated content. Companies with modernized distribution channels versus traditional publishers (such as the relationship of News Corporation and Dow Jones) will be able to leverage these channels to better meet market demands, and again give rise to a profitable outcome.

These industry conditions present an interesting value proposition for private equity firms experienced in capitalizing on these types of market inefficiencies, resulting in more effective and profitable companies. I suspect that this may be a main proponent of Apax Partners’ cash purchase for Thomson Learning, a price considered to be exorbitant by some executives within the publishing industry.