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Gil Ostrick
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What are the
major differences when valuing Internet related companies to mature
unrelated entities?
Before
illustrating examples of valuations perhaps a little background will
explain the differences between the two. The most significant factors
in calculating the cost of capital are size (market value capitalization),
economic growth, business and industry risk. The cost of capital is
the expected rate of return the investment will yield in an informal
market. Risk is defined as the degree of uncertainty as to the realization
of expected future returns. The above cost of capital demonstrates
the income approach of valuing an entity. Economic income is any measure
of incoming inflow to the subject being valued which can be converted
into value through either discounting or capitalizing at appropriate
cost of capital rates. This could include net revenues, net operating
income, net cash flows, etc. The other approach to value an enterprise
is the market value approach which compares the market price of stocks
of corporations engaged in the same or similar lines of business having
their stock actively traded in a free and open market either on an
exchange or over the counter. This is how all investment bankers,
venture capitalists and institutional investors value all business
units.
Internet valuations
generate higher values that the old economy companies because of
the dynamic potential for growth for an industry that has universal
market acceptance. The Internet has as much usefulness as discovering
electricity.
How do investors
justify paying even higher prices for Internet common shares?
If the economy slows and interest rates stop rising or fall,
it will increase the likelihood that old economy companies will
continue to invest in the Internet and telecommunications. That’s
a positive for Internet stocks. In recent weeks the expectation
of higher interest rates was viewed by the market as bullish for
internet stocks because those companies were expected to continue
growing even if mature economy companies slowed. In other words
just about everything seems bullish for the Internet or so the bulls
believe. Think about these facts for a few minutes. The new economy
which is Internet and related information technology including Tele-communications
have the most dynamic growth and their market capitalization increased
because of the universal market acceptance of its products or services.
The Internet can be used for sales or marketing, increasing productivity,
and using information to make better business decisions. The Internet
typifies the information age which will most likely change every
aspect of how we do business both personally and in corporate life.
The speed of the Internet age will exceed the rate of growth of
the industrial revolution. Just look at AOL acquiring Time Warner
or CISCO and Yahoo who have higher market capitalization’s
than most of the Dow Jones 30 industrial stocks who have been around
for fifty to hundred years. Just take a look at Eastman Kodak, Phillip
Morris, ALCOA, and International Paper and Caterpillar. All good
companies but how does their economic future compare to the Internet?
Of course picking the right Internet.com takes a lot of due diligence
to get the proper valuation.
Many Internet
companies will fail because management and technological innovation
cannot keep pace with what the market requires, but as an industry
just look at the NASDAQ composite index that is growing at a much
faster rate than the S & P 500 index or the Dow Jones index.
In short, the Internet will combine the best features of telecommunications
and information technology to make all companies more effective
and profitable since the Internet or E-Commerce is better, faster,
cheaper, and perhaps in the future more convenient than the way
we sell and process information to make informed decisions. While
the anticipation of earnings in developmental stage Internet companies
are intangible, the value is perceived as real and investors take
the risk at much higher multiples. The reward or economic payoff
is worth the risk. Venture capitalists and companies involved in
information technologies have expanded dramatically in funding Internet
entities. Another big difference between accounting data and capital
market data suggests that the usefulness of financial audit reports
is rather limited. Business valuations are about estimating future
economic income streams discounted back to their present values.
The result is then multiplied by capitalizing the cost of capital
adjusted for a sustainable long-term economic growth rate. Economic
income as opposed to accounting income for business valuation by
Wall Street ads research and development, amortization of good will
strategic investments by entities whose payoff will not come for
five years but has great income revenue or market share potential.
Internet companies heavily invest in the use of marketing expenses
to establish new brands, enter new markets, or gain market share.
America on Line must have sent 20 to 30 disks to access its service
to every personal computer owner in the United States. By accounting
standards, the Internet companies are losing money. Just look at
the negative earnings per share reported in audited financial statements.
However, if you look at how Wall Street and other business valuators
estimate these values, you would see why the market valuations of
Internet companies are accelerating. If you add back to economic
income, these type of investments that the accountants write off
you can see why the Internet companies have more value than mature
companies whose prospect for economic growth aren’t as great.
Even in terms of business risk, for the Internet economy, the experts
see that everyone will use the Internet just like the invention
of the automobile or electricity, which mitigates risk in relation
to the potential payoffs (benefits). In our business valuation practice
we valued an Internet company that was just formed with a two million
dollar valuation. The Company raised over $700,000, went public
two years later at $7 per share and rose to $38 per share one month
later. Several months later it was negotiating a $70 million exchange
of common shares with another Internet Company. We did a due diligence
assignment for a tiny publicly held telecommunications company that
was losing money which based on our report purchased a very profitable
competitor doing over $16 million in sales volume. In the last few
weeks we have seen several Internet start ups in Southern California
needing us to do business valuations to choose between being acquired
by a strategic buyer or getting another round of venture capital.
Two years ago, every young company complained. Where are the venture
capitalists? In the last year all that has changed as more Internet
companies have demonstrated values those venture capitalists, investor
angels and other strategic buyers in information technology entities
were willing to pay for the new economy companies. The higher multiples
given to Internet valuations suggests as opposed to the old economy
is based on intangibles such as dynamic industry and specific company
appeal to excel in its market niche.
About the
Author:
Gil Ostrick is a principal in Value Added Advisors, LLC, specializing
in wealth enhancement solutions for business including valuations
and performance measurement. Valuations are used predominantly in
buying or selling business or dissenting shareholder actions. Independent
valuations inform sellers as to a fair price to accept deals related
to investment capital from venture capitalist or strategic buyers.
If companies are looking to purchase other companies in their industry,
Value Added Advisors performs due diligence and valuations to document
a fair price for both parties. The firm employs Certified Valuation
Analysts’ with over ten years experience in information technology
companies as well as manufacturers and distributors.
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