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Bursting the bubble

Traditional forms of due diligence and value metrics have been outmoded in the latest dotcom fervour, writes Richard Crump

EVERY MONTH, it seems that one of the new generation of dotcom companies is attracting a sky-high valuation. The irrational exuberance gripping investors and financiers when it comes to social media sites – the new darlings of the internet boom – has resulted in spiralling valuations that have reached staggering heights.

Facebook, Twitter and Groupon have garnered an estimated value of $119bn (£74bn) between them, but have only generated revenues of $2.8bn in 2010, much of which was produced by Facebook. Companies in the Standard & Poor’s 500 are typically assigned a market value of zero to four times their earnings, so why are social media sites being assigned valuations of 100 times revenue or more?

The dizzying leaps in valuations, which have come as some of the most prominent companies of the social media revolution prepare for public listings, raise questions about whether a tech bubble, akin to that of 2000, is on the cards, as financiers start skimping on due diligence in the clamour to claim a slice of the next big thing.

Looking at some of the valuations, it is easy to draw comparisons with the investments made in internet companies that failed during the previous dotcom fever to grip the market. For example, the likes of, a sports fashion website, burned through $135m of investor cash before collapsing a year after its launch.

Social e-commerce company Groupon has seen its valuation grow from $6bn to $20bn in a matter of months, despite being a young loss-making company in a competitive market. Twitter, loss-making and still trying to find a workable business model five years after its launch, has been valued at $9bn. Zynga, the social network games company that has millions hooked on growing virtual vegetables in the Farmville game, is also valued at $9bn.

Jon Coker, investment manager at venture capital firm MMC Ventures, which has invested in a range of internet tech companies, including a company that manages video content online, an e-commerce business and an online retail broker for financial services businesses, suggests that such valuations are aggressive and overly optimistic.

“There is a huge amount of potential priced into those shares,” he says. “Those deals have been over-valued by people who don’t necessarily have the right knowledge of the sector. They will be quick to react the other way if the business doesn’t perform as well as they expect.”

Applying value

Value per userSimon Harris, senior manager in the valuations team at PwC, says the difficulty for would-be financiers is that the traditional value metrics used for established companies are difficult to apply.

“It is a value on the potential and that’s what makes it risky,” says Harris. “But just because those traditional multiples look big, it doesn’t necessarily mean that they are over-valued. When Google IPO’d, it was at 200 times earnings – now, that looks like it was good value.”

However, the price-to-earnings metric that has traditionally been used to assess the value of established technology companies are not appropriate for the latest wave of social media investments, says Harris. In most cases, the companies involved are not yet making profits, and if they are, the valuations being made on them are so far out of kilter with the profits earned that looking at price-to-earnings provides little or no meaningful insight.

According to Harris, comparing the value-per-user of social media companies with telecoms operators and broadcasters works as an alternative value metric when price-to-earnings breaks down [see chart].

Coker at MMC Ventures agrees that earnings are not the most efficient metric for valuing the potential of early-stage internet companies.

“A lot of the value created by the founders and angel investors are not shown in earnings. It is about the platform they have built and the customers they can get on board,” says Coker. “We look at their earnings forecast and create a picture as to where we think the company is going to be in four years’ time and what that means in terms of potential cash flow.”

Coker adds that more emphasis is put on the potential customers when performing due diligence on a prospective dotcom company. “How do they purchase; how long do they need the product; how long will they use it for; what revenue model do they buy it on?” he says.

As a great deal of the valuation is based on potential, Harris at PwC says that the due diligence fundamentals are not really that different from those for traditional companies.

“You have to get to the nuts and bolts of what drives value. Is there a capable management team; do they have the necessary infrastructure in place; is there a platform they can leverage; how do they interact with customer; how is the user base grown?” he explains.

However, he does concede that there is an “exuberance to assume that the next Facebook is the next Facebook, and not just a bad company”. ?

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