company companies percent million capital businesses revenue
Valuing high-tech companiesFor the past several years, investors have once again been piling into sharesof companies with fast growth and high uncertainty—especially Internet andrelated technologies. The rapid rise and sudden collapse of many such stocksat the end of the 20th century raised questions about the sanity of a stockmarket that appeared to assign higher value to companies the more their lossesmounted. Now, amid signs that the current tech boom is wobbling, even the USSecurities and Exchange Commission is getting into the act, announcing in late2015 its plans to investigate how mutual funds arrive at widely varyingvaluations of privately held high-tech companies.In the search for precise valuations critical to investors, we find that somewell-established principles work just fine, even for high-growth companieslike tech start-ups. Discounted-cash-flow valuation, though it may soundstodgily old school, works where other methods fail, since the core principlesof economics and finance apply even in uncharted territories, such as start-ups. The truth is that alternatives, such as price- to-earnings or value-to-sales multiples, are of little use when earnings are negative and when therearen’t good benchmarks for sales multiples. More important, these shorthandmethods can’t account for the unique characteristics of each company in afast-changing environment, and they provide little insight into what drivesvaluation.Although the components of high-tech valuation are the same, their order andemphasis differ from the traditional process for established companies: ratherthan starting with an analysis of the company’s past performance, begininstead by examining the expected long-term development of the company’smarkets—and then work backward. In particular, focus on the potential size ofthe market and the company’s market share as well as the level of return oncapital the company might be able to earn. In addition, since long-termprojections are highly uncertain, always value the company under differentprobability-weighted scenarios of how the market might develop under differentconditions. Such techniques can help bound and quantify uncertainty, but theywill not make it disappear: high-growth companies have volatile stock pricesfor sound reasons. What follows is an adaptation of analysis we published in2015, using public data from 2014 and 2015. The analyses herein are presentedas an exercise to illustrate the methodology. They are not meant as acommentary on the current market situation and should not be used as the basisfor trading in the shares of any company.## Start from the futureWhen valuing high-growth companies, start by thinking about what the industryand company might look like as the company evolves from its current high-growth, uncertain condition to a sustainable, moderate-growth state in thefuture. Then interpolate back to current performance. The future state shouldbe defined and bounded by measures of operating performance, such as customer-penetration rates, average revenue per customer, sustainable margins, andreturn on invested capital. Next, determine how long hypergrowth will continuebefore growth stabilizes to normal levels. Since most high-growth companiesare start-ups, stable economics probably lie at least 10 to 15 years in thefuture.To demonstrate the valuation process for high-growth companies, let’s walkthrough an abbreviated, potential valuation of Yelp, a popular online site forreviewing local businesses, using public data about the company. In 2014,approximately 545 million unique visitors wrote 18 million reviews on 2million businesses. As the company explains in its annual report, “Thesereviews are written by people using Yelp to share their everyday localbusiness experiences, giving voice to consumers and bringing ‘word of mouth’online.”Originating in San Francisco, the company now serves around 150 cities aroundthe world. Yelp’s revenues between 2009 and 2014 grew more than tenfold fromjust under $26 million to $378 million, representing a compound annual growthrate of 71 percent. (Revenues in 2015 were up 48 percent over the previousyear as of the third quarter.) To estimate the size of the potential market,start by assessing how the company fulfills a customer need. Then determinehow the company generates (or plans to generate) revenues.Understanding how a start-up makes money is critical. Many young companiesbuild a product or service that meets the customer’s need but cannot identifyhow to monetize the value they provide. Yelp provides end users with anextensive online forum to review the experiences of other customers whenselecting a local business. Although Yelp provides a convenient service to thecustomer, today’s Internet users often do not pay for online reviews.Instead of charging the end customer, Yelp sells local advertising tobusinesses that register on the website. A basic listing is free, but thecompany offers paid services, such as enhanced listings with photos and video,a sponsored search (where the company appears early in the consumer’s searchresults), and a “call to action,” which allows the consumer to schedule anappointment or the business to provide a coupon. In 2014, that localadvertising contributed $321 million of the company’s $378 million inrevenues. Two other sources of revenues, brand advertising and other services,allow companies to purchase general advertisements and conduct transactions.Both are growing rapidly, but they continue to be a smaller part of annualrevenues. Using these revenue drivers as a guide, start your valuation byestimating the potential market, product by product.## Size the marketAlthough Yelp management rightfully touts its unique visitors and growing baseof customer reviews, what really matters from a valuation perspective is itsability to convert local businesses into Yelp clients. Start with estimatinghow many local businesses are in Yelp’s target markets, how many businesseswill register with Yelp, and how many of those businesses will convert to itspaid services. There are approximately 66 million small and midsize businessesin Yelp’s target markets. As of 2014, the company had registered 2 millionbusinesses on its site. Of the businesses that registered, only 84,000 werepaying clients. With 1 percent market penetration, there is plenty of room forgrowth (exhibit).To build a revenue forecast, first estimate the number of business that mightregister with Yelp. We estimate both historical and future registration ratesby analyzing Yelp’s historical data. Since registration is free and Yelp iswell known, we model penetration, for this exercise, to reach 60 percent. Thattranslates to 8.5 million registered businesses by 2023. For most start-ups,forecasting a 60 percent share is extremely aggressive, since additionalcompetition is likely to enter the market. For this business, however, it isreasonable to assume that the largest company is likely to capture asignificant portion of the online market—since businesses desire anadvertising partner that generates the most traffic, and consumers desire awebsite with the most reviews. In that way, this business is similar to otherswith a community of users that reinforces the use of the product, such asMicrosoft’s Windows operating system, which still retains more than 80 percentof its market.With registered businesses in hand, next estimate the conversion rate frombasic (free) to enhanced (pay) services. To estimate this number, we analyzeddata from cohorts of Yelp’s markets based on entry dates to annual conversionrates the company has reported. Based on historical data, we project thatYelp’s penetration rate will grow from 4 to 5 percent as the cohorts mature.This number is quite conservative, but historical data have not pointed tomuch movement over time, even for Yelp’s earliest markets.Would you like to learn more about our Strategy & Corporate Finance Practice?Complete the forecast by estimating revenues per client. Again, data fromearly markets are relatively stable, averaging near $3,800 per business.Assuming average revenue per paying business increases at 3 percent per yearleads to revenue of $5,070 per business by 2023. Multiplying the number ofpaying clients in 2023 (423,000) by the average revenue per business leads toestimated total local-advertising revenue of $2.2 billion in 2023. Addingestimates of revenues for brand advertising and other services yields anestimate of total 2023 revenues of $2.4 billion.Next, we test our revenue estimate by examining potential market share in2023. BIA/Kelsey, a research and advisory company that focuses on localadvertising, estimated that local businesses spent $132.9 billion onadvertising in 2013, of which $26.5 billion was placed online. Between 2013and 2017, the research company expects online advertising to grow by 14percent per year, to $44.5 billion. Assuming that number grows by 5 percentper year, we estimated total online-advertising revenues will come to $60billion in 2023. Although search engines such as Google are likely to continueto capture the lion’s share of this market, there is still room for Yelp tocapture a portion of local advertising. Our estimate for Yelp in this exercisetranslates to a potential market share of 4 percent by 2023.## Estimate operating margin, capital intensity, and return on investedcapitalWith a revenue forecast in hand, the next step is to forecast long-termoperating margins, required capital investments, and return on investedcapital (ROIC). Since Yelp’s current margins as a fast-growing start-up arenot indicative of its likely long-term margins, it is important to examine thefundamentals of its business model and look to companies with similar businessmodels. OpenTable is another high-growth company actively serving businessesin local markets. OpenTable provides reservation services for restaurants.Similar to Yelp, the company generates revenue by deploying a dedicated salesteam to local restaurants to encourage enrollment. OpenTable’s managementforecast that, when mature, it would reach operating profit margins of about25 percent. Combined with our revenue forecast, this margin projection wouldtranslate to a potential growth in operating profit from a loss of $8.1million in 2013 to a profit of $619 million in 2023.But are these forecasts realistic? To address this question, examine othersoftware companies that provide a similar conduit between consumers andbusinesses, funded by businesses. The key value drivers for Google, LinkedIn,and Monster Worldwide, though not a perfect comparison, offer some insightinto what is possible.If Yelp can match Google, perhaps 25 percent operating margins are notunrealistic. But not every business-to-business Internet company has been ableto maintain such healthy margins. For instance, Monster Worldwide generatedoperating margins near 30 percent prior to 2010, but it has watched marginserode under competitive pressure. In 2013, domestic margins hovered near 15percent, and the company’s overall margin declined below 10 percent. Successwith consumers by no means assures ongoing success with the businesses and, byextension, with financial results.To estimate future cash flow, we also had to forecast capital requirements.Most businesses require significant capital to grow. This is not the case formany Internet companies. In 2014, Yelp required only $92 million of capital on$378 million of revenues, or 24 percent. Unlike traditional companies, whichoften consume significant capital as they grow, Internet companies requirelittle fixed equipment; most of the capital resides in short-term assets suchas accounts receivable. To create cash flow for Yelp, we maintained thispercentage of invested capital to revenue, which is also in line with Google,LinkedIn, and Monster Worldwide. With high operating margins and littleinvested capital, ROIC is so high that it is no longer a useful measure. Butwhat about the competition? If ROIC is so high, shouldn’t competitors enterand eventually force prices down? Perhaps, but Yelp’s real capital resides inintangibles such as brand and distribution capabilities, and these are noteasily captured using today’s financial statements.## Work backward to current performanceHaving completed a forecast for total market size, market share, operatingmargin, and capital intensity, it is time to reconnect the long-term forecastto current performance. To do this, you have to assess the speed of transitionfrom current performance to future long-term performance. Estimates must beconsistent with economic principles and industry characteristics. Forinstance, from the perspective of operating margin, how long will fixed costsdominate variable costs, resulting in low margins? Concerning capitalturnover, what scale is required before revenues rise faster than capital? Asscale is reached, will competition drive down prices?Often the questions outnumber the answers. To determine the speed oftransition from current performance to target performance, we examined thehistorical progression for similar companies. Unfortunately, analyzinghistorical financial performance for high-growth companies is oftenmisleading, because long-term investments for high-growth companies tend to beintangible. Under current accounting rules, these investments must beexpensed. Therefore, accounting profits are likely to be understated relativeto the true economic profits. With so little formal capital, many Internetcompanies have high ROIC figures as soon as they become profitable.Consider Internet retailer Amazon. In 2003, the company had an accumulateddeficit (the opposite of retained earnings) of $3.0 billion, even thoughrevenues and gross profits (revenues minus direct costs) had grown steadily.How could this occur? Marketing- and technology-related expenses significantlyoutweighed gross profits. In the years between 1999 and 2003, Amazon expensed$742 million in marketing and $1.1 billion in technology development. In 1999,Amazon’s marketing expense was 10 percent of revenue.In contrast, Best Buy spends about 2 percent of revenue for advertising. Onemight argue that the eight-percentage-point differential is more appropriatelyclassified as a brand-building activity, not a short-term revenue driver.Consequently, ROIC overstates the potential return on capital for new entrantsbecause it ignores historically expensed investment.## Develop weighted scenariosA simple and straightforward way to deal with uncertainty associated withhigh-growth companies is to use probability-weighted scenarios. Evendeveloping just a few scenarios makes the critical assumptions andinteractions more transparent than other modeling approaches, such as realoptions and Monte Carlo simulation.To develop probability-weighted scenarios, estimate a future set of financialsfor a full range of outcomes, some optimistic and some pessimistic. For Yelp,we developed three potential scenarios for 2023. In our first scenario,revenues grow to $2.4 billion on roughly 423,000 converted accounts withmargins that match Google’s. In our second scenario, we assume that Yelpprogresses much better than expected. Registrations for free accounts followthe base-case scenario, but the company doubles its conversion rate from 5 to10 percent, leading to nearly a half million accounts and approximately $4.6billion in revenue. In this scenario, the company continues its path toprofitability, with margins comparable to Google’s. This is an optimisticestimate based on past performance, but a 10 percent conversion rate is by nomeans implausible. The last scenario assumes that Yelp generates less than$1.2 billion in revenue by 2023 because the international expansion goespoorly. Without expected revenue growth, margins grow to just 14 percent,matching Monster Worldwide’s domestic business. To derive current equity valuefor Yelp, weight the intrinsic equity valuation from each scenario ($5.0billion for the high case, $3.4 billion for the base case, and $1.3 billionfor the low case) by its estimated likelihood of occurrence, and sum acrossthe weighted scenarios. Based on our illustrative probability assessments of10 percent, 60 percent, and 30 percent, respectively, for the three scenarios,we estimate Yelp’s equity value at $2.9 billion and value per share at $39.Whether this price is appropriate depends on your confidence in the forecastsand their respective probabilities. Were they too optimistic, too pessimistic,or just right?Scenario probabilities are unobservable and highly subjective. If theprobability of occurrence for the most pessimistic scenario were tenpercentage points higher, Yelp’s estimated value would be more than 10 percentlower. For start-up companies with promising ideas but no actual businesses,the sensitivities can be significantly higher. Take, for example, a start-upcompany that needs to invest $50.0 million to build a business that could beworth $1.2 billion with a probability of 5 percent and completely worthlessotherwise. Its estimated value today would be $10.0 million. But if theprobability of success were to fall by just half a percentage point, its valuewould decline by more than half. It should be no surprise that the shareprices of start-up and high-growth companies are typically far more volatilewhen compared with companies with mature businesses.As a result, understanding what drives the value of the underlying businessacross the scenarios is more important than trying to come up with a single-point valuation. A careful analysis of Yelp’s business following the lineslaid out above helps. For Yelp, the growth of the advertising market and themarket share it could attain are important— but they can be forecasted withina reasonable range (and don’t differ that much across scenarios). Morecritical—and harder to predict—are the conversion rates to paid-serviceaccounts and the average revenues per account that Yelp realizes in comingyears. Conversion rates and revenues per account are the key value drivers forYelp.