Internet companies’ valuations –back to the future?

With the recent talk of high profile IPO plans and multi-billion valuations of internet companies I wonder if we are experiencing a second round of the tech bubble. Theory tells us that a company’s worth is equal to the present value of its future cash flows. In practice it is very difficult to forecast cash flows, even for brick and mortar companies with fairly stable revenues. In the on-line realm, forecasting cash flows is only an illusion of due diligence. Amazon lost money in the 90s and now is worth around $85 billion. Some analysts said it would never make money, and certainly it wouldn’t if it had remained selling books on-line. But who did effectively forecast that Amazon would become an e-commerce platform, and even if someone did, how to value that?

Not all companies can replicate the success of Amazon. Take MySpace for example, which was bought in 2005 by NewsCorp for $580 million, it hit a top valuation of $12 billion in 2007, and in 2011 it was sold to Specific Network for $35 million. This illustrates that the perception of MySpace’s ability to generate cash in the future changed dramatically in a short period of time. The overvaluation of internet-enabled opportunities that in the end do not deliver the expected returns are common. The “new media” opportunity in the AOL-Time Warner merger comes to mind, $350 billion made it the largest merger in U.S. history, and a colossal failure.

More recently we have seen several internet companies that command incredibly high valuations in relation to their earnings. Linkedin with a market value of around $9.5 billion has revenue around $200 million. Pandora with a value of around $3.6 billion had revenues of $90 million for the first 3 quarters of fiscal 2011 but still reported a loss of $0.3 million, they don’t expect to report earnings until the end of fiscal 2012. Later this year we’ll see multi-billion IPOs for Groupon and Zynga. Groupon launched in the end of 2008, in two years it had revenues around $700 million, which generated an offer by Google for $6 billion (in the low range of the valuations in the news today). Zynga on the other hand is already very profitable, it generates $17 million of free cash flow each month giving it a valuation of $14.5 billion.

Certainly some of the multi-billion on-line companies will give shape to their respective market segments and be very profitable, others will “pivot” until they figure out a successful business model, and others –most of them– will perish in the attempt. Insofar as investors think these companies can effectively be as profitable as their valuations suggest I wouldn’t say we are experiencing a bubble. Nevertheless, I do believe some companies are overvalued by Venture Capital activity that is betting on selling these companies to the established players (e.g. Google, Facebook, MS, etc.) at much higher prices in the future. This phenomenon has been characteristic of the development of the business models enabled by the internet. Whenever there is an opportunity of something becoming the next big thing a lot of capital flows in and valuations soar when competitors rush to get in first. In the end, some companies turn out to be worth their buzz, and many others don’t.