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Larry Gerbrandt in Los Angeles raises the spectre of the unwelcome return of relative valuation
Like a bad horror movie franchise, some valuation concepts seem to keep coming back for another sequel in hopes that this time they’ve got it right. I’m talking about the biggest financial sink-hole ever created: ‘relative valuation’. The technique rose to improbable heights at the peak of the Internet bubble more than a decade ago and was widely discredited in the ensuing disastrous crash.
Like Freddie Krueger, some nightmares shouldn’t come back, but relative valuation (RV) is one of those ideas that on the surface solves so many problems and holds out the possibility of fabulous riches that it creeps back when you least expect it. As the old saw goes: “Those who fail to learn from history are doomed to repeat it.”
Here’s how RV works: find a metric, usually a ‘value per user’ or ‘value per clickthrough’ or ‘value per subscriber’ or ‘value per stream’. Now in and of itself, these kinds of metrics can be useful, and if thoroughly understood and dissected, can even be legitimately used for Comparable Valuation, one of the three generally accepted valuation techniques (the other two being Replacement Cost and the Income Method, usually accompanied by a discounted cash flow analysis). In the media and entertainment world, Replacement Cost is rarely employed unless the asset is largely composed of equipment or certain types of hard goods inventory. The Income Method is by far the most common, and often the most rigorous, since it requires looking at things like revenue, expenses and, most important potential income and how fast it is likely to grow over time. But back to RV.
RVs are almost always the tool relied upon to put a value on startups, especially digital or Internet start-ups, when revenue, much less positive EBITDA, is still on the distant financial horizon. It usually starts with looking at a competitor that has been successful—possibly even gone public—and has enough publicly available numbers from which the ‘value per something’ can be calculated. During the 2000 digital bubble, ‘value per unique visitor’ was the go-to RV and was cited in dozens if not hundreds of initial public offering filings.
What we have learned (or should have learned) in the ensuing decade is that the market leader—the one to which all the RVs are pegged—often becomes so dominant that none of the contenders ever get traction. Examples of those are companies such as eBay, Amazon and Google. On the other hand, we have the example of MySpace, that once dominated social media networking, became the go-to RV when it sold to News Corp for $580 million and had 100m accounts.
The resulting $5.80 per account was quickly turned into RV currency and was used as such in business plans and analyst reports alike. The real trouble with RVs is that they are intrinsically bound to the specific economics of the subject site and their specific business model. Because a venture capitalist is willing to place a 1-in-10 bet on a start-up with a promising but yet to be proven business plan at a multi-million (or in latter stage financings multi-billion) dollar valuation does not create a Comparable, at least not one that can be freely used on other startups.
We should be well past the days when a site gets a big valuation based solely on traffic, with a promise that “we can figure out how to monetise that traffic later”. Facebook IPO investors bought the stock on the basis of market dominance but Wall Street analysts who base their valuations on things like discounted cash flow are still waiting to see whether the company can figure out sustainable ad models without driving away users.
Ironically it is when comparing relatively mature pure play companies with very similar assets and operating strategies that RVs actually work well, at least in terms of screening for companies that might be under or overvalued. For instance, movie theatre chains are often compared on the basis of EBITDA multiples and sometimes even ‘value per screen’. Certain classes of basic cable networks—usually those with less than 25m subscribers (this only applies to the US market) may have a core value of $3 to $6 per subscriber because that is what it generally costs in start-up losses to get to that level. Newspapers and other publishing assets are also frequently compared based on revenue multiples or value per paid circulation subscriber.
What is going on in these cases is that in maturity these RVs have actually grown up to be Comparables and the underlying assets can also be valued using the Income Method based on discounting future cash flow. What we do know is this: just as the Internet IPOs of 2000 did not create a new form of ‘Internet currency’ that defied financial logic in the traditional valuation world, RVs based on a follow-the-leader mentality inevitably leads to unsustainable valuations when it comes time to generate revenue and long-term sustainable EBITDA growth.
Larry Gerbrandt has been a media analyst for over 25 years with firms like Kagan and Nielsen. He is principal of Media Valuation Partners, providing research and expert witness services. He is also a managing director at Janas Consulting providing management consulting, valuation and investment banking.