Wednesday, May 18, 2011

Is Skype worth $8.5 billion? An exercise in valuing young, growth companies

Last week, Microsoft announced that it would buy Skype for $8.5 billion. The reaction was fast, furious and very predictable. First, there was the search for reasons for the deal and technology mavens listed a few. Second, there was the reaction from investors and analysts, which was generally not very positive. Third, it was noted that Bill Gates, the face of Microsoft for so long, was strongly in favor of the deal (thus providing cover for Steve Ballmer).

Ultimately, though, the discussion of the deal was lacking in one key respect: Is Skype worth $8.5 billion to Microsoft? A few of the analysts noted that the price paid was roughly ten times Skype's revenues in 2010, an undoubtedly rich price, but by itself proving nothing. After all, if you had been able to buy into Google at ten times revenues in 2003, you would be rich now. A great deal of attention was paid to whether Skype was the right company for Microsoft to buy and the strategic/synergistic fit of the two companies.  It has always been my contention with acquisitions that it is not the strategic fit or synergistic stories that make the difference between a good deal and a bad one, but whether you buy a company at the right price. Put in more direct terms, buying a company that is a poor strategic fit at a low price is vastly preferable to buying a company that fits like a glove at the wrong price.

So, let's get back to valuation basics. What is the value of Skype? The question is rendered more difficult to answer because Skype is a private business and we know little about the insides of the financial statements. It is widely reported, though, that Skype had operating losses of $7 million on revenues of $ 860 million in 2010. Taking those numbers as a base, I tried to value Skype, making what I thought were very optimistic assumptions:
- Continued revenue growth of 20% (which was what they had last year) for the next 5 years and a gradual tapering down of growth to 3% in ten years.
- A surge in pre-tax operating margins to 30% over the next ten years; this margin is at the very upper end of the technology spectrum (where companies like Google reside).
- A decline in the cost of capital from 12% now (reflecting the uncertainty associated with young, growth businesses) to a cost of capital of a mature company in ten years
With those assumptions, I estimated a value of $ 3.8 billion for Skype. It is entirely possible, however, that I am wrong on my key assumptions - revenue growth rates and target margins. In fact, changing those base inputs gives me the following table:

Is it possible that Skype is worth more than $8.5 billion? Sure, if you can deliver revenue growth higher than 35% and a pre-tax operating margin of 30%. Is it probable? I don't think so.

The value drivers for Skype - revenue growth, target pre-tax operating margin and survival - are generally the constants you worry about with young, growth companies. In the Little Book of Valuation, in the chapter on valuing young growth companies, I argue that these value drivers also should give you indicators of value plays in young, growth companies. Thus, when investing in a young, growth company (Tesla Motors, Linkedin, Facebook etc.), here are some of the indicators you would look at:
a. Size of potential market: Since high revenue growth is easier to pull off, when the market is large, you want to invest in companies that are entering large potential markets rather than narrower, specialized markets.
b. Competitive barriers: For margins to improve over time, you need space to grow and protection from intense competition. This can come from patents (for a young, biotechnology company), a technological advantage, a brand name or the sheer ineptitude of established competitors.
c. Survival skills: Survival boils down to two types of resources: financial and personnel. Young, growth companies with access to capital, little or no debt and large cash balances have a much better chance of surviving than companies without those characteristics. In addition, companies that are dependent on a key person or personnel with no back-up are much more at risk than companies that have a good bench.
So, take your favorite young, growth company for a qualitative spin around this track and see if it passes the tests.

You can download the spreadsheet that I used for the valuation of Skype and play with the revenue growth and operating margin numbers. You can also use the spreadsheet to value any other young, growth company. As you do these valuations, recognize that uncertainty is the name of the game and that you are making estimates for the future. You will be wrong, but so will everyone else, and at least you are trying.

23 comments:

dshahinian said...

Great post! Thanks for putting up the excel file

Immortal said...
This comment has been removed by the author.
Immortal said...

Prof,

Although the price paid by Microsoft can be justified only after couple of years from now if its able to extract the acquisition benefit but Skype has earned itself a very good deal considering that it was being valued btwn the range of 3-4 billions last year(close to the number you have projected)& which looks a fair price but i feel without counting the synergy premium any valuation of such transaction is incomplete...Company can always rightfully counter argue the premium valuation on Synergy benefits....Also Subjectivity in Valuation makes this process so exciting..else it wud just remain an excel model where u punch in the number and get the result..I hope u wud agree with me :)

richard tucker said...

any chance of a valuation post on LinkedIn IPO valuation?

Dave said...

@richard tucker
I was hoping for the same thing...

JPWoodland said...

Prof,

In your revenue growth assumptions are you taking into account a potential deep integration of Skype into Microsoft's existing software - and therefore it's large install base? I agree $8.5 billion will still be a big stretch, but I do think that IF successful at integrating the technologies that MSFT can add value.

@Richard, me too re Linkedin.

Mike said...

@Rich, @Dave, @JP,

Prof has graciously provided the spreadsheet. Can you go ahead and estimate Linkedin's revenue growth and margin, then plug it into the spreadsheet?

i said...

Professor:

An thoughts on acquisitions purely from a point of view of not letting a competitor get a hold of the asset? what i mean is, if a competitor gets a hold of the asset, he can potentially overtake you significantly, hence the buyout.... even though the asset not that strategically important to the acquirer himself.Thanks!

Nilesh said...

Dear Prof,
insightful article Prof.
Talking about valuations,
how do we value Start-Up venture capital & incubation firms [in emerging markets]??
To what extent one should pay human capital premium. when possible, please post an article explaining this. it would be of great help.

thanks and regards,
nilesh

Aswath Damodaran said...

My point with the Skype valuation is that I do not have deep insights into the value of these companies. The same goes for Linkedin. If you plug in last year's revenues and operating income, you are already well on your way. The two inputs that you will have to make are revenue growth and a target margin. You can set the former at last year's revenue growth rate. For the latter, you can either leave margins as is (Linkedin is making money) or pick a target margin. The fun is in the doing, not in the final number. So, go for it!

Mark said...

I run the Valuecruncher site.

We have done quite a lot of valuation work with early-stage/growth companies. Here are our high-level thoughts:

Agree with the comment from Prof Damodaran that the fun is in the process - not the final answer. You can run a DCF - but it isn't quite like valuing a utility.

Our approach is to build a range of scenarios around the future performance of the business. Recognize that there is uncertainty with the forecasts - build that into the valuation.

With early-stage/growth companies - accept that the only thing you can guarantee about your forecasts are that they are going to be wrong.

Build a range of scenarios - base case, upside and downside. If it is really early-stage - build a scenario where the company burns money for 2-years and goes out of business. Recognise the range of possible outcomes - which isn't easy.

Use a reasonable discount rate - cover the uncertainty with the range of forecast scenarios.

Complete valuations for each scenario - and then risk weight them. Four scenarios - each at 25% or three at 30% and an outlier at 10%.

There is huge value (we think) in doing the valuations for the range of scenarios. Understand the valuation implications under the different possible future conditions. For growth companies that can be a big range - the fun is in the doing.

Is this an easy answer - no. More work even. Building high-quality (but simple) scenarios is an art. But something to think about for those early-stage/growth valuations. Enjoy...

kent said...

The tax rate assumption in your spreadsheet has an impact on valuation. I'm completely ignorant in this case, but does Skype's domicile (Luxembourg) reduce the potential tax hit?

Throw in the avoidance of the cash repatriation tax, and one can almost justify the price MSFT paid for the company....

Ritesh said...

Dear sir,

Nice post

I have not been able to find out that why we add the cash available to the Value of operating assets to derive value of Equity.

Please Explain

Scott said...

I appreciate the notion of providing a general framework that would be a good starting point for analysis of any company, but in the case of Microsoft/Skype isn't it possible that the cost of capital - or opportunity cost of capital in Microsoft's case - is a big part of the synergy of this deal? That is, financial synergy in addition to operational and strategic synergy? I thought that Microsoft was sitting on billions in cash which is earning maybe 1.5% in interest. Wouldn't the value of Skype look much higher using Microsoft's opportunity cost of capital of 1.5% instead of Skype's 12%? I realize that Microsoft is putting capital at risk in buying Skype and should require a greater rate of return than it is currently getting for cash but I think that it would provide a good "worst case" valuation from Microsoft's point of view.

himanshu said...

Hi Professor,

I liked the sensitivity analysis done for Skype valuation. I think revenue growth that can be assumed should be decided considering synergies that Microsoft will achieve with Office,Lync and Xbox thing. Definitely skype with facebook would have been the next big thing for world. So, this might have definite consideration for this big acquisition for Microsoft.

sorrisosv said...

Professor,
according to your book, rely on a key person in a company is risky.
So would u consider risky investing on apple?

sorrisosv said...

Professor,
according to your book, rely on a key person in a company is risky.
So would u consider risky investing on apple?

KC said...

Dear Professor,

Its always humbling and intensely worthwhile to visit your writings. The $3.5B odd you have arrived at seems a reasonable value for Skype when considered individually. So the differential of $5B is value of synergy that MSFT sees (or as shown by Skype) plus some error.
I guess you don't want to address that here.

Krishna

Erik Rambo said...

Can you explain how you arrive at your terminal year's reinvestment rate? Why does it not use sale/capital as in other years?

Many thanks for the insightful blog.

Aswath Damodaran said...

Once you get to stable growth, your growth rate has to be consistent with your return on capital and reinvestment rate (to keep your balance sheet from imploding)
g= ROIC * Reinvestment Rate
Reinvestment Rate = g/ ROIC
In stable growth, the ROIC has to be equal to or just above your cost of capital. That is how I worked to my terminal value numbers.

Sasa Stevanovic said...

Thanks proffesor you are helping us in Bosnia and Herzegovina to understand concept of valuing company.:-)

John Smith said...

Well actually the skype service has been going down since microsoft buy it, intead of that facebook have improve a new system of video chat which is very useful and many people is using it right now, i wonder what the CEO people of microsoft were thinking about... they should buy cialis online or something else that really could improve their market.

Robert Connor said...

We love Skype and use to keep in touch with family!