Valuing dot-coms.

n the present era of cheap and accessible capital, Internet entre- preneurs have succeeded in quickly transforming their business ideas into billion-dollar valuations that seem to defy the common wisdom about profits, multiples, and the short-term focus of capital markets. Valuing these E L E C T R O N I C C O M M E R C E148 You don’t have to step through the looking glass into a parallel universe to understand the valuations of Internet stocks. Discounted-cash-flow analysis can focus your mind on the right issues, help you see the risks, and separate the winners from the losers. The authors thank Pat Anslinger, Ennius Bergsma, Michael Drexler, and Jan Schultink for their contributions to the methods described in this article. Driek Desmet is a principal in McKinsey’s London office; Tracy Francis is an alumna of the Sydney office; Alice Hu is a consultant and Tim Koller is a principal in the Amsterdam office; and George Riedel is a principal in the Sydney office. This article is adapted from a chapter in the third edition of Valuation: Measuring and Managing the Value of Companies (New York: John Wiley & Sons), to be published in the United states in summer 2000. Copyright © 2000 McKinsey & Company. All rights reserved. I Driek Desmet, Tracy Francis, Alice Hu, Timothy M. Koller, and George A. Riedel dot-coms Valuing This article, and m any others, can be found on the McKinsey Quarterly website: w w w.m ckinseyquarterly.com (148-157) Valuation 1/25/00 9:13 AM Page 148 特此声明：本智库提供文章仅供学习交流，非商业用途！ 文件分享人：CEO智库 中国最专业的企业管理、资本运作与金融管理知识管理平台，向成长 企业高管、CEO、金融界人士提供高端财经、资本市场、投行、管理、战 略等知识性文档和最新资讯。CEO智库由协纵国际企业港有限公司发起， CEO足迹遍布香港、澳洲、美国、英国等国家和地区。 • 作为资本和管理领域的知识管理平台，提供进驻企业展示商业模式、产 品和服务的平台和渠道 • 拥有企业在跨地域跨地点运营时非常有用的内部信息管理和内控管理平 台，而这平台对客户全部免费开放 • 社区和论坛提供客户与资本与管理专家对接，是帮助客户获得决策辅助 建议的平台 • 组群和论坛具备CRM、IR、知识管理、MIS管理功能，是客户强有力的成 长助手 协纵国际企业港是中国首家柔性办公和企业成长连锁基地。母公司盛 富资本为亚洲投行，提供跨境商业地产资产管理解决方案，下辖私募股权 投资、房地产基金、资本筹集、购并和香港上市保荐业务，近年从英美引 入最新柔性办公基地（Flexible Managed Office）模式，提供灵活柔性办 公场所，配合协助企业成长的增值服务。 租期：短可一月 长可七年 面积：小至一席 大至一层 成本：节约投资 避免浪费 地点：入驻一点 多点通行 服务：知识智库 资本投资 柔性办公空间解决方案 30-1800平米办公面积可灵活划分 即租即用，低成本获规模形象 含装修到家具，可选个性化二装和 布置 宽敞前台、洽谈室、等候室、休息室、中央主机房 配有行政秘书及咖啡茶水服务 配有视频会议和电话会议系统的会议室和室 24小时空调，全电脑门禁安防监控系统 大幅降低成本的虚拟办公和办公位方案 办公位方案 入住一点获辐射全国的地址 代客来电接听，中英文应答 一卡在手畅通全国的会议和办公服务 临时接待客户服务 初创业者获大企业办公环境 成长解决方案 财务、法律、税务支持与外包 人力资源、E营销、企业战略诊断 免费专业智库支持，沙龙、论坛和商业互惠联盟，提供商业人脉拓展机会 商业模式和辅导，引入PE投资和安排私募配售 管理、战略咨询、私募配售和高管培训 母公司拥有上市保荐人资格和旗下PE基金，可帮助解决管理和资本困惑 协纵深圳柔性办公基地 ◆华侨城智慧广场基地：南山区华侨城侨香路与深云路交汇处智慧广场B座11层 ◆车公庙财富广场基地：福田区车公庙深南大道与农园路交汇处财富广场A座24层 ◆联合广场基地：福田区滨河路5022号联合广场B栋7层 ◆蛇口明华国际会议基地：南山区蛇口龟山路八号明华国际会议中心二号楼12层 ◆佳和华强大厦基地：福田区深南中路佳和华强大厦B座10层(华强北） ◆闽泰大厦基地：南山区滨海大道与文心五路交汇处闽泰大厦14层 ◆南方国际广场基地：福田区益田路3013号南方国际广场B栋18层 协纵北京柔性办公基地 ◆京信大厦基地：朝阳区东三环北路甲二号京信大厦13层 ◆朝外MEN大厦基地：朝阳区朝外大街26号MEN大厦12、29层 ◆中汇广场基地：东城区东直门南大街11号中汇广场C座10、11层 协纵上海柔性办公基地 ◆招商局大厦基地：陆家嘴东路161号招商局大厦12层 协纵佛山柔性办公基地 ◆卓远国际商务大厦基地：禅城区季华五路二号一座卓远国际商务大厦6、7、 11、13层 柔性办公基地遍布全国 免费热线/Toll-free Hotline: 传真/Fax: 电邮/Email: 网站/Website: 智库/CEO Knowledge: 微博/Micro Blog: 400-654-0654 86-755-8289 9966 service@myceosuite.com www.myceosuite.com www.ceoknowledge.com http://t.sina.com.cn/ceosuite CEO智库 CEO KNOWLEDGE 协纵国际企业港有限公司 CAPITAL EXECUTIVE OFFICE LIMITED high-growth, high-uncertainty, high-loss firms has been a challenge, to say the least; some prac- titioners have even described it as a hopeless one. In this article, we respond to that challenge by using a classic discounted-cash-flow (DCF) approach to valuation, buttressed by microeconomic analysis and probability-weighted scenarios. Although DCF may sound suspiciously retro, we believe that it works where other methods fail, reinforcing the continuing relevance of basic economics and finance, even in uncharted Internet territory.1 Yet it is important to bear in mind that while the valuation techniques we sketch out can help bound and quantify uncertainty, they won’t make it disappear. Internet stocks are highly volatile for sound and logical reasons, and they will remain highly volatile. DCF analysis when there is no CF to D Three related factors make it hard to value Internet companies. First, like many start-ups, they typically have losses or very small profits for a few 1For a complete discussion of the DCF approach, see Tom Copeland, Timothy M. Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, second edition, New York: John Wiley & Sons, 1995. Chapter 3, “Cash Is King,” may be of particular interest. (148-157) Valuation 1/25/00 9:14 AM Page 149 years, partly because of the high marketing costs (aimed at attracting cus- tomers) that they must write off against current earnings. Second, these companies are growing at very high rates: successful ones will increase their revenues by 100 times or more in the early going. Finally, the fate of these companies is quite uncertain. Shorthand valuation approaches, including price-to-earnings and revenue multiples, are meaningless when there are no earnings and revenues are growing astronomically. Some ana- lysts have suggested benchmarks such as multiples of customers or multiples of revenues three years out. These approaches are funda- mentally flawed: speculating about a future that is only three or even five years away just isn’t very useful when high growth will continue for an additional ten years. More important, these shorthand methods can’t account for the uniqueness of each company. The best way of valuing Internet companies is to return to economic funda- mentals with the DCF approach, which makes the distinction between expensed and capitalized investment, for example, unimportant because accounting treatments don’t affect cash flows. The absence of meaningful historical data and positive earnings to serve as the basis for price-to-earnings multiples also doesn’t matter, because the DCF approach, by relying solely on forecasts of performance, can easily capture the worth of value-creating businesses that lose money for their first few years. The DCF approach can’t eliminate the need to make difficult forecasts, but it does address the prob- lems of ultrahigh growth rates and uncertainty in a coherent way. In this discussion, we assume that the reader has a basic knowledge of the DCF approach. Three twists are required to make this approach more useful for valuing Internet companies: starting from a fixed point in the future and working back to the present, using probability-weighted scenarios to address high uncertainty in an explicit way, and exploiting classic analytical tech- niques to understand the underlying economics of these companies and to forecast their future performance. We illustrate this approach with a valuation of Amazon.com, the archetypal Internet company. In the four years since its launch, it has built a customer base of ten million and expanded its offerings from books to compact discs, videos, digital video discs, toys, consumer electronics goods, and auctions. In addition, Amazon has invested in branded Internet players such as pets.com and drugstore.com, and since the end of September 1999 it has 150 THE McKINSEY QUARTERLY 2000 NUMBER 1 Shorthand valuation techniques are absurd if there are no earnings and revenues grow astronomically (148-157) Valuation 1/25/00 9:14 AM Page 150 allowed other retailers to sell their wares on its Web site through what it calls its “associates program.” Indeed, the company has become a symbol of the new economy; market research shows that 101 million people in the United States recognize the Amazon brand name. All this activity has been rewarded with a high market capitalization: $25 billion as of mid-November 1999. Yet Amazon has never turned a profit and is expected to lose at least $300 million for the year, so it has become the focus of a debate about whether Internet stocks are greatly overvalued. Start from the future In forecasting the performance of high-growth companies like Amazon, don’t be constrained by current performance. Instead of starting from the present—the usual practice in DCF valuations—start by thinking about what the industry and the company could look like when they evolve from today’s very high-growth, unstable condition to a sustainable, moderate- growth state in the future; and then extrapolate back to current perfor- mance. The future growth state should be defined by metrics such as the ultimate penetration rate, average revenue per customer, and sustainable gross margins. Just as important as the characteristics of the industry and company in this future state is the point when it actually begins. Since Internet-related companies are new, more stable economics probably lie at least 10 to 15 years in the future. But consider what Amazon has already achieved. Its ability to enter and dominate categories is unprecedented, both in the off- and the on-line worlds. In 1998, for example, it took the company only a bit more than three months to banish CDNOW to second place among on-line purveyors of music. In early 1999, Amazon assumed the leadership among on-line purveyors of videos in 45 days; recently, it became the leading on-line con- sumer electronics purveyor in 10. Let us create a fairly optimistic scenario based on this record. Suppose that Amazon were the next Wal-Mart, another US retailer that has radically changed its industry and taken a significant share of sales in its target markets. Say that by 2010, Amazon continues to be the leading on-line retailer and has established itself as the overall leading retailer, both on- and off-line, in certain markets. If the company could take a 13 and 12 percent share of the total US book and music mar- kets, respectively, and captured a roughly comparable share of some other markets, it would have revenues of $60 bil- lion in 2010, when Wal-Mart’s revenues will probably have exceeded $300 billion. 151V A L U I N G D O T- C O M S (148-157) Valuation 1/25/00 9:14 AM Page 151 What operating profit margin could Amazon.com earn on that $60 billion? The superior market share of the company is likely to give it significant pur- chasing power. Remember too that Amazon will earn revenues and incur few associated costs from other retailers using its site. In this optimistic scenario, Amazon, with an average operating margin in the area of 11 percent, would most likely do a bit better than most other retailers. And what about capital? In the optimistic scenario, Amazon may well need less working capital and fewer fixed assets than traditional retailers do. In almost any scenario, it should need less inventory because it can consolidate its stock-in-trade in a few warehouses, and it won’t need retail stores at all. We assume that Amazon’s 2010 capital turnover (revenues divided by the sum of working capital and fixed assets) will be 3.4, compared with 2.5 for typical retailers. Combining these assumptions gives us the following financial forecast for 2010: revenues, $60 billion; operating profit, $7 billion; total capital, $18 bil- lion. We also assume that Amazon will continue to grow by about 12 percent a year for the next 15 years after 2010 and that its growth will decline to 5.5 percent a year in perpetuity after 2025, slightly exceeding the nominal growth rate of the gross domestic product.2 To estimate Amazon’s current value, we discount the projected free cash flows back to the present. Their present value, including the estimated value of cash flows beyond 2025, is $37 billion. How can we credibly forecast ten or more years of cash flows for a company like Amazon? We can’t. But our goal is not to define precisely what will happen but instead to offer a rigorous description of what could. Weighting for probability Uncertainty is the hardest part of valuing high-growth technology companies, and the use of probability-weighted scenarios is a simple and straightforward way to deal with it. This approach also has the advantage of making critical assumptions and interactions far more transparent than do other modeling approaches, such as Monte Carlo simulation. The use of probability-weighted scenarios requires us to repeat the process of estimating a future set of finan- cials for a full range of scenarios—some more optimistic, some less. For Amazon, we have developed four of them (Exhibit 1). 152 THE McKINSEY QUARTERLY 2000 NUMBER 1 2Real GDP growth has averaged about 3 percent a year for the past 40 years, and the long-term expected inflation rate built into current interest levels is probably about 2 to 2.5 percent a year. Our goal is not to define precisely what will happen to Internet companies but to offer a rigorous description of what could happen (148-157) Valuation 1/25/00 9:14 AM Page 152 In Scenario A, Amazon becomes the second- largest retailer (on- or off-line) based in the United States. It uses much less capital than traditional retailers do because it is primarily an on-line operation. It captures much higher operating margins because it is the on-line retailer of choice; even if its prices are comparable to those of other on-line retailers, it has more purchasing clout and lower oper- ating costs. This scenario implies that Amazon was worth $79 billion in the fourth quarter of 1999. Scenario B has Amazon capturing revenues almost as large as it does in Scenario A, but its margins and need for capital fall in the range between those of the first scenario and the margins and capital requirements of a traditional retailer. This second scenario implies that Amazon had a value of $37 billion as of the fourth quarter of 1999. Amazon becomes quite a large retailer in Scenario C, though not as large as it does in Scenario B, and the company’s economics are closer to those of traditional retailers. This third scenario implies a value for Amazon of $15 billion. Finally, in Scenario D, Amazon becomes a fair-sized retailer with traditional retailer economics. On-line retailing mimics most other forms of the busi- ness, with many competitors in each field. Competition transfers most of the value of going on-line to consumers. This scenario implies that Amazon was worth only $3 billion. We now have four scenarios, in which the company’s value ranges from $3 billion to $79 billion. Although the spread is quite large, each scenario 153V A L U I N G D O T- C O M S E X H I B I T 1 Amazon.com: Potential outcomes 1Books and music sold outside the United States as well as sales of videos, digital video discs, toys, and consumer electronic goods in any market. US book sales, $ billion Scenario A 15% market share in US books, 18% in US music US music sales, $ billion Other sales,1 $ billion Total sales, $ billion Margin of earnings before interest, taxes, and amortization, percent Discounted- cash-flow value, $ billion Scenario B 13% market share in US books, 12% in US music Scenario C 10% market share in US books, 8% in US music Scenario D 5% market share in US books, 6% in US music 48 31 19 5 85 60 41 17 13 9 6 5 24 20 16 7 14 11 8 7 79 37 15 3 (148-157) Valuation 1/25/00 9:14 AM Page 153 is plausible.3 Now comes the critical phase of assigning probabilities and generating the resulting values for Amazon (Exhibit 2). We assign a low probability, 5 percent, to Scenario A, for though the company might achieve outrageously high returns, competition is likely to prevent this. Amazon’s current lead over its competitors suggests that Scenario D too is improbable. Scenarios B and C—both assuming attractive growth rates and reason- able returns—are therefore the most likely ones. When we weight the value of each scenario, depending on its proba- bility, and add all four of these values, we end up with $23 billion, which happened to be the com- pany’s market value on October 31, 1999. It therefore appears that Amazon’s market valuation can be supported by plausible forecasts and probabilities. Now, however, look at the sensitivity of this valuation to changing probabili- ties. As Exhibit 3 shows, relatively small variations lead to big swings in value. Indeed, the volatility of the share prices of companies like Amazon has been precipitated by small changes in the market’s view of the likelihood of different outcomes. Nothing can be done about this volatility. From probability to reality The last difficult aspect of valuing very high-growth companies is relating future scenarios to current performance. How can you tell a soon-to-be- successful Internet play from a soon-to-be-bankrupt one? Here, classic micro- economic and strategic skills play a critical role because building sound sce- narios for a business and understanding that business both require knowledge of what actually drives the creation of value. For Amazon and many other 154 THE McKINSEY QUARTERLY 2000 NUMBER 1 E X H I B I T 2 Amazon.com: Expected value Scenario A Probability, percent Expected value, $ billion Discounted- cash-flow value, $ billion x = 79 5 3.9 Scenario B 37 35 13.0 Scenario C 15 35 5.3 Scenario D 3 25 0.8 $23.0 billion E X H I B I T 3 Amazon.com: Volatility of expected values Low probability of outcome Scenario A 0 25 35 40 Percent Scenario B Scenario C Scenario D Base probability of outcome High probability of outcome 5 35 35 25 10 50 35 5 Discounted-cash-flow value, $ billion 16 23 32 3We capture cash-flow risk through the probability-weighting of scenarios, so the cost of equity applied to each of them shouldn’t include any extra premium; it can consist of the risk-free rate, an industry-average beta, and a general market-risk premium. (148-157) Valuation 1/25/00 9:14 AM Page 154 Internet companies, customer-value analysis is a useful approach. Five fac- tors drive the customer-value analysis of a retailer like Amazon: • The average revenue per customer per year from purchases by its cus- tomers, as well as revenues from advertisements on its site and from retailers that rent space on it to sell their own products • The total number of customers • The contribution margin per customer (before the cost of acquiring customers) • The average cost of acquiring a customer • The customer churn rate (that is, the proportion of customers lost each year) Let us see how Amazon could achieve the financial performance predicted by Scenario B and compare this with the company’s current performance. As Exhibit 4 shows, the biggest changes over the next ten years involve the number of Amazon’s customers and the average revenue for each. In Scenario B, Amazon’s customer base increases from 9 million a year in 1999 to about 120 million worldwide by 2010—84 million in the United States and 36 million outside it. We assume that Amazon will remain the number-one US on-line retailer and achieve an attractive position abroad. Scenario B also calls for Amazon’s average revenue per customer to rise to $500 by 2010, from $140 in 1999. That $500 could be accounted for by two CDs at $15 each, three books at $20 each, two bottles of perfume at $30 each, and one personal organizer at $350. Amazon will probably con- tinue to dominate its core book and music markets. It will probably enter adjacent categories and may come to dominate them. In Scenario B, Amazon’s 2010 contribution margin per customer before the cost of acquiring customers is 14 percent, a figure in line with that of current top-notch large-scale retailers—Wal-Mart, for instance. Despite competition, this seems rational in view of Amazon’s likely ability to gain offsetting economies of scale through devices such as renting other retailers space to market their products on Amazon’s Web sites. Scenario B predicts that Amazon will have acquisition costs per customer of $50 in 2010. Despite the argument that these costs will rise once all on- line customers have been claimed,