Is Skype worth $8.5 billion? An exercise in valuing young, growth companies
Posted by Aswath Damodaran
Wednesday, May 18, 2011
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 ...view middle of the document...
* 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.
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