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 VALUATION OF INTERNET START-UPS

A THESIS

Presented to the Department o f Finance, Real Estate, and Law

College of Business Administration

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California State University, Long Beach

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In Partial Fulfillment

o f the Requirements for the Degree

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Master of Business Administration

By Christine U. Haecker

B.A., 1998, University o f Tuebingen, Germany

August 2000

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 UMI Number: 1401625

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___ c®

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UMI Microform 1401625

Copyright 2001 by Bell & Howell Information and Learning Company.
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 WE, THE UNDERSIGNED MEMBERS OF THE COMMITTEE,

HAVE APPROVED THIS THESIS

VALUATION OF INTERNET START-UPS

By

Christine U. Haecker

COMMITTEE MEMBERS

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L.R. Runyon, Ph.D. (Chair) Finance, Real Estate, and Law

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Peter A. Anunermann, Ph.D. Finance, Real Estate, and Law
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Yulong Ma, PI Finance, Real Estate, and Law

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ACCEPTED AND APPROVED ON BEHALF OF THE UNIVERSITY

Luis Calingo, Pn.D.

Dean, College o f Business Administration

California State University, Long Beach

August 2000

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 ABSTRACT

VALUATION OF INTERNET START-UPS

By

Christine U. Haecker

August 2000

The purpose o f this study is to introduce and to discuss the merits of different

methods that can be applied to the valuation o f Internet start-ups. These start-ups

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cannot be adequately valued with traditional models, such as the DCF method or the

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Market Multiple method, due to their lack of profits.

Given the shortcomings o f current valuation methods, this research aims at

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establishing more appropriate valuation methods for Internet start-ups. Specifically,

four new valuation methods are discussed in depth, followed by a sample company

valuation for each method. The four methods are the Economic Value Added method,
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the Benchmarking method, the Customer Contribution approach, and the Real Options

approach.

Finally, these methods, with their inherent advantages and disadvantages, will

be compared and contrasted in the conclusion. Furthermore, the methods will be

ranked according to various criteria, and findings about their practicality and

necessary further research will be discussed.

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 CONTENTS

Page

LIST OF TABLES......................................................................................................... v

LIST OF FIGURES........................................................................................................ vii

LIST OF ABBREVIATIONS...................................................................................... viii

CHAPTER

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1. INTRODUCTION............................................................................................. 1

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2. CURRENT VALUATION METHODS FOR INTERNET START-UPS...

Discounted Cash Flow Method (DCF).......................................................

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Market M ultiple............................................................................................. 6
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First Mover Advantage/Advertising Budget.............................................. 7

3. ECONOMIC VALUE ADDED APPROACH (EVA)................................... 8

Determination o f the “Correct” Current Value.......................................... 14

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Sensitivity Analysis....................................................................................... 15
Problems with the EVA Method................................................................. 16

4. BENCHMARKING.......................................................................................... 18

Sensitivity Analysis....................................................................................... 20
Problems with the Benchmarking M ethod................................................. 20

5. CUSTOMER CONTRIBUTION APPROACH.............................................. 23

Estimation of the Gross Worth Per Customer........................................... 23

Estimation o f the Number o f Customers................................................... 25
Gross Customer W orth................................................................................. 27
Total Value o f Company............................................................................... 28
Basic Premises............................................................................................... 29

iii

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 Page

CHAPTER

5. CUSTOMER CONTRIBUTION APPROACH

Problems with the Customer Contribution Approach................................ 29

6. REAL OPTIONS APPROACH....................................................................... 31

Growth Option.............................................................................................. 33
Linking DCF and Option Value................................................................... 34
Real Options Defined.................................................................................... 36
Black-Scholes M odel.................................................................................... 39
Binomial M odel............................................................................................ 44
Problems with the Real Options Approach................................................ 48

7. CONCLUSION................................................................................................. 50

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BIBLIOGRAPHY......................................................................................................... 55

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iv

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 LIST OF TABLES

TABLE Page

1. Required Return o f Investors......................................................................... 10

2. EVA on the Example of Amazon.com........................................................ 11

3. P/E Ratios......................................................................................................... 12

4. Amazon’s Revenue Growth........................................................................... 14

5. Sensitivity Analysis o f Growth Rate Drivers.............................................. 16

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6. Benchmarking Approach................................................................................ 19

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7. Sensitivity Analysis for the Benchmarking Approach...............................

8. Gross Worth per Customer............................................................................. 24

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9. Gross Margin o f Selected E-Retailers.......................................................... 24

10. Estimation of the Number of Customers...................................................... 27

11. Calculation o f the Gross Sum of Customer Worth..................................... 27

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12. Total Customer Worth or Total Worth o f Company.................................. 28

13. The Market Valuation o f Future Growth Opportunities (G O).................. 35

14. Value Drivers of Valuation Approaches...................................................... 37

15. Effect o f Input Factors.................................................................................... 40

16. DCF Valuation of Global Commerce Corporation..................................... 42

17. Sensitivity Analysis........................................................................................ 43

18. Comparison o f Valuation Methods.............................................................. 51

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 Page

TABLE

19. Adequacy o f Methods for the Valuation o f Internet Start-ups............... 52

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vi

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 LIST OF FIGURES

FIGURE Page

1. Life cycle o f companies............................................................................... 10

2. EVA calculation methodology (Backward).............................................. 9

3. EVA calculation methodology (Forward)................................................. 15

4. Worldwide Internet users in m illions......................................................... 25

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5. Customers o f product 1, 2, and 3 ............................................................... 26

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6. Uncertainty and value................................................................................... 32

7. Binomial tree for Global Commerce Corporation.................................... 45

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8. Option values while folding back................................................................ 46

9. European vs. American put option............................................................. 47

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vii

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 LIST OF ABBREVIATIONS

A Underlying Asset
CAPM Capital Asset Pricing Model
Corp. Corporation
Cust. Contr. Customer Contribution
DCF Method Discounted Cash Flow Method
EB Value from Existing Business
EVA Approach Economic Value Added Approach

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FCF free Cash Flow
g Growth Rate
GO
Market Cap.
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Market Capitalization
MV
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Market Value
Mil M illion
n Number of Years
NPV Net Present Value
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P Probability
P/E Ratio Price to Earnings Ratio
Req’d Required
WACC Weighted Average Cost o f Capital
X Strike Price

viii

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 CHAPTER 1

INTRODUCTION

“If I were a business school professor in finance, I would assign the following

exam: How do you value Internet companies? And I would fail everyone that did not

leave the answer sheet blank” (Warren Buffett in Plunkett, 1999).

The goal o f this investigation is to introduce and to discuss the merits o f

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different methods that can be applied to the valuation o f Internet start-ups. These

start-up companies are typically characterized as being in the early stages o f

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development and having significant year-over-year losses, but also having high growth

opportunities. In addition, they utilize the Internet as their primary channel o f

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conducting business, and have non-traditional business models. This study will

specifically focus on Internet retailers, or e-retailers, although the same valuation

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methods could also be applied for Internet start-ups in different areas.

Traditionally, companies have been valued based on the present value of future

free cash flows using the Discounted Cash R ow (DCF) approach. However, this

method results in a negative net present value (NPV) for most Internet start-ups on

account of their heavy losses. Yet, these start-ups trade at astronomical stock market

valuations due to high expectations about future opportunities. This disparity leads

one to believe that traditional valuation methods are inadequate. Consequently,

valuation methods need to be found that more appropriately value Internet start-ups.

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 In Chapter 2 this study commences with an overview of valuation methods

currently being used for Internet start-ups. This overview will provide a discussion of

each valuation method and a short analysis o f the inherent problems associated with

using each method for the valuation of Internet start-ups. Included are the DCF, the

Market Multiple, and the First Mover Advantage/Advertising Budget methods.

First, the traditional DCF valuation method, as explained above, is

inappropriate for the valuation of Internet start-ups, because it assumes little

uncertainty and thus fails to account for growth opportunities accurately

(see Figure 1).

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C ash­
flow
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r « ,i v .s w f t A pproaches Fin ance-M athcm ati cai Approach

• EVA M ethod • D C F-M ethod
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• B en d n n arfcin t
• C u it.C o o tr . A pproadi
M ark et M ultiple A pproaches
• Reel O p tions A pproach
• C o m p arab le Com pan y Approach
‘ C o m p arativ e T ransadioci A pproadi

Years
Introduction Growth M aturity Degeneration

FIGURE 1. Life cycle o f companies.

The market multiple method values a company based on the market value of

comparable companies currently traded in the marketplace. However, the wildly

2

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 fluctuating market values of these companies indicate a division of opinions about the

correct market valuation of such start-ups. As such, this method seems to be

inadequate as well.

Lastly, the non-numerical First Mover Advantage/Advertising Budget method

bases the valuation of Internet start-ups according to their time o f entry and their

popularity. Obviously, the intrinsic problem here is that a valuation is very hard to

quantify and thus highly subjective.

Given the shortcomings o f current valuation methods, new approaches need to

be found. This investigation introduces and discusses in detail four new methods for

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the valuation o f Internet start-ups. These methods are the Economic Value Added

method, the Benchmarking approach, the Customer Contribution approach, and the
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Real Options approach. These four valuation methods w ill be compared and
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contrasted in the conclusion of this study and suggestions about their proper usage will

be given.

Chapter 3 introduces the Economic Value Added Method (EVA). This

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valuation approach works backward by calculating the revenue growth rate implicit in

the current market capitalization and assessing if this growth rate seems feasible. If

necessary, a more reasonable growth rate can be assumed, and the appropriate market

capitalization can be calculated. The inherent problem is that the model results in a

growth rate and a subjective judgement about this growth rate’s reasonableness is

required for the final valuation. Moreover, companies are encouraged to focus on

revenues instead of earnings.

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