You learn about business valuation in business school. But are the business valuation concepts you learn in business school used in business valuations in the real world?
You must have heard about Google’s interest in buying Groupon’s business at a reported valuation of $5-6 Billion! How could Google arrive at this business valuation of Groupon’s business? Valuation principles direct us to use either the discounted cash flow method or valuation multiples method to arrive at business valuations.
Business Valuations using the Discounted Cash-flow Method
To arrive at business valuation using the Discounted Cash-Flow (DCF) process, we need to project out the cash flow of the business into the foreseeable future. We discount this cash flow at the appropriate discount rate to arrive at the present value of cash flow for this valuation period. We then estimate a terminal value (present value of the cash flow beyond the foreseeable future assuming cash flow grows at a constant rate – usually inflation rate or slightly higher). The sum of the present value of cash flows for the foreseeable valuation period and the terminal value form the basis of the business valuation using the DCF method.
Can we estimate Groupon’s business value using the DCF method? We will need detailed projections of Groupon’s future cash flow which we do not have! We can try to arrive at the business valuation with some estimates. But why do this when we have an easier approach?
Business Valuations using the Multiples
Business valuation using the valuation multiples is essentially looking at the business valuation similar companies have obtained recently and relating that to known business metrics like sales, earnings per share, customers, etc. Groupon does not have any comparable companies with publicly available data. We therefore need to look at companies with similar business characteristics, growth rates, profit margins, etc. to arrive at the appropriate valuation multiples.
Your first task when trying to arrive at a multiples based valuation is to find comparable companies. Comparable companies are similar companies or companies that are in the same business, companies with similar characteristics, growth rates, profit margins, etc. Often it is not possible to get an exact match so picking a company with similar characteristics, growth rates and profit margins is sufficient.
For Groupon, Google itself may be a comparable company to arrive at valuation multiples. Google is significantly larger but its slower growth rates compensate for the size difference. Apple has shown great growth but is much larger and is not a purely service business. eBay can be a comparable firm to arrive at valuation multiples too. Let us start with Google.
Sales Multiples (valuation multiple)
According to the NYT, Groupon’s revenue may top $1 billion a year. This is a good place to start. Google has revenues of $ 27.55 billion and a business valuation of $ 149.21 billion (enterprise value) today according to Yahoo Finance. This works out to a sales valuation multiple of 5.4x (149.21/27.55).
Using this 5.4x sales valuation multiple, Groupon’s business value will be $1 Billion*5.4 = $5.4 billion! This business valuation is in the ball park of the rumored deal price!
Earnings Multiples (valuation multiple)
Google has a PE multiple of 23.23. PE stands for Price/Earnings per share. This indicates that its business valuation is approximately 23.23 times its earnings as Google has very little debt. If we assume that Groupon has the same profit margins as Google (28.8%), we can estimate its potential earnings at $ 288 million (28.8%*$1 Billion).
Using the above estimates, we can arrive at Groupon’s business valuation of $6.69 billion (288*23.23). This business valuation is again in the ball park of the rumored deal price! At first sight, it looks like Google is overpaying for Groupon. But it may not be overpaying. It may be a steal!
So are the business valuation concepts you learn in class used in business valuations in the real world? Looks like a resounding YES! So make sure you get your MBA finance concepts clear. You may be called to use it in the near future!
Go ahead and try the same with EBAY or AAPL’s valuation multiples. Let us know what you would pay for Groupon using valuation multiples.