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Tuesday, October 11, 2005

All Your Irrational Exuberance Are Belong To Us, Pt 2

The Stalwart thinks that current media/web 2.0 valuations are approaching bubble-era irrationality, factoring in unrealistic growth expectations, viz eBay + Skype.

His is one post in a growing tide of buzz about Web 2.0 valuations approaching irrationality lately. Let me take a few minutes to try and debunk this line of thought. I think this is emphatically not the case - being skeptical is cool; but what's fun about media/web 2.0 is that we're creating and capturing very real value.

OK. Let's do a bit of basic valuation, beginning with media 1.0. The market values newspaper readers at ~ $850ish, and cable subcribers at about $2-3k. Price/sales (or EV/Rev, which is prolly a bit more accurate) multiples are on the order of ~ 1.5-4x. That gives us a bit of context.

Now, eBay's current value/user is ~ $600ish. Is this in itself irrational? Not really; the context above tells us so, and it also equates to an EV multiple of about 14, which is high, but not out-of-line for a growth play with strong margins (30%+) and strong growth prospects in the media (or almost any) sector.

OK. So eBay's valuation isn't irrational. Is the price it bought Skype at irrational? It bought Skype at a value of between $50-$100/user (depending on your assumptions; not so important).

So in a naive scenario, the question is: can Skype really add $50-100 of lifetime future cashflows per user (or PV, if ya like) to eBay?
This is the pessimists' (fairly unrealistic) view, which assumes no growth in the user base.

Now, let's chalk out another, more realistic scenario. Let's assume Skype's user base doubles in the next 5-7 years. In fact, this is an assumption we've already accepted as rational, which is implicit in eBay's EV multiple of 14. In this scenario, the question becomes: can Skype add $25-50 of future per user to eBay?

In scenario 1, the total value added by Skype is between 8-16% of eBay's current value/user; in scenario 2, the total value added is between 4-8%.

To think about this, let's look at Skype's current revenues/user. They work out to about between $1.5-3. Now, let's multiply this revenue/user by eBay's EV/revenue multiple of 14. The result is a value/user of between $20 and $42. Note (I can't stress this enough), this is real-world value at rational multiples.

Now, this number - Skype's current revenue/user at eBay's EV/revenue multiple, to grab an implied value/user for Skype - is already awfully close to the amount of value eBay has to realize from Skype in scenario two, where the user base doubles.

Basically, what I'm pointing out is that to make this acquisition work, even if we assume zero synergy benefit, Skype has to either double it's user base, or it has to double it's revenues/user. This is not exactly a huge growth target for a play on the trajectory of Skype.

For example, it can achieve this by, for example, a relatively sane growth rate of 10% over the next 5-7 years; in fact, this assumption is already embedded in eBay's current valuation, as I've already pointed out.

Now, if we go further, and assume some marginal synergy benefits between eBay and Skype - not entirely unrealistic - the conclusion we reach is that for this deal to work, Skype has to less than double it's revenues or user base.

Lemme make this clear: the doubling is an upper bound. That's the pessimists' worst-case scenario. Any better case scenario means, in fact, eBay can break even with Skype making less than 2x what it does now.

So, I think this makes it pretty clear even the pessimists' worst-case scenario is fairly rational, and nowhere (repeat: nowhere) do we need to resort to bubble-era valuation trixxx (viz, massive growth rates, etc).

Hopefully, this is a useful practical demonstration and object lesson in why Media + Web 2.0 is becoming interesting to so many people beyond the usual suspects: this time around, the value that's being created actually does exist outside of spreadsheets :)

-- umair // 7:08 AM //


This is a nice analysis. However, it has absolutely nothing to do with Web 2.0.
// Anonymous Anonymous // 4:41 PM


I don't know that you could put it any more plainly ... yet the naysayers still won't get it. They don't read, they don't think, they don't anayze ... they're driven by emotion & if it weren't for being burned in bubble1.0, they'd be "all over this stuff"

Frankly, I'm "chuffed" that the herd mentality is to kick web2 to the ground ... all the more for those of us that actually "get it"
// Blogger David Gibbons // 9:01 PM

If you add a side of facts and a smattering of citations to that dish I might eat it.

Otherwise its just going to stick in my throat.
// Anonymous webprofessor // 9:35 PM


Thanks for the comments.

Webprof: A side of facts? The whole analysis is based on eBay and Skype's *public financial data*.

anaonymous: Nothing to do with Web 2.0? Apart from the fact that the *companies I'm analyzing are Web 2.0 plays*.

Dudes...come on.

David: Thanks!! I'm baffled by the naysayers too...
// Blogger umair // 10:52 PM

I think that revenue multiplier applies to companies that have a lot of expected future growth.

Taking 7 years of growth and *then* applying that multiplier might be unrealistic.
// Anonymous Bill Seitz // 2:04 PM

One comment on your analysis: It is only correct to multiply the Skype rev/user by Ebay's EV multiple if you beleive that Skype has (or will have) similar margins and/or growth rates. I personally have a hard time believing that P2P VOIP will have 30%+ operating margins given the plethora of substitutes which means that much of the burden for making this deal pencil out will fall disporportionatly on the growth rate side of the equation. As it stands, your 10%/year is obviously pretty conservative, but it may be interesting to run an analysis assuming much lower margins (RBOCs?) and see what that implies in terms of growth rates and whether or not that is realistic.
// Anonymous Bill Burnham // 9:19 PM

Hi Bill B,

That is good point. This was just back of the envelope, so I didn't matched comps up perfectly.

It would be very interesting to apply possibly RBOC comps and check implied growth rates; if I have a few mins, I'll try and tackle it.

Intuitively, I think margins will be lower than eBay, but higher than RBOCs (etc) due to monopoly effects.

Bill S,

I'm not sure I understand your point...I'm not taking 7 yrs of growth and then applying.
// Blogger umair // 9:36 PM
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