Venerable retailer J.C. Penney opened its doors more than a century ago and boasts annual revenues of nearly $13 billion from its 1,100 stores. Yet a three-year-old website with an untested business model and little discernible revenue is closing in on the department store chain’s $3 billion market cap: Pinterest.
The online scrapbooking site recently raised $200 million in venture capital funds to bring its implied valuation to $2.5 billion, according to a February 20 story in The Wall Street Journal. Founded by three young entrepreneurs in March 2010, the tech start-up has 48 million users as of December 2012, up from nine million in the prior year, the article noted.
While Pinterest is wildly popular, its business model remains unproven. Users, including businesses, sign up for free accounts. The company is just gearing up to accept paid advertising and recently unveiled a free analytics tool for users with business-related accounts to track what has been pinned from their sites.
Pinterest may be thinking hard about ways to make money, but it remains unclear whether the firm’s financial strategies can bring in enough revenue to cover costs and generate a healthy profit, which will be especially important once the company goes public. No matter. Pinterest has garnered the interest of such Silicon Valley blue-chip venture capital firms as Andreessen Horowitz (as in Netscape co-founder Marc Andreessen). For now, Pinterest has money to burn.
The company is one of at least 25 start-ups that command market caps of one billion dollars or more, according to a February 4 story in The New York Times. The billion-dollar start-ups club includes such familiar names as productivity application Evernote, travel rental site Airbnb, online questionnaire software SurveyMonkey and streaming music service Spotify. But such high valuations are bringing back concerns that the market is entering another tech bubble like the dot-com frenzy in the late 1990s that led to scores of Internet companies going belly up and investors losing vast fortunes.
Wharton finance professor Jeremy Siegel, who warned that Internet and other tech stocks were overvalued in 1999 shortly before the dot-com bubble burst, says the sector is not in the same kind of peril today. “It’s a world of difference,” he notes. Back then, tech companies — including well-capitalized S&P 500 firms like AOL, Sun Microsystems and EMC — were trading at sky-high valuations, Siegel says, adding that shell companies without good business ideas also were given similar pricetags simply because they were a “dot-com.”
In an April 1999 editorial for the Journal, Siegel warned that tech’s high valuations could not be sustained. Back then, Siegel pointed out that AOL was selling at more than 700 times its earnings for the past 12 months, an “unprecedented valuation for a firm with this market value,” and one which put it among the country’s 10 most highly valued firms. Yet, the Internet service provider came in only 311th in profits and 415th in sales against other companies. (AOL has since spun off from Time Warner and currently is valued at $2.8 billion.)
Such inflated valuations are not the norm in the tech sector today. “Big tech companies are [trading at] less than 20 times earnings,” he points out, citing as examples the valuations of market leaders Google and Apple. “It’s not overvalued.”
At $450 a share, Apple is currently trading at about 10 times fiscal 2013 projected earnings per share of $44.19. Google is trading at $815, or 18 times fiscal 2013 projected earnings per share of $45.55. Microsoft is trading at 10 times 2013 earnings and Yahoo is at 21 times this year’s profit. These price-to-earnings ratios are hardly inflated vis-a-vis the market: As of March 22, the S&P 500 was trading at 14 times forward earnings, the Nasdaq 100 was at 15 times and the Dow hovered at 13 times. The market is “nowhere near as speculative” today because investors remember the painful lessons of the dot-com crash, Siegel notes. “People have been burned. They’re more cautious. Their memories are in place.”
But there are several reasons why Pinterest and a select group of start-ups are getting valuations that any brick-and-mortar company would envy.
New Cycle of Growth
Social media is turning out to be a lasting tech trend, thanks largely to the success of Facebook, Twitter and LinkedIn. The exponential growth of users at Pinterest and other billion-dollar start-ups are signals that these companies could be the next tech leaders, and venture capitalists want to get in early to cash out at the time of an IPO or shortly thereafter.
On a macroeconomic level, it also helps that investor sentiment is rising as the U.S. economy recovers, according to Wharton management professor Saikat Chaudhuri. As a new cycle of growth emerges, investors are feeling more bullish. “They’re optimistic now about the future and placing bets,” he says.
But unlike the last tech bubble, “we’re seeing investors being more critical,” Chaudhuri adds. So while they are looking to invest, “they have also shown a bit more restraint.” He notes that investors today are quick to ask the start-up where it is parking its money and how the business plans to “monetize” — jargon for a business model that will lead to revenue and profits.
Venture capitalists have also become pickier, especially following a consolidation in the VC industry. The number of VC companies is down by about half from 1,000 companies five years ago, says Doug Collom, vice dean of Wharton’s San Francisco campus.
VCs historically make an annual average return of 15% to 20%, but recently that figure has fallen to 6% because finding good bets has been difficult, Collom adds. Start-up investors are not being compensated enough for the level of risk they are shouldering, and there are better places to put their money.
Not only is the number of VC funds shrinking, but so is the fund size, notes Wharton management professor Raffi Amit. “The industry is in a major transition and consolidation.” Mitigating the decline somewhat is that 10 to 15 years ago, several million dollars typically was needed to get a company off the ground; today, $50,000 to $100,000 can suffice, he adds.
Still, the remaining VCs are placing their bets more conservatively, watching to see where others are investing. “There is the herd phenomenon. Some sectors are considered hot, and hence a disproportionate amount of capital flows into companies in these hot sectors,” Amit says.
If VCs see that other firms with proven track records, such as Kleiner Perkins and Accel Partners, are backing a tech company, they are more likely to jump in as well because the start-up has been “validated,” Collom notes. As more big name VCs invest in the same company, it creates a “feeding frenzy dynamic that drives the price up, pushing valuation up beyond rationality,” he adds. Hence a $2.5 billion valuation for Pinterest becomes reality as VCs wonder, “Are they the next Google?”
Don’t Throw Out DCF with the Bathwater
As one of the hottest social media companies to emerge since Facebook, Pinterest could well be worth a high valuation. But how did VCs arrive at $2.5 billion?
The traditional method of valuing companies is through the discounted cash flow model, or DCF, which projects a company’s cash flows out by several years and discounts it to arrive at the present value. But applying the DCF model becomes a challenge when a start-up is not making any money. “It’s difficult to value companies that are very young, that don’t have positive cash flows or even revenues,” says Wharton finance professor Luke Taylor. Even so, the “discounted cash flow model is simply correct finance.”
David Wessels, an adjunct finance professor at Wharton, concurs. In a book he co-authored titled, Valuation: Measuring and Managing the Value of Companies, Wessels suggests that the discounted cash flow model is the best way to value high-growth companies because the core principles of economics and finance apply even in uncharted territory. But instead of using a firm’s historical performance in the model, Wessels says, one should start by examining the expected long-term developments of a company’s market and work backwards. Given that long-term projections are uncertain, it is critical to develop different financial scenarios.
OpenTable vs. Groupon
Wessels, with co-authors Tim Koller and Marc Goedhart, analyzed the business of OpenTable, a provider of online restaurant reservations.
The company generates revenue by charging business customers $1 for every seated diner who uses the site to make reservations and 25 cents if the customer uses the restaurant’s website. There is also a monthly subscription fee of $250 for restaurants to use OpenTable’s proprietary computer system that manages reservations and table seating, keeps track of guests and provides e-mail marketing. In addition, there is a one-time installation fee of $800.
From 2004 to 2008, OpenTable’s revenue grew from $10 million to $56 million, a compounded annual growth rate of 53%. Subscription fees comprised 54% of its 2008 revenue while reservation fees took up 42% and the rest came from installation fees.
In 2008, OpenTable reported that 34 million diners used its service at 10,335 restaurants. That comes to about 30% of the 30,000 reservation-taking restaurants in the U.S. The authors projected that by 2018, OpenTable will command 60% of the U.S. market and also profit from a continued expansion overseas. They based the 60% prediction on OpenTable’s market share in San Francisco in 2008.
If the number of restaurants increased by 2% a year, or twice the rate of population growth in the U.S., there would be 36,500 U.S. restaurants taking reservations by 2018. A 60% share for OpenTable means it would have 21,900 restaurants as clients. As for the firm’s foreign operations, the authors assumed the growth would match that of the U.S., delayed by six years. By their calculation, OpenTable could record global revenue of $306.8 million by 2018.
To stress-test their projection, the authors first compared OpenTable’s growth path with the first five years of expansion of Internet companies founded in the 1990s that now make more than $10 million in revenue. “Benchmark against other high-growth companies in the past to see if the projection is reasonable,” Wessels says.
OpenTable’s revenue grew from $10 million to $56 million from 2004 to 2008, which matched the performance of the median Internet company. The book, released in its fifth edition in 2010, forecast that by 2012, OpenTable would book revenue of $141.2 million, a bit higher than the median Internet company but within the bounds of distribution.
The authors also looked at OpenTable’s target operating margin of 30% to 35% and compared the forecast to other consumer Internet companies such as Expedia, Priceline, Orbitz and Monster.com. OpenTable’s margin range is higher, but the authors predicted that achieving it is feasible because the company is the leader in the online reservations market and has little competition.
Finally, they considered three scenarios for OpenTable: exceeding, meeting or underperforming expectations by 2018. If the company outperforms, its eventual valuation was estimated at $1.14 billion. If it meets forecasts, then $719 million was the calculated value. It was $545 million if OpenTable lags predictions. OpenTable went public in May 2009.
As of March 22, OpenTable had a market cap of $1.4 billion. Last year, it booked revenues of $161.6 million with an operating margin of 23%.
OpenTable exceeded expectations, as Pinterest and other highly valued tech start-ups one day might, but it also could easily have fallen by the wayside, much like what happened to daily deals site Groupon.
Before its IPO in November 2011, Groupon was valued at more than $6 billion. On the stock’s first day of trading, Groupon’s valuation jumped to $16.6 billion. But later on, accounting problems surfaced, profits stumbled and revenue growth fell below Wall Street’s expectations. Last month, the company fired CEO and founder Andrew Mason. Groupon is now valued at $3.8 billion, a loss of $13 billion in market cap in little more than a year.
Going public is a sobering event. After an IPO, the focus of investors shifts from a company’s user growth and buzz to its financial performance, testing the start-up’s business model. “The real acid test is when they get out into the public market,” Collom notes.
Until then, VCs make an educated guess whether these hot start-ups are worth the money — and the dice keep rolling. Most bets do not pay off. And even among those investments that make it to Pinterest’s level of funding, “there’s a lot of debate about whether companies can sustain these valuations,” Collom says.