Calculating the net worth (value) of a company is often a fickle business. Companies like PriceWaterhouseCoopers and other large accounting firms have made a living off such valuations because they are often so difficult to calculate. Some compare this to nothing more than "crystal balling" or taking numbers from the air. Why should anyone argue with this when you read the latest business-related news? Take the recent eBay example (link) where executives have finally admitted that they overpaid for Skype (an Internet Telecoms Company) purchased by eBay over 2 years ago. The company made a offer of 4.1 billion, of which is now looks like they paid 1.4 billion too much. It is easy to criticize such a transaction when you are dealing with such large dollar values but let me try to demonstrate to complexity of such valuation and projecting future cash flow.
The complexity of projecting future cash flow can be as simple as the following example. Many of us have walked into a bank to ask for a mortgage on a new house we wish to purchase. I did so recently on my home I purchased in Surrey. Part of the calculations a bank uses is you annual income (your pay cheque), liquid assets (cash, or something that can be converted to cash relatively quickly - usually in less than 6 months - mutual funds, stocks, etc), hard assets (other homes), rolling stock (vehicles), and long term securities (GIC's, RRSPs). If the calculation were simple, the bank would simply add up the value of all these income deriving lines minus all you costs (debts) you would then have a straight forward net worth calculation. However, life is often never that simple.
The complexity even with obtaining a mortgage arises from the following where in finance the two things are often true: first a dollar today is worth more than a dollar tomorrow; and second (related) their is no way to guarantee the sensitivity of future markets. The first speaks to the buying power of money. This buying power is in its simplest form is a function of inflation. As inflation goes up, the value of goods you buy conversely rises (goods like houses). However, since your wage and income does not also go up with inflation (usually a function of a bargaining agreement or a contract), the amount of goods you can purchase with the same dollar you had yesterday goes down. This is why you often see the Bank of Canada often intervening in markets by raising interest rates. As our economy is based on borrowing money, the bank is essentially trying to curb spending (or borrowing money to spend) to reduce inflationary pressures within the country. The bank you are applying for a mortgage to also knows this and wants to ensure that you wages along with other goods will service (pay the loan) for the long haul when the value of that dollar is questionable. They essentially want a good cushion (along with someone with good credit). The second related concept to this is sensitivity. As no one knows exactly how the markets will fluctuate, we have to make an educated guess based on where our economy is going. Also known as speculation, this is how many people make money of the stock market or real estate (buying low to sell high = profit). To aid in this, the bank often discounts ("takes away") some the value of your assets to account for the loss of buying power as describe above. For example, you current assets maybe valued as following when applying for a mortgage: house (75% of appraised value), mutual funds (60% of current market value), vehicles (50% of current value), rental income from homes (50% of current income) and so forth. The higher the certainty that the value of a assets will retain that value (or go up) the higher the valuation for that assets. Cash in the bank would be valued at 100% as it is cash that is not affected by external market pressures. However, mutual funds are affected by stock fluctuations; real estate is affected by the supply and demand as well as affordability; and vehicles are affected by their age, usage, make, model etc. Unfortunately, a bank is the worst form of conservatism where your valuation comes second to their interest in giving you a favorable interest rate on your bank account.
As the above example shows, even simpler transactions can produce complications when trying to foresee into the future about what your dollar will be worth. Imagine trying to do this with a billion dollar company. And to demonstrate how much these valuations differ consider the following: With oil & gas companies for example, their valuation is looking to purchase is often a function of potential (estimated) oil & gas reserves; with a drug company like Pfizer, the valuation is tied up in research and the potential for a new better drug on the market; or a blue-chip company like Lockheed Martin, their valuation is in long-term contracts they have arranged to provide artillery to the US army. The real difference comes with those companies based on the Internet. Their are no hard assets (few buildings), often no real contracts, and no established stream of revenue (most are often in the start-up phase and are dependent on debt to get going). Even those that have been in the industry for some time (like Google) are still considered unpredictable given the rate at which technology has been evolving (a phenomena known as disruptive technology-automobile replaces horse, digital photography replaces film, etc). Google is considered the best search engine on the Internet (and valued at $600/share for it) but it could be replaced tomorrow with something better.
Finally, back to the central argument. eBay gambled on telecoms technology but didn't know how exactly to value the company. Revenues were only at $60 million but eBay paid 683 times too much. eBay was trying to value potential cash flows and that's where all rules went out of the window. The best experts have challenges trying to project future growth and often end up valuing the intrinsic value of the company (what is worth to the competition). In my experience when trying to value such companies you should keep two things in mind: your time horizon short given the technology life-cycle; and second create some sensitivity in the analysis. Even for the business cases I currently author, I will include a Net Present Value (or net worth) of the project at several different discount rates (6%,8%,10%). This illustrates the sensitivity of such cash flows to small fluctuations in the discount rate. The lower the rate, the more sure you are that the cash flows are going to stay the same. This conservative approach, unfortunately means that most projects don't get off the ground. As an organization though, you have understand what your objectives are for investments and what is an acceptable risk. For eBay, a company founded and based on the Internet, the risks tolerance is obviously much higher then there would be at a bank.
My 2 thoughts anyways...
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