In the present era of cheap and accessible capital, Internet entrepreneurs have succeeded in quickly transforming their business ideas into billion-dollar valuations that seem to defy the common wisdom about profits, multiples, and the short-term focus of capital markets. Valuing these high-growth, high-uncertainty, high-loss firms has been a challenge, to say the least; some practitioners have even described it as a hopeless one.
In this article, we respond to that challenge by using a classic discounted-cash-flow (DCF) approach to valuation, buttressed by microeconomic analysis and probability-weighted scenarios. Although DCF may sound suspiciously retro, we believe that it works where other methods fail, reinforcing the continuing relevance of basic economics and finance, even in uncharted Internet territory.1 Yet it is important to bear in mind that while the valuation techniques we sketch out can help bound and quantify uncertainty, they won’t make it disappear. Internet stocks are highly volatile for sound and logical reasons, and they will remain highly volatile.
DCF analysis when there is no CF to D
Three related factors make it hard to value Internet companies. First, like many start-ups, they typically have losses or very small profits for a few years, partly because of the...