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(originally published by Booz & Company)


Are Internet Companies Overvalued (Again)?

What we can learn from eBay’s acquisition of Skype.

In September 2005, eBay Inc. acquired Skype Technologies, an unprofitable Internet protocol–based voice telephony company, for US$2.6 billion in cash and stock (as well as earn-outs, which potentially provide the sellers with additional revenue if the company meets certain financial performance targets; in this deal it could increase the purchase price to $4 billion). This transaction marked the beginning of a new wave of Internet industry mergers and acquisitions following a long, painful correction. Other major deals since the eBay–Skype deal have included Google’s acquisitions of DoubleClick and YouTube, Microsoft’s acquisition of Aquantive, and News Corporation’s purchase of MySpace. In fact, more than 1,150 technology transactions worth more than $30 billion have closed since — many featuring lofty valuations, considering that most of the acquired companies had short operational histories and limited or nonexistent earnings.

There is a very strong chance that, to a large degree, acquirers are overpaying either because of limitations in common techniques for placing a value on mergers and acquisitions or perhaps because of a lack of investment discipline in firms with excess cash. For example, one of the more popular valuation methods is discounted cash flow, in which all future cash flows from an acquired company are estimated and then “discounted” to give them a present value. But the outcome of the analyses in many of these deals is often little more than a guess, especially when there is not enough history about the company being acquired or a sufficient number of comparable firms to determine with any degree of accuracy what its next ten years will be like. If the revenue assumptions or synergy estimates are too aggressive, then the buyer has overpaid. Another way of approaching valuation is by comparing previous similar transactions. But here, too, the record is small or insufficiently applicable to be credible.

Therefore, in addition to these somewhat lacking models, we recommend that today’s dealmakers also use a real options framework, which seeks to analyze and value the options, or strategic alternatives, that a company will have once it acquires another company. Although this method also depends on some assumptions, the rigor of building this type of analytical framework makes it much less vulnerable to pure guesswork and is an excellent way to determine the efficacy of management assumptions. We applied this approach to the eBay–Skype deal because it is the oldest of the recent wave, enabling the analysis of several quarters of financial data, eBay management’s long-term plans for Skype, and Wall Street analysts’ financial projections.

Several premises drove eBay’s acquisition of Skype.

  • eBay was facing a slow-down of its core business in a maturing online auction market.
  • eBay management had achieved previous success in its diversifying acquisition of Paypal, which allows purchases and money transfers to be completed online.
  • “Convergence” would rapidly eliminate differences among separate Internet-based businesses.
  • Direct competitors were rumored to be interested in buying Skype.
  • Skype’s Voice over Internet Protocol (VoIP) communications capabilities would transform the way people make and receive calls.

Consequently, eBay management was convinced that Skype would accelerate trading on eBay by letting buyers and sellers communicate over the Internet; Paypal integration on the Skype system would allow easier payment methods for users; Skype could promote eBay services, and vice versa; and the acquisition would enable eBay to pursue entirely new businesses such as pay-per-call.

In our assessment, a discounted cash flow analysis of the core Skype business, under fairly aggressive assumptions, yields an enterprise value of only about $1.5 billion, $1.1 billion short of the purchase price. To arrive at this, we conducted a strategic analysis of the VoIP landscape to review eBay’s assumptions for long-term operating margins as discussed in publicly available merger materials. Our review identified significant areas where eBay appears to have been overly optimistic — especially given the highly competitive VoIP landscape as startups, large Internet companies, and incumbent telecom/cable companies enter the industry. For example, eBay assumed 20 to 25 percent long-term operating margins versus a more realistic 15 percent. We also took Wall Street analyst projections for the Skype unit and conducted multiple discounted cash flow analyses that covered several potential scenarios, from best case to worst.

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  1. James Alleman and Eli Noam, eds., The New Investment Theory of Real Options and Its Implications for Telecommunications Economics (Springer, 1999): An examination of how real options can be applied to the telecommunications landscape. Click here.
  2. “eBay to Acquire Skype,” September 12, 2005: The original announcement of the eBay–Skype deal, on the Skype Web site. Click here.
  3. Raul Katz, “Irrational Exuberance: How the Telecom Industry Went Astray,” s+b, Summer 2003: What happens when demand myths, faulty forecasts, and financing traps converge. Click here.
  4. Kevin Keasey and Philip Moon, “Gambling with the House Money in Capital Expenditure Decisions: An Experimental Analysis,” Economic Letters, vol. 50, no. 1 (January 1996): How management behavior may be altered under a variety of capital structure situations. Click here (subscription required).
  5. Johnathan Mun, Real Options Analysis: Tools and Techniques for Valuing Strategic Investments and Decisions (2nd ed., John Wiley & Sons, 2005): A qualitative and quantitative description of the methods used in evaluating real options and why and when they are applicable. Click here.
  6. Lenos Trigeorgis, ed., Real Options in Capital Investment: Models, Strategies, and Application (Praeger, 1995): An in-depth examination of the value of real options. Click here.
  7. Real Options Group Web site: The mandate of this academic organization is to help managers embrace and capitalize on uncertainty by using real options in investment decisions. The group hosts an annual conference on the subject. Click here.
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