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(originally published by Booz & Company)


Are Internet Companies Overvalued (Again)?

Because the discounted cash flow analysis clearly showed that eBay’s rosy forecasts had led the online auctioneer to a higher valuation than Skype was likely worth, we then examined whether a combination of real options for the future, including potential growth in new business areas such as pay-per-call services and mobile payments, as well as the possibility of eventually combining and divesting assets, could be used to justify the additional $1.1 billion that eBay paid.

However, the real options analysis was less than promising: We found only a limited chance that Skype would help eBay grow its business beyond what it would be without the acquisition or that the combination would allow eBay to streamline its operations. Given the gap between our discounted cash flow and real options value and what eBay paid, even aggressive synergy assumptions representing 5 to 10 percent of the purchase price, or $130 million to $260 million, were not enough to justify the premium. In addition, this amount would be offset (partially or fully) by the costs associated with diversification and the cross-border nature of the deal. (Skype is based in Luxembourg.)

We thus concluded that in the eBay–Skype deal reality fell short of the hype. The premium could be justified only if very dubious assumptions were used and competitive dynamics were ignored — the latter especially questionable in a volatile industry such as telecommunications. Furthermore, our analysis concluded that merely forming a partnership with a company like Skype, or building auction-related VoIP services internally, might have been sufficient to provide eBay with entry into new businesses that it hopes to gain from the Skype acquisition. Finally, the sustainability of any competitive advantage was far from guaranteed, which also undercuts the logic of the deal. Therefore, although the acquisition might have embodied an acceptable diversification strategy for eBay, the assumptions used to validate the purchase price appear to be overly aggressive and are difficult to justify through any combination of valuation models.

We are not arguing that all the recent Internet transactions are flawed. The acquisitions of DoubleClick and MySpace, in particular, appear to have been smart moves. However, we are raising the question whether overpayment in many of these deals is destroying shareholder value. In fact, we wonder whether, as has happened in other mature industries, excess cash and nonoptimal capital structure have fostered a lack of management discipline or even management hubris. Another potential explanation for the high values in these deals could be the intense competition for assets among a small number of large players. Executives in technology companies must make fast and risky M&A decisions in uncertain environments because industry rivalries are so intense. But there are real trade-offs that must be considered, namely the “gambling with house money” syndrome.

It was precisely this syndrome that fueled the first Internet bubble. We should remember that a sign of the end of the first bubble was highly speculative transactions. It is now pertinent to ponder whether some acquisitions of the current era will ever realize their transformative promise. Irrational exuberance, the phrase made famous by Alan Greenspan, may once again be raising its frothy head.

Author Profiles:

Raul L. Katz ([email protected]) is director of business strategy research at the Columbia Institute for Tele-Information and an adjunct professor in the finance and economics division at Columbia Business School. Formerly a vice president and partner at Booz Allen Hamilton, he is president of Telecom Advisory Services LLC, a strategy consulting firm.
Paul Zangrilli ([email protected]), a former product manager at Yahoo Inc., is a research analyst at the Columbia Institute for Tele-Information. 
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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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