Wednesday, November 2, 2011

Are you ready to value Groupon?



After a series of missteps, it looks like the Groupon valuation is ready to hit the market on Friday, with the final pricing to be done on Thursday. To bring you up to date on this unfolding story, the initial talk during the summer was that the company would be valued at $20 billion or more. In the months afterwards, loose talk from management of how customer acquisition costs were not operating expenses and what should be recorded as revenues got in the way of the sales pitch. As management credibility crumbled, the value dropped by the week and it looks like the company will now go public at an estimated value of about $12 billion, though only 5% of the shares will be offered in the initial offering.

As with the Linkedin and Skype valuations that I did earlier this year, I thought it would be useful to do a valuation of Groupon. Before I put my numbers down, though, let me emphasize that I don't have an inside track on this valuation and that these are just my estimates. Rather than contest them, I would suggest that you go into the spreadsheet that I have attached with the valuation and make your own estimates.

Before I do the valuation, though, a little on Groupon’s business model. Groupon works with any business (retail, restaurant, service) allowing it to sell products/services at a discount (usually 50% or higher). Thus, a restaurant that normally would charge $50 for a meal can offer a 50% discount to Groupon customers who would buy it at $25; Groupon and the business then split the $25. With a 50/50 split, Groupon's revenues would then be $12.50. (One of the controversies over the last few month was whether Groupon could claim revenues of $25 (the discounted price of the service) or $12.50 (its share)).

Valuation of Groupon business
Current numbers
To get the current numbers, I started with the S1 that Groupon filed with the SEC in October 2011. This filing has the numbers from 2010 and for the first nine months of 2011 (as well as the first nine months of 2010), which can be used to extract the trailing 12-month numbers for the company.
Trailing 12 month = Last 10K - First 9 months, 2010 + First 9 months, 2011

Revenue growth
Rationale: This was a tough one! Groupon’s revenues increased from $312 million in 2010 to $1,290 million in 2011, an increase of more than 300%. That is going to be impossible to sustain but to make a judgment on growth rates for the future, I had to estimate the potential market. The potential market is large since it encompasses “long term excess capacity” at almost any consumer-oriented businesses. It is worth noting that this excess capacity is high right now, because of the poor state of the economy, but even allowing for halving in excess capacity across the board, there is plenty of room to grow. 
My estimate: 50% compounded revenue growth for next 5 years, declining to a stable growth rate of about 2% in year 10. Groupon’s total revenues in year 10 will be about $25 billion.

Target operating margin and reinvestment
Rationale: Groupon is losing money right now and it is doing so because its marketing and customer acquisition costs are huge. That, by itself, is to be expected, given their focus on increasing the number of subscribers. To estimate what their margins will be, if they succeed with their business model, we have to estimate what these two expenses will look like for a mature Groupon. I tried to estimate these numbers, using the very limited information that is in the financial statements for the last two years.
Since I am assuming high growth in revenues, I thought it prudent that the firm reinvest to generate this growth. I have estimated a dollar in capital invested in the business will generate $2 in incremental revenues. Since the average subscriber in Groupon generates only $11.6 in revenues for the company, continued high growth will require substantial costs in acquiring new customers and holding on to existing ones.
My estimate: The pre-tax operating margin will improve gradually over time to 23% in year 10, with operating margins staying negative through year 6A legitimate argument against high margins is that this is a business where the competition is active and aggressive, both from established players like LivingSocial and Amazon but from new players. If you buy into this argument, you will use lower, more conservative margins.

Cost of capital
Rationale: Groupon is a small, high growth, high risk business right now. If my revenue growth and margin estimates come to fruition, though, it will become a larger, more profitable and more stable entity over the next 10 years. As that happens, its cost of capital should change.
My estimate: In the initial period, I assumed that Groupon would continue to be all-equity funded and have a cost of equity of firms in the top decile in terms of risk. (With a beta of 2, a riskfree rate of about 2% and an equity risk premium of 6.5%, this works out to a cost of capital of 15%). In its mature state, I dropped this cost of capital to the market-wide average in November 2011 of about 8%.

Steady State
Rationale: At some point in time, Groupon’s growth days will be behind it and it will be a mature company, growing at roughly the same rate as the economy. When that happens, its risk profile and cost structure will resemble that of a mature company. I am also assuming, rather optimistically, that there is a 0% chance that the firm will collapse over the next 10 years.
My estimate: Groupon will become a mature company in 10 years, growing at the same rate as the economy (2.05% in nominal terms). Its cost of capital will drop to 8%. Since it will have built up some significant competitive advantages at that point, I will assume that it can generate a return on capital of 10% in perpetuity after year 10.


Overall valuation
Based on these inputs for compounded revenue growth, target margin, reinvestment and cost of capital, the value that I obtain for the operating assets of the firm is $9.73 billion. Look at the valuation page on the Groupon spreadsheet for the numbers. It is worth noting that the present value of the expected cash flows over the next 10 years is -$5.4 billion. That reflects the expectation that the firm will need to raise fresh equity (and thus dilute your share of value) to fund it's cash flow needs over the next decade.

Valuation of Groupon equity per share
Cash: The cash balance as of September 30, 2011, was $243.9 million. To this, I added the expected proceeds of $478.8 million from the IPO, since the proceeds will be kept in the firm to meeting working capital and investment needs. (If the founders had withdrawn the proceeds to cash out some of their ownership, I would not have done this.)
Debt: Groupon has no conventional interest bearing debt but it does have some leases. Since the magnitude of these leases is small (about $91 million, see page 76 of S1), I have ignored it in both my cost of capital computation and in this stage of the valuation.
Equity options: Groupon has 18.4 million options outstanding, with an average exercise price of $1.11 and an assumed maturity of 5 years. Using the company-provided estimate of volatility of 44% and the expected IPO price of $16 as the stock price, the option value was estimated to be $275.53 million.
Value per share: The value per share can be computed now:
That is based on the presumption that all shares are equal (in voting rights). Since the shares that will be offered to the public are the lesser voting right shares, the value would have to be adjusted down to reflect that. My estimate would be that the class A shares are worth about $14/share and that the class B shares are worth about $15.50/share.

Bottom line
With my estimates for Groupon, the value per share that I get is $14.62, not far off from the low end of the IPO range of $16-$18 per share. Allowing for the difference in voting rights, I would lower the value per share to less than $14. Given the high-ball estimates that we have seen on other social media companies that have gone public in the last few months, this would suggest one of the following:

  1. The market for social media companies is growing up and attaching more reasonable values for these companies.
  2. The antics of Groupon management have hurt it in the market’s eyes; this is the "mismanaged IPO discount" on value.
  3. The stock has been deliberately under priced because only 5% of the shares are being offered in the IPO and the company (and its investment bankers) want to see it pop on day one.
My guess is that it is a combination of all three factors. Groupon has to be credited with building an interesting business model that has a large potential market and is scaleable.  What makes this company interesting is that investing in it is indirectly a bet on the economy. Unlike most young growth companies that are dependent on the economy becoming stronger and more vibrant for higher value, Groupon's value is likely to be higher if the economy stays in the doldrums. After all, what business in a healthy economy wants to sell its products for 70% or 80% of list price?


Would I buy Groupon? No, and not just because it is over priced at $16 to $18 ... Having watched how the company's management has played games with investors for the last few months, I am unwilling to tango with them, especially since they have already telegraphed their unwillingness to accept input from me (by cutting my voting rights essentially to zero). But that is my choice. You can make your own estimates and judge for yourself...


Postscript: A few of you have already noted that I have been optimistic in my assumptions and you are absolutely right: high revenue growth, a healthy target margin, declining cost of capital and no chance of failure. My point is that even with those assumptions, I am falling short of the IPO price. Better still, I would like you to go in and make your own estimates in the Groupon spreadsheet and value the company. To keep tabs on all of our different estimates, I have created a shared Google spreadsheet where you can input estimates and value per share. Should be fun!

20 comments:

Hin said...

Prof Damodaran,

May I assume you've priced in a premium on Goupon for being a young company by using a beta of 2 for the initial cost of capital?

I am not sure about this but when we value a young public company, should there be a so called 'start-up' or 'young company' premium? Startups and young companies are relatively more risky than mature companies but this startup risk should be diversifiable (unsystematic risk) hence shouldnt this be not included in the calculation of wacc?

Pranav Pratap Singh said...

Somehow, we are never able to justify investing in internet companies on the basis of dcf valuation. Most of these companies have shown that this prudence was justified. Still, could we be missing some peice of the puzzle which always leads to this difference in valuation?

Aswath Damodaran said...

The start up premium is an adjustment to reflect the fact that many IPOs don't make it. In the spreadsheet, you can incorporate it by bringing in the probability of failure. I used 0% for Groupon but if you use a higher percent, you will reduce value.
And Pranav, that is not true... I found quite a few internet companies that were cheap in 2001 and 2002 (including Amazon...). So, it depends on when you do the valuation.

Andrew F said...

Once the dust has settled from the IPO, I will be shorting...

I suspect many businesses that participate in this model for promotions are not very savvy. They may eventually learn that they are training the customers to value their products much less. Given that a very high percentage of customers who redeem these offers will not patronize that business in the future, the cost per repeat customer acquisition is sky high (for a restaurant, I suspect it is over $100, for a spa or the like, probably many hundreds of dolllars), especially with the substantial margins charged by Groupon. I suspect this business model is a bit of a fad. Consumers and businesses will get fatigued with the model and margins will get squeezed hard.

Carson Cole said...

Good work. Revenue estimates are likely high, and I suspect after their next results are out, it'll be a lot more evident that their growth is way down. I imagine they wanted to get this IPO done now, before those results come out.

I wrote a similar piece, but more focused on their cash flow (http://investingeyesopen.blogspot.com/2011/10/groupon-deal-if-it-lasts.html), which really paints a scary picture. Since they'll likely get this deal done, pricing it so that initial buyers can sell immediately for a profit, the proceeds will be sufficient to cover cash flow needs for the next 6-7 months. After that, it'll get interesting...

magic19 said...
This comment has been removed by the author.
magic19 said...

Prof Damodaran:
Why do we neglect two items, the Depre.& Amort. and delta on net working capital, when processing the DCF Model? Is it unnecessary to invlove these two items in internet company valuations?

Ron Elmer said...

Just my opinion, but I honestly think this stock will go to zero. It's just a matter of when.

Aswath Damodaran said...

Magic19,
The reinvestment number that you see in the valuation is a composite number and includes all of these items:
Reinvestment = Cap ex - Deprecn + Chg in WC
The reason that I don't break it into detail is that it is impossible to do for a young company since future reinvestment can come from cap ex, acquisitions, infrastructure or working capital.

Alex said...

One issue I would emphasize more (adding to the strength of the general "don't buy, maybe short if it doesn't get too crowded" feeling of the post and comments) is -- where's the moat?!

It seems to me to be a business with no competitive moat -- no barriers to entry -- and indeed there already is a pile-up of competition, both startups and obvious extensions of existing businesses (e.g a restaurants-focused site like OPEN offering groupon-like deals to the restaurants it already has commercial relation with).

Therefore, margins should be truly abysmal, no?

Aswath Damodaran said...

Alex,
I agree with you, with one caveat. This is a business where the "sheer numbers" may be the moat. In other words, success can feed on itself and here is why. If you are a restaurant and you are looking at offering a coupon deal, you would rather go with Groupon, if it has 100,000 subscribers in the city than with LivingSocial, if it has only 5000. I agree that it is a fairly weak competitive advantage, but we are learning how this business works.. and does not...

Andrew F said...

Scale might be a moat, to an extent, but it will require Groupon to reduce their margins to an extent that cannot be matched by smaller competitors. Thus, those restaurants are only interested in acquiring customers through their service. Living Social might have only 5,000, but what stops that restaurant from trying both services, especially if Groupon offers not advantage in terms of the margin they take?

angad said...

Prof Damodaran,

Do you feel that increased competition will in fact force groupon to lower their margin's? Small businesses cannot afford to constantly sell their services for 75% off. They are using groupon as a sort of advertisement to attract new customers. Which means groupon's most important statistic would be the number of customers that purchase a deal and end up being repeat customers to the business that offered the deal. If small businesses find this number to be low, they will find new means of advertising their business. Unlike traditional forms of advertising, the business that offers the deal will loose money for every customer that is not a repeat customer.In your valuation I believe you have made the incorrect assumption that groupon's business model is a sound one. I personally feel that groupon's business model is flawed, and that their services will only benefit a small percentage of businesses.

Aswath Damodaran said...

Angad,
Exactly what I am worried about and what Groupon probably is also worried about...

Jake Beaulieu said...

All,

I unfortunately work in the restaurant industry (local franchise, mid to higher end, sit down casual) while completing my finance degree and can attest first hand to the future concerns/hurdles for Groupon's growth projections and costs for growth. Groupon customers are what we call "amateurs" they are only going out to eat out because it is half off. I have NEVER experienced a return customer from a Groupon. I have also noticed recently similar $15 for $30 coupons from customers from Facebook.

From the restaurant ownership point of view the profit sharing has already been disclosed above. What has not been shared is the general dissatisfaction from ownership/management for their experiment with Groupon. Low to negative financial returns, new customers who tend to be rude (claim to not like their food and demand gift cards for a return visit), and even attempt to fraudulently reuse Groupon coupons multiple times. One guest even claimed that their piece of junk car with 22" rims was damaged by the valet.

I feel this shows parallels with many folks concerns as follows:

1. Continued high cost of marketing to reach new costumers since many customers do not repeat the experiment
2. Decreasing market share due to growing competition
3. Thus far the economy appears to be sliding slight positive year over year (from a restaurant revenue point of view in my 3 yr experience). As indicated previously, a healthy economy/business will not agree to Goupon's demands therefore a shrinking customer base over time.

I hope this adds some boots on the ground color to the concerns shown in the comments and calculations in your blog.

Happy Holidays

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