You may have seen that investors sent Zynga’s shares down by as much as 40% in after hours trading last night, taking the share price to $3, which is 70% off the level of their mid-December IPO. The business is still growing – revenues were up 19% to $332m for the quarter – but losses widened and the company slashed its growth targets.
This is a similar story to GroupOn (share price off 74% since it’s November 2011 IPO) and even Facebook (share price off 26% since its May IPO).
Which raises the obvious question of why IPO investors are making these mistakes. The most common answer is that gullible investors hungry for growth stores were duped by greedy management teams and clever bankers, and that is a partial explanation, but I wonder if there is something more going on here. I wonder if part of the issue is that the discounted cash flow (DCF) methodology bankers use for valuing companies is letting them down because it doesn’t deal well with rapidly changing markets.
Back in 2011 I wrote about how DCF isn’t appropriate for startups, quoting Benchmark Capital partner Bill Gurley:
Those of us with a fondness for finance will argue until we are blue in the face that discounted cash flows (DCF) are the true drivers of value for any financial asset, companies included. The problem is that it is nearly impossible to predict with any accuracy what the long-term cash flows are for a given company; especially a company that is young or that might be using an innovative and new business model. Additionally, knowing what long-term cash flows look like requires knowledge of a vast number of disparate future variables. What is the long-term growth rate? What is the long-term operating margin? How long will this company hold off competition? How much will they be required to reinvest? Therefore, from a purely practical view, the DCF is an unruly valuation tool for young companies. This is not because it is a bad theoretical framework; it is because we don’t have accurate inputs. Garbage in, garbage out.
DCF is now inappropriate for public companies like Zynga, Groupon and Facebook for the same reasons it is inappropriate for startups. Their markets are changing so fast that inputs to DCF models aren’t accurate.
I want to finish with two caveats – firstly I’m not an investment banker, and write from suspiscion, not experience, and secondly (for all you DCF lovers) there is nothing wrong with DCF from a theoretical perspective. As Gurley says discounted cash flows are the true drivers of value for any financial asset, my point is that the practical challenges in using DCF for startups now extend to public companies.
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