Groupon is the next Facebook, so say the experts. A rumored Google offer at $6 billion was turned down, and the latest rumor has it valued at $15 billion for an IPO.
What is it really worth?
The real answer is that no one knows the true value of Groupon. However, one of the most valuable skills you can pickup as an MBA is to perform a back-of-the-envelope valuation of a company. Incidentally, this is also a VERY popular interview question. In learning about valuation, you’ll likely be startled to find that there is a ridiculous amount of uncertainty involved. This is one of the main reasons many mergers and acquisitions turn out to be disappointing (one estimate pins this number at 75%). Nevertheless, let’s value Groupon and see if Google was low-balling or if hype has created a bubble.
To value the company, I’ll attempt to find something close to its free cash flows and then discount these values back to the present value (stop me if you’ve heard of this before).
Let’s start with revenue. I’ll use the following equation for this approach:
coupons sold/year * average dollars/coupon * Groupon % of coupon revenue
Based on its own website numbers, Groupon has sold some 24 million Groupons since its inception. Because Groupon caught fire this year, let’s assume that 75% of sales were in 2010—18M Groupons total. Next comes the average dollars per Groupon. I’m going to assume $20 per Groupon, based on browsing the website. Finally, from interviews and news stories, we know that Groupon and the merchant split the revenue 50/50. Multiplying these values together leads to
18 million x $20 x 50% = $180 million in revenue.
Because Groupon is a private company and we don’t have access to their detailed financial statements, I’ll have to make more assumptions to find free cash flow. However, I’m just going to use net profit instead of free cash flow because this is the closest value that I can quickly calculate. Groupon is a web-based company, so I’ll use a profit margin value of 30% based on comparisons to Google and Microsoft. There are issues with this profit margin that I’ll discuss later, but let’s go ahead and use it. Multiplying the $180 million in revenue we calculated by 30% = $54 million. This is our estimate of Groupon’s profit in 2010.
Now comes the fun part. We will estimate the profit for Groupon over the next four years and then calculate the terminal value, which is the value of Groupon’s profit in perpetuity. There are three key assumptions we need to make here:
- Growth of Groupon over the next 4 years
- Growth of Groupon after 4 years, in perpetuity
- Discount rate
We are going to make a somewhat optimistic assumption of 50% YoY growth in each of the next four years. We could look at comparable companies in their early years to check this value and if we were doing a more thorough valuation we would actually apply this growth to revenue and then recalculate profit. For simplicity we will apply the 50% rate to profit.
Here’s our estimate of Groupon’s profit over 5 years:
|Year 0||Year 1||Year 2||Year 3||Year 4|
|$54 MM||$81 MM||$122 MM||$182 MM||$273 MM|
To calculate the terminal value, we need to now make our assumption about future growth and the discount rate. Let’s assume an industry growth rate of 5%. Average values for the discount rate range between 10% and 15%, so we’ll assume 10%. Again, we could get a somewhat more accurate value by looking at industry comparables for these numbers and we’d also want to use a different kind of discount rate, but all that would take much more space than is available on the back of an envelope.
Using these values, we calculate a terminal value of
273 million * (1+0.05)/(0.1-0.05) = $5.733 billion
This is the Year 4 value grown by 5% in perpetuity in Year 4 dollars. We need to discount it back to the present value:
$5.733 billion / (1+0.1)^4 = $3.915 billion
Discounting each of the first 5 years back to present value leads to:
|Year 0||Year 1||Year 2||Year 3||Year 4|
|Future Value||$54 MM||$81 MM||$122 MM||$182 MM||$273 MM|
|Present Value||$54 MM||$74 MM||$100 MM||$137 MM||$187 MM|
Finally, we add up the present values from Year 0 to Year 4 plus the terminal value to get the final Groupon valuation:
Notice that this is in the ballpark of the rumored $6 billion value of the rumored Google offer, but not really close to the latest rumored IPO value of $15 billion. We can get to the $15 billion value if we assume a year-over-year growth for the first four years of 105%.
Why is our valuation so different? First, I am operating entirely on assumptions and publicly available data. It is entirely possible that a company looking to acquire Groupon has additional information and that my assumptions are way off. Second, it is also possible that hype has inflated the value. Finally, because nobody knows what the true value is, much is left to interpretation.
Do our assumptions jive with other information?
We also want to examine other factors related to the company that may impact our assumptions. For example, the deal space is becoming increasingly competitive. Can Groupon sustain its competitive advantage and therefore its growth? Also, if the economy improves, will people still be so eager for deals. Using business frameworks to analyze the situation can be very helpful in checking assumptions.
Let’s return to the profit margin and evaluate one of my key assumptions. According to several articles, Groupon’s costs may be much higher than I am accounting for. Typically when they enter a new city, they hire a new sales force. This is quite costly and not scalable. If it continues with this model, Groupon will have difficulty achieving the economies of scale that will lower costs. They have recently released a self-service Groupon option that may help with scalability, but the jury is still out. Based on this additional information, it is possible that my assumption of 30% for the profit margin is too high, meaning the company value will be even lower.We also want to examine if the growth they’ve had (and which we are predicting in the valuation) is likely to continue. Offering a Groupon is a costly way for a company to acquire a customer. If it turns out that the lifetime value of these customers does not exceed the acquisition cost, companies will stop offering Groupons. For example, a yoga company offering a $20 Groupon for $40 worth of service will only receive $10. Assuming the services cost $30 to the yoga company, a customer will have to return two more times with no discount for the company to break even. This is a deep discount and, personally, I wonder how many companies will be repeat Groupon users once the craze slows down.
Another important piece of information would be to determine which of our assumptions are most influential over the final valuation. Then we can attempt to gather better information to make more informed assumptions around these values.
There are a number of other exercises that we can engage in, but I’ll leave that up to anyone who reads this blog and is interested.
Feel free to post your valuations for Groupon and let me know if I am way off or right on! It will be a great exercise and help prepare you for one of the most important skills an MBA can gain.