Who is right on internet valuations? Public markets or VCs?

IPO letter on gold coins stack

What do Facebook, Zynga and Groupon have in common? Yes, they went public recently. Yes, they are all part of the grand web evolution. Yes, they have been growing really, really fast. Yes, they all are desktop-first companies struggling to find traction in an increasingly mobile world. Yes, they are buying up companies willy-nilly in order to figure out this mobile thing. However, there is one thing that really unites them: they were overvalued as private companies and after going public they have been presented with a reality check.

The latest to get that reality check in Zynga, which today saw its stock tank almost 40 percent to about 3 bucks a share in after-hours trading. The reason? It missed its second quarter 2012 revenue targets and painted a dismal picture for the near future. The sentiment on the company is quite negative on Wall Street.

ZNGA Chart

ZNGA data by YCharts

Same goes for Groupon, which was at one time offered $6 billion by Google and now has a market valuation of about $4.68 billion. Private investors are rumored to have valued Zynga between $7-to-$9 billion, but in public markets it is being valued at around $3 billion. Facebook was valued at $80 billion when it was private. These days, it is valued at around $62 billion.

It is hard to imagine a web without Facebook and its authentication system and it is only a matter of time before Facebook launches their version of an off-Facebook ad network, much like Google’s AdSense. So is it worth a $100 billion or $60 billion?

In reality, the big question that really comes to mind: are private investors (that is, VCs and late-stage investment groups) overvaluing the new-breed of Internet companies? Or is the public market not valuing them properly? The answer – private investors. Why? Because these fast-growing companies are getting nosebleed valuations from private investors without much regard for the business logic.

Is Pinterest is worth $1.5 billion? Who knows, but it will eventually grow into that valuation? Twitter is valued at $10 billion – which is great for them but in order to become a business to justify that (or higher) valuation, they need to do some crazy things, including going against their own core values. Private investors can convince themselves that they know better.

Now compare this with software companies that have gone public this year. In a recent report for his clients, Ted Tobiason of Deutsche Bank noted:

Twelve software deals priced year-to-date, continuing last year’s strong run. Nine of the twelve priced above their filed ranges and each of these is above issue. The sector’s median return is an impressive 41%. The median software deal priced at 3.6x forward sales versus 3.3x last year. The range at pricing extends from 1.6x for Exa to 7.8x for Splunk, with SaaS names in particular garnering significant focus from investors. Splunk is currently trading at 13.8x forward sales. After appreciating 65% from its IPO price of $17.

Software companies have other advantages that are important in volatile markets. Subscription-based models have much greater forward visibility in their businesses. While consumer-based Internet companies can have tremendous top-line growth opportunities, their businesses can be very difficult to forecast. And the point has been emphatically made recently that one of the challenges of creating a new market such as social media is that it is tough to predict consumer behavior and how things like the shift to mobile will impact revenues and margins.

It is hard to fault Ted’s logic. So, if there is any inefficiency in the market, I think it is how private investors value fast growing Internet companies. And the overvaluation starts early.

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