Recent high-priced, high-tech initial public offerings and filings from social media companies like LinkedIn, Zynga and Groupon have some Goizueta professors wondering if return-hungry investors are making the same mistake they did more than a decade ago in the first Internet boom: closing eyes to the possibility of questionable revenue-recognition and other issues that could unreasonably inflate their valuation.
“Social networking is a hot market item right now,” says James D. Rosenfeld, an associate professor of finance at Emory University’s Goizueta Business School. “But there are some concerns about the values that are being assigned to these companies. Traditional companies have a track record, and you can look at the price-earnings ratios of similar publicly traded companies to determine their approximate valuation in an IPO.
“But many of these Web firms haven’t recorded profits yet, so there’s less of an anchor.”
He’s concerned about investors’ use of non-traditional metrics, like “pages eyeballed” or another formula that takes a firm’s enterprise value (the market value of equity, plus the book value of debt, minus cash on hand) and divides it by EBITDA, or earnings before taxes, interest, depreciation and amortization.
“Enterprise value over EBITDA was commonly used to value IPOs during the 1990s Internet boom,” recalls Rosenfeld. “But after the bust, some analysts admitted it was a flawed metric. I’m worried that some investors may have forgotten that lesson.”
With interest rates at record lows, fund managers are chasing the technology sector in hopes of higher returns, observes Jagdish N. Sheth, a chaired marketing professor at Goizueta.
“An IPO aims to attract capital and typically presents the most positive side of a company, but the evidence is that most stocks that debut at a high IPO value tend to drop significantly after six months, often leaving the underwriters and initial speculators as the only ones with big gains.”
The challenge actually goes back to pre-IPO reporting, adds Sheth, who has sat on the board of directors at multiple start-ups.
“Pre-IPO governance is still ill-defined by regulators,” he said. “They define and limit the kinds of investors that may be approached, but not how the information is presented. Often, there’s a mad dash to restate the pre-IPO financial statements when a company’s ready to go public, and even then the reporting may contain borderline assumptions and other issues. We’ve seen issues like this before, when companies would book ‘phantom revenue,’ and I’m worried about these kinds of issues arising again in today’s scramble to go public.”
Revenue recognition “is a big concern,” adds Benn R. Konsynski, a chaired professor of information systems and operations management at Goizueta.
“It’s OK to use specialized revenue recognition metrics if they clearly augment the generally accepted accounting principles, or GAAP,” he explains. “But if the distinction’s not clear, and the logic uncertain, the financial reporting is likely to be misleading — similar to the way the ambiguity of derivatives helped to bring on the recent banking crisis and recession. The problem is that when something unique comes along many investors say ‘the old rules don’t apply anymore.’”
But that only holds until things fall apart, Konsynski adds, since “then they realize that the old rules did apply” and new systems of instruments and protocols need to be thoroughly examined.
“New contexts bring new measures,” Konsynski said. “But they should inform, not replace the common basis of analysis.”
– Marty Daks
