Netscape Communications Corporation Case Study

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Netscape’s valuation using DCF Model:

To value Netscape using a DCF model, I assumed revenues grow at a constant rate g, over a period of ten years from 1996 to 2005. I further assumed the unlevered cost of capital to be 15%, COGS to be 10.44% of revenues and depreciation expense to be 5.52% of revenues from 1996 to 2005. I assumed R&D expenses to be 36.8% of revenues from 1996 to 2000 and then declined linearly to 25% in 2005. Other expenses were assumed to be 68.7% of revenues in 1996 and then declined linearly to 20% in 2000 and remain at 20% until 2005. CAPX was assumed to be 38.7% of revenues and declined linearly to 10.02% in 2000 and remain at 10.02% until 2005. I further assumed that there was no change in net-working capital and that Netscape faced a 35% tax rate and could not use tax-loss carry forwards. Once the above mentioned cash flows were projected for the period of 10 years from 1996 to 2005, free cash flow for each year in the projected period was calculated using following equation:

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The terminal value for the cash flows was estimated using multiple of a comparable firm(s). It is important to note that since for this method one has to assume that the comparable firm(s) will have similar business risk, expected future growth and profitability as the firm being valued, identifying closely comparable firm(s) for which all the assumptions hold good is a challenging task. Moreover, multiples are also subject to distortions due to market misvaluations and accounting policies.

The exhibit 3 of the case text provides us with P/E ratio and debt to total capital ratio for Netscape and its direct and indirect competitors. Since it’s not evident whether the debt to capital ratio considers book value of debt or market value of debt, one can argue that since all the three competitor firms have zero to negligible debt it is safe to use P/E ratio for this method. Since the exhibit does not provide with AOL’s P/E ratio the choice comes down to either Microsoft or Spyglass. Since Spyglass was not a publicly traded company at the time, Microsoft was the only choice left for this method to estimate terminal value which was estimated using the following equation:

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Plugging in the P/E ratio value of 39.00 for Microsoft and estimated NOPAT or unlevered net income for 2005, terminal value of equity was estimated. All the free cash flows were then discounted to present value by using the unlevered cost of capital of 15% in the following equation:

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The net present value or the enterprise value was then determined by adding all the present values. Assuming that the net debt stays the same after the IPO I then calculated the market value of equity by subtracting net debt from the estimated enterprise value of Netscape. This number was then divided by the number of shares outstanding at the time, to estimate the stock price. Based on this valuation, the revenues should grow at the rate of 38.40% to justify a share price of $28 and at the rate of 29.16% to justify a share price of $14. (See Exhibit B &C of Report). Based on my analysis and considering the growth potential for Netscape’s products & services and the industry at the time, the IPO market trends for high tech firms serving in the internet industry, a growth rate of 38.40% over the ten year period following the IPO seemed very much achievable. Hence according to my analysis the IPO will be underpriced at $28 per share.

It’s worth comparing the growth rates found above with the growth rate of a firm operating in the same industry as Netscape which went public during the same time period. For example, Yahoo operated in the internet industry and went public on 12th April 1996. Yahoo’s revenue growth rates over a period of 5-10 years after the IPO, fluctuated significantly and so it makes sense to look at the compounded average growth rate over this period which was found to be 36.48%. (See Exhibit D of Report). Comparing this growth rate with Netscape’s required growth rate of 38.40% to justify a stock price of $28 provides further evidence that Netscape’s stock price at $28 was justified and given the growth potential of the industry at the time, the expected growth rate should have been achievable.

Exhibit A

Post Money Share Price

Percentage of shares held by investors in last funding round

11%

Capital raised in last funding round (in millions)

$18

# of shares outstanding (in millions)

33

Funding Round Price

$ 4.96

Prefunding Value (in millions)

$ 145.64

Post Funding Value (in millions)

$164

Share Price

$4.96

Exhibit B

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Exhibit C

[pic 10]Exhibit D

Year

Revenues (in thousands)

Growth Rate

1999

$ 591,786.00

2000

$ 1,110,178.00

88%

2001

$ 717,422.00

-35%

2002

$ 953,067.00

33%

2003

$ 1,625,097.00

71%

2004

$ 3,574,517.00

120%

2005

$ 5,257,668.00

47%