How an Online Business Creates Value for an Investor

A fascinating new trend from the last three years has been the emergence of social media. Having created value through serving advertisements on a scale comparable to Google (sort of), companies like Facebook have created all sorts of amazing business opportunities for aggressive investors and entrepreneurs to cash in on. Over the course of 2011, we watched companies like Groupon, Linkedin, and Zynga build up massive equity bases through initial public offerings.

However, during each of these offerings, the market came to very seriously scrutinize the cash flows and the revenues of the companies in the spotlight. Given the complexity of these offerings, and how it is that they can fit into an aggressive technology portfolio, I’m going to take some time this week to discuss how it is that each of these companies  creates value for investors, and what secures the revenues of these firms. Today, I’ll start with Groupon.

Groupon has been a massive internet success story for the last few years. Having turned down a buy-out offer from Google for $6B, investors were skeptical about the company’s potential as a public offering, because they felt that it would be difficult to ever realize a higher value than what had already been offered. Essentially, people felt as though the sales would never justify a price greater than $6B.

The reasons for these fears generally stemmed from the many stories about how it was that Groupon would generate so many orders from their deals that it would drive a small business out of operations. The second issue that people were having with Groupon was related to its accounting. Specifically, Groupon was reporting revenues using a metric that did not take into account some commissions that were to be paid out to sales contractors. This means that they were effectively over-reporting their revenues to investors, which artificially justified the valuation being presented. So what’s really going on here?

While Groupon was most certainly overstating its earnings with its metrics, its important to remember that we invest in IPOs based on potential for growth. Even though the metrics being provided didn’t give investors the perspective they particularly wanted, it did indicate a benchmark for growth on the gross margin. This means that we can use this metric as an indicator of the company’s success and potential.

Understanding then that the company has so many different countries and avenues for it to expand into, and so many different opportunities to improve its cost base, its no surprise that the IPO was a success. Combine this with the rate at which margins for these sales commissions have the potential to increase due to their one-time nature, Groupon demonstrated to investors that it has the fundamental capacity to continue its growth on a cash flow basis, even though the nominal top line growth is showing less promise.

While the stock itself is showing signs of decline, it will be interesting to watch how it is that Groupon performs after the release of its latest earnings, to see if that internal margin growth reflects the initial investor sentiment.