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AD-351-E
May 2016

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Netscape: Simulation Techniques for Company Valuation

With a usage share of 90%, the most popular Web browser in the mid-1990s was Netscape

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Navigator, the best-known product of Netscape Communications Corp. The company, based in
Mountain View, California, had been founded in April 1994, and its revenues (which also came
from consulting and support services) had doubled every quarter in 1995.

Riding the crest of the Internet wave, the company needed to raise capital to keep expanding
at the wave’s speed. On August 9, 1995, Netscape made an initial public offering (IPO) of ¿ve
million shares at $28 per share, hoping to raise $140million.
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When planning an IPO, companies hire an investment bank to act as an intermediary with
investors. This intermediary, called the underwriter, helps the issuer of the securities arrive at an
appropriate price per share and completes the procedures to raise the required capital. A large
IPO is normally underwritten by several investment banks.

The underwriters of Netscape’s IPO were Morgan Stanley and Hambrecht & Quist (H&Q). (H&Q
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backed the IPOs of Apple and Adobe Systems in the 1980s and those of Amazon and MP3.com
during the 1990s. In 1999 it was acquired by Chase Manhattan Bank.)

In order to calculate Netscape’s value, the IPO underwriters divided the future into two periods:
during the first period (1995–2005), free cash flows were modeled for each year based on a
specific set of assumptions; during the second period (from 2006 onward), a stable growth rate
was assumed for the free cash flows, from which the value of the ¿rm after 2005 was calculated
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– this is known as the terminal value (TV). The total value of the company would then be the
sum of the present value of the free cash flows between 1995 and 2005, plus the present value
of the terminal value.
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This case was prepared by Professor Rafael de Santiago as the basis for class discussion rather than to illustrate either
effective or ineffective handling of an administrative situation. May 2016.

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Last edited: 12/20/16

1

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AD-351-E Netscape: Simulation Techniques for Company Valuation

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Netscape’s revenues in 1995 were $33.25million. The valuation was based on the following
assumptions (see Figure 1, which is a screenshot of the Excel file that goes with this case):1

Revenue growth rate 65%

Terminal value growth rate 4%

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Cost of sales 10.4% of revenues
R&D 36.76% of revenues
Tax rate 34%
Other operating expenses 80% of 1996 revenues, decreasing to 20% by 2002
and level thereafter
Capital expenses 45% of 1996 revenues, decreasing to 10% by 2000

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and level thereafter
Depreciation 5.5% of revenues
Discount rate 17.96%

The information that appears in the top part of Figure 1 (“Assumptions”) is data taken as given.
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The percentages in the row labeled “Other operating expenses” show the decline rate year by
year from 80% in 1996 to 20% by 2002. The percentages in the row labeled “Capital
expenditure” show the decline rate from 45% in 1996 to 10% by 2000. Capital expenditures
are therefore calculated as each year’s revenue multiplied by these percentages.

The free cash flow (FCF) is calculated as net profit plus depreciation minus capital expenditures
(minus change in working capital, which is assumed to be zero). The cumulative FCF is
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calculated by adding the successive free cash flows corresponding to each year.

The terminal value (TV) is an estimate of the firm’s value after 2005. If it is already hard to
forecast cash flows over a 10-year period, it is even more complicated to do so over the entire
future life of a company. To accomplish this task, there are several approaches. The IPO
underwriters used what is known as the perpetuity growth model, which requires making
assumptions about cash-flow growth. This method values the company after the forecast period
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as a perpetuity, using the following formula:

݂݈݅݊ܽǦ‫ ݓ݋݈݂݄ݏܽܿݎܽ݁ݕ‬ή ሺͳ ൅ ܸܶ݃‫݁ݐܽݎ݄ݐݓ݋ݎ‬ሻ

ܸܶ ൌ 
݀݅‫ ݁ݐܽݎݐ݊ݑ݋ܿݏ‬െ ܸܶ݃‫݁ݐܽݎ݄ݐݓ݋ݎ‬

The numerator is the projected FCF in 2006 (i.e., the 2005 FCF multiplied by one plus the TV
growth rate, which was assumed to be 4%). The denominator is the difference between the
discount rate and the TV growth rate. This calculation gives the present value, in 2006, of an
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endless stream of cash flows growing at the rate of 4%.

The total NPV (net present value) is the sum of the present value of the free cash flows up to
2005 plus the present value of the company’s TV after 2005. With the above set of assumptions,

1 The information used in this case is based on work by Professor Anant Sundarum, reported in S.G. Powell and K.R. Baker,
Management Science, Wiley, 2nd ed., 2009, pp. 383–384.

2 IESE Business School-University of Navarra

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 t
Netscape: Simulation Techniques for Company Valuation AD-351-E

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Netscape’s value adds up to more than $1billion. Dividing the total NPV by the 38million
shares, we get $27.82, which justified the IPO share price.
Figure 1

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Source: Based on Powell and Baker, Management Science, Wiley, 2nd ed., 2009, p. 384.

The last rows in Figure 1 (under “Performance”) contain three additional measures to evaluate
the terms of the IPO: the ratio of the TV to the total NPV; the year in which the free cash Àows
turn positive for the first time; and the maximum loss (or the lowest value of the cumulative
free cash Àow).

Was the IPO Valuation Justified?

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Although the above discussion illustrates (in a summarized way) an approach to company
valuation that is widely used, the goal is not to discuss the valuation itself. Our focus is to
quantify the uncertainty involved in the IPO, as the underwriters’ valuation may have been
affected by the uncertainty regarding the main drivers behind their assumptions.

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AD-351-E Netscape: Simulation Techniques for Company Valuation

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Based on the information available at the time, we know that the revenue growth rate was
expected to be around 65%, with a standard deviation of 5%. R&D expenses were assumed to be
at least 32% of revenues, at most 42%, and most likely 36.76%. The market-risk premium could
be anywhere between 5% and 10%, no particular value being more likely than the rest. The risk-
free rate was not expected to go below 6%, nor above 7.5%, with the likeliest value being 6.71%.

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The company’s beta was not expected to change from the estimated value of 1.5, nor was the
tax rate expected to change.

The TV growth rate could be 1%, 2%, 3% and so on, all the way up to 10%, each value with
the same probability. Capital expenditures and other operating expenses (as a percentage of
revenues) could be between one point below and one point above the percentages that appear

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in the upper block of Figure 1 (“Assumptions”), no value being more likely than the other.
Depreciation could also vary uniformly between 4.5% and 6.5%. Cost of sales were expected
to be around 10.44%, with a standard variation of 1.6%.

How does the uncertainty in these parameters affect the price per share? Was the IPO valuation
justified in light of these uncertainties? Would you buy the shares at $28?
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No
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4 IESE Business School-University of Navarra

This document is authorized for educator review use only by WILLIAM MARTINEZ, Universidad de Los Andes - Colombia (UniAndes) until May 2021. Copying or posting is an infringement of
copyright. Permissions@hbsp.harvard.edu or 617.783.7860