Friday, March 10, 2017

January 2017 Data Update 10: The Pricing Game!

It's taken me a while to get here, but in this, the last of my ten posts looking at publicly traded companies globally, I look at pricing differences across regions and sectors. I laid out my rationale for looking at pricing in my most recent post on the topic, where I drew a distinction between good companies, good management and good investments, arguing that investing is about finding mismatches between reality (as driven by cash flows, growth and risk) and perception (as determined by the market). 

Multiple = Standardized Price
When looking at how stocks are priced and especially when comparing pricing across stocks, we almost invariably look at pricing multiples (PE, EV to EBITDA) rather than absolute prices. That is because prices per share are a function of the number of shares and are, in a sense, almost arbitrary. Before you respond with indignation, what I mean to say is that I can make the price per share decrease from $100/share to $10/share, by instituting a ten for one stock split, without changing anything about the company. As a consequence, a stock cannot be classified as cheap or expensive based on price per share and you can find Berkshire Hathaway to be under valued at $263,500 per share, while viewing a stock trading at 5 cents per share as hopelessly overvalued. 

The process of standardizing prices is straight forward. In the numerator, you need a market measure of value of  equity, the entire firm (debt + equity) or the operating assets of the firm (debt + equity -cash = enterprise value). If you confused about the distinction, you may want to review this post of mine from the archives. In the denominator, you can scale the market value to revenues, earnings, accounting estimates of value (book value) or cash flows.

As you can see, there is a very large number of standardized versions of value that you can calculate for firms, especially if you bring in variants on each individual variable in the denominator. With net income, for instance, you can look at income in the last fiscal year (current), the last twelve months (trailing) or the next year (forward). The one simple proposition that you should always follow is to be consistent in your definition of multiple.

The "Consistent Multiple" Rule:   If your numerator is the market value of equity (market capitalization or price per share), your denominator has to be an equity measure as well (net income or earnings per share, book value of equity. For example, a price earnings ratio is consistent, since both the numerator and denominator are equity values, and so is an EV to EBITDA multiple. A Price to EBITDA or a Price to Sales ratio is inconsistent, since the numerator is an equity value and the denominator is to the entire business, and will lead to conclusions that are not merited by the fundamentals.

Pricing – A Global Picture
To see how stocks are priced around the world at the start of 2017, I focus on four multiples, the price earnings ratio, the price to book (equity) ratio, the EV/Sales multiple and EV/EBITDA. With each multiple, I will start with a histogram describing how stocks are priced globally (with sub-sector specifics) and then provide country specific numbers in heat maps. 

PE ratio 
The PE ratio has many variants, some related to what period the earnings per share is measured (current, trailing or forward), some relating to whether the earnings per share are primary or diluted and some a function of whether and how you adjust for extraordinary items. If you superimpose on top of these differences the fact that earnings per share reported by companies reflect very different accounting standards around the world, you can already start to see the caveats roll out. That said, it is still useful to start with a histogram of PE ratios of all publicly traded companies around the world: 
Note that of the 42,668 firms in my global sample, there were only 25,493 firms that made it through into this graph; the rest of the sample (about 40%) had negative earnings per share and the PE ratios was not meaningful.  While the histogram provides the distributions by regional sub-groups, the heat map below provides the median PE ratio by country: 
If you go to the live heat map, you will also be able to see the 25th and 75th quartiles within each country, or you can download the spreadsheet that contains the data.  I mistrust PE ratios for many reasons. First, the more accountants can work on a number, the less trustworthy it becomes, and there is no more massaged, manipulated and mangled variable than earnings per share. Second, the sampling bias introduced by eliminating a large subset of your sample, by eliminating money losing companies, is immense. Third, it is the most volatile of all of the multiples as it is based upon earnings per share.

Price to Book 
In many ways, the price to book ratio confronts investors on a fundamental question of whether they trust markets or accountants more, by scaling the market’s estimate of what a company is worth (the market capitalization) to what the accountants consider the company’s value (book value of equity). The rules of thumb that have been build around book value go back in history to the origins of  value investing and all make implicit assumptions about what book value measures in the first place. Again, I will start with the histogram for all global stocks, with the table at the regional level imposed on it: 
The price to book ratio has better sampling properties than price earnings ratios for the simple reason that there are far fewer firms with negative book equities (only about 10% of all firms globally) than with negative earnings. If you believe, as some do, that stocks that trade at less than book value are cheap, there is good news: you have lots and lots of buying opportunities (including the entire Japanese market). Following up, let’s take a look in the heat map below of median price to book ratios, by country. 
Again, you can see the 25th and 75th quartiles in either the live map or by downloading the spreadsheet with the data. Pausing to look at the numbers, note the countries shaded in green, which are the cheapest in the world, at least on a price to book basis, are concentrated in Africa and Eastern Europe, arguably among the riskiest parts of the world. The most expensive countries are China, a couple of outliers in Africa (Ivory Coast and Senegal, with very small sample sizes) and Argentina, a bit of a surprise.

EV to EBITDA 
The EV to EBITDA multiple has quickly grown in favor among analysts, for some good reasons and some bad. Among the good reasons, it is less affected by different financial leverage policies than PE ratios (but it is not immune) and depreciation methods than other earnings multiples. Among the bad ones is that it is a cash flow measure based on a dangerously loose definition of cash flow that works only if you live in a world where there are no taxes, debt payments and capital expenditures laying claim on those cash flows. The global histogram of EV to EBITDA multiples share the positive skew of the other multiples, with the peak to the left and the tail to the right: 
Again, there will be firms that had negative EBITDA that did not make the cut, but they are fewer in number than those with negative EPS.  Looking at the median EV to EBITDA multiple by country in the heat map below, you can see the cheap spots and the expensive ones. 
As with the other data, you can get the lower and higher quartile data in the spreadsheet. As with price to book, the cheapest countries in the world lie in some of the riskiest parts of the world, in Africa and Eastern Europe. China remains among the most expensive countries in the world but Argentina which also made the list, on a  price to book basis, drops back to the pack.

EV to Sales 
If you share my fear of accounting game playing, you probably also feel more comfortable working with revenues, the number on which accountants have the fewest degrees of freedom. Let’s start with the histogram for global stocks: 
Of all the multiples, this should be the one where you lose the least companies (though many financial service companies don’t report conventional revenues) and the one that you can use even on young companies that are working their way through the early stages of the life cycle.  The median EV/Sales ratio for each country are in the heat map below: 
You can download more extensive numbers in the spreadsheet. By now, the familiar pattern reasserts itself, with East European and African companies looking cheap and China looking expensive. With revenue multiples, Canada and Australia also enter the overvalued list, perhaps because of the preponderance of natural resource companies in these countries.

Pricing – Sector Differences 
All of the multiples that I talked about in the last section can also be computed at the industry level and it is worth doing so, partly to gain perspective on what comprises cheap and expensive in each grouping and partly to look for under and over priced groupings. The following table, lists the ten lowest-priced and highest priced industry groups at the start of 2017, based upon trailing PE: 
Multiples by Sector
In many of the cheapest sectors, the reasons for the low  pricing are fundamental: low growth, high risk and an inability to generate high returns on equity or margins. Similarly, the highest PE sectors also tend to be in higher growth, high return on equity businesses. I will leave the judgment to you whether any fit the definition of a cheap company. The entire list of multiples, by sector, can be obtained by clicking on this spreadsheet.

One comparison that you may consider making is to pick and multiple and trace how it has changed over time for an industry group. Isolating pharmaceutical and biotechnology companies in the United States, for instance, here is what I find when it comes to EV to EBITR&D for the two groups over time:

You can read this graph in one of two ways. If you are a firm believer in mean reversion, you would load up on biotech stocks and hope that they revert back to their pre-2006 premiums, but I think you would be on dangerous ground. The declining premium is just as much a function of a changing health care business (with less pricing power for drug companies), increasing scale at biotech companies and more competition. 

Rules for the Road
  1. Absolute rules of thumb are dangerous (and lazy): The investing world is full of rules of thumb for finding bargains. Companies that trade at less than book value are cheap, as are companies that trade at less than six times EBITDA or have PEG ratios less than one. Many of these rules have their roots in a different age, when data was difficult to access and there were no ready tools for analyzing them, other than abacuses and ledger sheets. In Ben Graham's day, the very fact that you had collected the data to run his "cheap stock" screens was your competitive advantage. In today's market, where you can download the entire market with the click of a button and tailor your Excel spreadsheet to compute and screen, it strikes me as odd that screens still remain based on absolute values. If you want to find cheap companies based upon EV to EBITDA, why not just compute the number for every company (as I have in my histogram) and then use the first quartile  (25th percentile) as your cut off for cheap. By my calculations, a company with an EV/EBITDA of 7.70 would be cheap in the United States but you would need an EV to EBITDA less than 4.67 to be cheap in Japan, at least in January 2017.
  2. Most stocks that look cheap deserve to be cheap: If your investment strategy is buying stocks that trade at low multiples of earnings and book value and waiting for them to recover, you are playing a game of mean reversion. It may work for you, but there is little that you are bringing to the investing table, and there is little that I would expect you to take away. If you want to price a stock, you have to bring in not just how cheap it is but also look at measures of value that may explain why the stock is cheap. 
  3. If you are paying a price, you are "estimating" the future: When I do an intrinsic valuation (as I did a couple of weeks ago with Snap), I am often taken to task by some readers for playing God, i.e., forecasting revenue growth, margins and risk for a company with a very uncertain future. I accept that critique but I don't see an alternative. If your view is that using a multiple lets you evade this responsibility, it is because you have chosen not to look under the hood, If you pay 50 times revenues for a company, which is what you might be with Snap, you are making assumptions about revenue growth and margins, whether you like it or not. The only difference between us seems to be that I am being explicit about my assumptions, whereas your assumptions are implicit. In fact, they may be so implicit that you don't even know what they are, a decidedly dangerous place to be in investing.


Thursday, March 9, 2017

Explaining a Paradox: Why Good (Bad) Companies can be Bad (Good) Investments!

In nine posts, stretched out over almost two months, I have tried to describe how companies around the world make investments, finance them and decide how much cash to return to shareholders. Along the way, I have argued that a preponderance of publicly traded companies, across all regions, have trouble generating returns on the capital invested in them that exceeds the cost of capital. I have also presented evidence that there are entire sectors and regions that are characterized by financing and dividend policies that can be best described as dysfunctional, reflecting management inertia or ineptitude. The bottom line is that there are a lot more bad companies with bad managers than good companies with good ones in the public market place. In this, the last of my posts, I want to draw a distinction between good companies and good investments, arguing that a good company can often be a bad investment and a bad company can just as easily be a good investment. I am also going argue that not all good companies are well managed and that many bad companies have competent management.

Good Businesses, Managers and investments
Investment advice often blurs the line between good companies, good management and good investments, using the argument that for a company to be a "good" company, it has to have good management, and if a company has good management, it should be a good investment. That is not true, but to see why, we have to be explicit about what makes for a good company, how we determine that it has good management and finally, the ingredients for a good investment.

Good and Bad Companies
There are various criteria that get used to determine whether a company is a good one, but every one of them comes with a catch. You could start with profitability, arguing that a company that generates more in profits is better than generates less, but that statement may not be true if the company is capital intensive (and the profits generated are small relative to the capital invested) and/or a risky business, where you need to make a higher return to just break even. You could look at growth, but growth, as I noted in this post, can be good, bad or neutral for value and a company can have high growth, while destroying value. The best measure of corporate quality, for me, is a high excess return, i.e., a return on capital that is vastly higher than its cost of capital, though I have noted my caveats about how return on capital is measured. Reproducing my cross sectional distribution of excess returns across all global companies in January 2017, here is what I get:

Blog Post on Excess Returns
To the extent that you want the capital that you have invested in companies to generate excess returns, you could argue that the good companies in this graph as the value creators and the bad ones are the value destroyers. At least in 2017, there were a lot more value destroyers (19,960) than value creators (10,947) listed globally!

Good and Bad Management
If a company generates returns greater (less) than its opportunity cost (cost of capital), can we safely conclude that it is a well (badly) managed company?  Not really! The “goodness” or “badness” of a company might just reflect the ageing of the company, its endowed barriers to entry or macro factors (exchange rate movements, country risk or commodity price volatility). The essence of good management is being realistic about where a company is in the life cycle and adapting decision making to reflect reality. If the value of a business is determined by its investment decisions (where it invests scarce resources), financing decisions (the amount and type of debt utilized) and dividend decisions (how much cash to return and in what form to the owners of the business), good management will try to optimize these decisions at their company. For a young growth company, this will translate into  making investments that deliver growth and not over using debt or paying much in dividends. As the company matures, good management will shift to playing defense, protecting brand name and franchise value from competitive assault, using more debt and returning more cash to stockholders. At a declining company, the essence of “good” management is to not just avoid taking  more investments in a bad business, but to extricate the company from its existing investments and to return cash to the business owners. My way of capturing the quality of a management is to value a company twice, once with the management in place (status quo) and once with new (and "optimal" management).

I term the difference between the optimal value and the status quo value the “value of control” but I would argue it is also just as much a measure of management quality, with the value of control shrinking towards zero for “good” managers and increasing for bad ones.

Good and Bad Investments
Now that we have working definitions of good companies and good managers, let’s think about good investments. For a company to be a good investment, you have to bring price into consideration. After all, the greatest company in the world with superb managers can be a bad investment, if it is priced too high. Conversely, the worst company in the world with inept management may be a good investment is the price is low enough. In investing therefore, the comparison is between the value that you attach to a company, given its fundamentals and the price at which it trades.

As you can see at the bottom, investing becomes a search for mismatches, where the market's assessment of a company (and it's management) quality is out of sync with reality. 

Screening for Mismatches
If you take the last section to heart, you can see why picking stocks to invest in by looking at only one side of the price/value divide can lead you astray. Thus, if your investment strategy is to buy low PE stocks, you may end up with stocks that look cheap but are not good investments, if these are companies that deserve to be cheap (because they have made awful investments,  borrowed too much money or adopted cash return policies that destroy value). Conversely, if your investment strategy is focused on finding good companies (strong moats, low risk), you can easily end up with bad investments, if the price already more than reflects these good qualities. In effect, to be a successful investor, you have to find market mismatches, a very good company in terms of business and management that is being priced as a bad company will be your “buy”. With that mission in hand, let’s consider how you can use multiples in screening, using the PE ratio to illustrate the process. To start, here is what we will do. Starting with a very basic dividend discount model, you can back out the fundamentals drivers of the PE ratio:

Now what? This equation links PE to three variables, growth, risk (through the cost of equity) and the quality of growth (in the payout ratio or return on equity). Plugging in values for these variables into this equation, you will quickly find that companies that have low growth, high risk and abysmally low returns on equity should trade at low PE ratios and those with higher growth, lower risk and sold returns on equity, should trade at high PE ratios. If you are looking to screen for good investments, you therefore need to find stocks with low PE, high growth, a low cost of equity and a high return on equity. Using this approach, I list multiples and the screening mismatches that characterize cheap and expensive companies.


MultipleCheap CompanyExpensive Company
PELow PE, High growth, Low Equity Risk, High PayoutHigh PE, Low growth, High Equity Risk, Low Payout
PEGLow PEG, Low Growth, Low Equity Risk, High PayoutHigh PEG, High Growth, High Equity Risk, Low Payout
PBVLow PBV, High Growth, Low Equity Risk, High ROEHigh PBV, Low Growth, High Equity Risk, Low ROE
EV/Invested CapitalLow EV/IC, High Growth, Low Operating Risk, High ROICHigh EV/IC, Low Growth, High Operating Risk, Low ROIC
EV/SalesLow EV/Sales, High Growth, Low Operating Risk, High Operating MarginHigh EV/Sales, Low Growth, High Operating Risk, High Operating Margin
EV/EBITDALow EV/EBITDA, High Growth, Low Operating Risk, Low Tax RateHigh EV/EBITDA, Low Growth, High Operating Risk, High Tax Rate

If you are wondering about the contrast between equity risk and operating risk, the answer is simple. Operating risk reflects the risk of the businesses that you operate in, whereas equity risk reflects operating risk magnified by financial leverage; the former is measured with the cost of capital whereas the latter is captured in the cost of equity. With payout, my definition is broader than the conventional dividend-based one; I would include stock buybacks in my computation of cash returned, thus bringing a company like Apple to a high payout ratio.

The Bottom Line 
If the length of this post has led you to completely forget what the point of it was, I don’t blame you. So, let me summarize. Separating good companies from bad ones is easy, determining whether companies are well or badly managed is slightly more complicated but defining which companies are good investments is the biggest challenge. Good companies bring strong competitive advantages to a growing market and their results (high margins, high returns on capital) reflect these advantages. In well managed companies, the investing, financing and dividend decisions reflect what will maximize value for the company, thus allowing for the possibility that you can have good companies that are sub-optimally managed and bad companies that are well managed. Good investments require that you be able to buy at a price that is less than the value of the company, given its business and management.

Thus, you can have good companies become bad investments, if they trade at too high a price, and bad companies become good investments, at a low enough price.    Given a choice, I would like to buy great companies with great managers at a great price, but greatness on all fronts is hard to find. So. I’ll settle for a more pragmatic end game. At the right price, I will buy a company in a bad business, run by indifferent managers. At the wrong price, I will avoid even superstar companies. At the risk of over simplifying, here is my buy/sell template:

Company's BusinessCompany's ManagersCompany PricingInvestment Decision
Good (Strong competitive advantages, Growing market)Good (Optimize investment, financing, dividend decisions)Good (Price < Value)Emphatic Buy
Good (Strong competitive advantages, Growing market)Bad (Sub-optimal investment, financing, dividend decisions)Good (Price < Value)Buy & hope for management change
Bad (No competitive advantages, Stagnant or shrinking market)Good (Optimize investment, financing, dividend decisions)Good (Price < Value)Buy & hope that management does not change
Bad (No competitive advantages, Stagnant or shrinking market)Bad (Sub-optimal investment, financing, dividend decisions)Good (Price < Value)Buy, hope for management change & pray company survives
Good (Strong competitive advantages, Growing market)Good (Optimize investment, financing, dividend decisions)Bad (Price > Value)Admire, but don't buy
Good (Strong competitive advantages, Growing market)Bad (Sub-optimal investment, financing, dividend decisions)Bad (Price > Value)Wait for management change
Bad (No competitive advantages, Stagnant or shrinking market)Good (Optimize investment, financing, dividend decisions)Bad (Price > Value)Sell
Bad (No competitive advantages, Stagnant or shrinking market)Bad (Sub-optimal investment, financing, dividend decisions)Bad (Price > Value)Emphatic Sell

YouTube Video


Friday, February 17, 2017

My Snap Story: Valuing Snap ahead of it's IPO!

Five years ago, when my daughter asked me whether I had Snapchat installed on my phone, my response was “Snapwhat?". In the weeks following, she managed to convince the rest of us in the family to install the app on our phones, if for no other reason than to admire her photo taking skills. At the time, what made the app stand out was the impermanence of the photos that you shared with your circle, since they disappeared a few seconds after you viewed them, a big selling point for sharers lacking impulse control. In 2013, when Facebook offered $3 billion to buy Snap, it was a clear indication that the new company was making inroads in the social media market, especially with teenagers. When Evan Spiegel and Bobby Murphy, Snap's founders, turned down the offer, I am sure that there were many who viewed them as insane, since Snap had trouble attracting advertisers to its platform and little in revenues, at the time. After all, what advertiser wants advertisements to disappear seconds after you see them? Needless to say, as the IPO nears and it looks like the company will be priced at $20 billion or more, it looks like Snap's founders will have the last laugh!

Snap: A Camera Company?
The Snap prospectus leads off with these words: Snap Inc. is a camera company. But is it? When I think of camera companies, I think of Eastman Kodak, Polaroid and the Japanese players (Fuji, Pentax) as the old guard, under assault as they face disruption from smartphone cameras, and companies like GoPro as the new entrants in the space, struggling to convert sales to profits. I don't think that this is the company that Snap aspires to keep and since it does not sell cameras or make money on photos, it is difficult to see it fitting in. If you define business in terms of how a company plans to make money, I would argue that Snap is an advertising business, albeit one in the online or digital space. I do know that Snap has hardware that it is selling in the form of Spectacles, but at least at the moment, the glasses seem to be designed to get users to stay in the Snap ecosystem for longer and see more ads.

So, why does Snap present itself as a camera company? I think that the answer lies in the social media business, as it stands today, and how entrants either carve a niche for themselves or get labeled as me-too companies. Facebook, notwithstanding the additions of Instagram and WhatsApp, is fundamentally a platform for posting to friends, LinkedIn is a your place for business networking, Twitter is where you go if you want to reach lots of people quickly with short messages or news and Snap, as I see it, is trying to position itself as the social media platform built around visual images (photos and video). The question of whether this positioning will work, especially given Facebook's investments in Instagram and new entrants into the market, is central to what value you will attach to Snap.

The Online Advertising Business
If you classify Snap as an online advertising company, the next step in the process becomes simple: identifying the total market for online advertising, the players in that market and what place you would give Snap in this market. Let’s start with some basic data on the online advertising market.
  1. It is a big market, growing and tilting to mobile: The digital online advertising market is growing, mostly at the expense of conventional advertising (newspapers, TV, billboards) etc. You can see this in the graph below, where I plot total advertising expenditures each year and the portion that is online advertising for 2011-2016 and with forecasted values for 2017-2019. In 2016, the digital ad market generated revenues globally of close to $200 billion, up from about $100 billion in 2012, and these revenues are expected to climb to over $300 billion in 2020. As a percent of total ad spending of $660 billion in 2016, digital advertising accounted for about 30% and is expected to account for almost 40% in 2020. The mobile portion of digital advertising is also increasing, claiming from about 3.45% of digital ad spending to about half of all ad spending in 2016, with the expectation that it will account for almost two thirds of all digital advertising in 2020.
    Sources: Multiple
  2. With two giant players: There are two dominant players in the market, Google with its search engine and Facebook with its social media platforms. These two companies together control about 43% of the overall market, as you can see in this pie chart:
    If you are a small player in the US market, the even scarier statistic is that these two giants are taking an even larger percentage of new online advertising than their historical share. In 2015 and 2016, for instance, Google and Facebook accounted for about two-thirds of the growth in the digital ad market. Put simply, these two companies are big and getting bigger and relentlessly aggressive about going after smaller competitors.
In a post in August 2015, I argued that the size of the online advertising market may be leading both entrepreneurs and investors to over estimate their chances of both growing revenues and delivering profits, leading to what I termed the big market delusion. As Snap adds its name to the mix, that concern only gets larger, since it is not clear that the market is big enough or growing fast enough to accommodate the expectations of investors in the many companies in the space. 

Snap: Possible Story Lines
To value a young company, especially one like Snap, you have to have a vision for what you see as success for the company, since there is little history for you to draw on and there are so many divergent paths that the company can follow, as it ages. That might sound really subjective, but without it, you are at the mercy of historical data that is both scarce and noisy or of metrics (like users and user intensity) that can lead you to misleading valuations.
Link to my book
That is, of course, another shameless plug for my book on narrative and numbers, and if you have heard it before or have no interest in reading it, I apologize and let's go on. To get perspective on Snap, let’s start by comparing it to three social media companies, Facebook, Twitter and LinkedIn and to Google, the old player in the mix, at the time of their initial public offerings. The table below summarizes key numbers at the time of their IPOs, with a  comparison to Snap's numbers.

GoogleLinkedInFacebookTwitterSnap
IPO date19-Aug-0419-May-1118-May-127-Nov-13NA
Revenues$1,466 $161 $3,711 $449 $405
Operating Income$326 $13 $1,756 $(93)$(521)
Net Income$143 $2 $668 $(99)$(515)
Number of UsersNA80.6845218161
User minutes per day (January 2017)50 (Includes YouTube)NA50225
Market Capitalization on offering date$23,000 $9,000 $81,000 $18,000 ?
Link to Prospectus (from IPO date)Link Link Link Link Link

At the time of its IPO, Snap has less revenues than any of its peer group, other than LinkedIn, and is losing more money than any of them. Before you view this is a death knell for Snap, one reason for Snap’s big losses is that unlike its competitors, Snap pays for server space as it acquires new users, thus pushing up its operating expenses (and pushing down capital investment in servers). There is one other dimension where Snap measures up more favorably against at least two of the other companies: its users are spending more time on its platform that they were either on Twitter and LinkedIn and it ranks second only to Facebook on this dimension.

The more important question that you face with Snap, then, is which of these companies it will emulate in its post IPO year. The table below provides the contrast rather by looking at the years since the IPO for each company.
Google and Facebook stand out as success stories, Google because it has maintained high revenue growth for almost a decade with very good profit margins and Facebook doing even better on both dimensions (higher growth in the earlier years and even higher margins). The least successful company in this mix is Twitter which has seen revenue growth that has trailed expectations and has been unable to unlock the secret to monetizing its user base, as it continues to post losses. Linkedin falls in the middle, with solid revenue growth for its first four years and some profits, but its margins are not only small but showed no signs of improvement from year to year. Now that it has been acquired by Microsoft, it will be interesting to see if the combination translates into better growth and margins.

My Snap Story & Valuation
To value Snap, I built my story by looking at what its founders have said about the company, how its structured and the strengths and weaknesses of its platform, at least as I see them. As a consequence, here is what I see the company evolving.
  1. Snap will remain focused on online advertising: I believe that Snap's revenues will continue to come entirely or predominantly from advertising. Thus, the payoff to Spectacles or any other hardware offered by the company will be in more advertising for the company. 
  2. Marketing to younger, tech-savvy users: Snap's platform, with its emphasis on the visual and the temporary, will remain more attractive to younger users. Rather than dilute the platform to go after the bigger market, Snap will create offerings to increase its hold on the youth segment of the market.
    Source: The Economist
  3. With an emphasis on user intensity over users: Snap's prospectus and public utterances by its founders emphasize user intensity more than the number of users, in contrast to earlier social media companies. This emphasis is backed up by the company's actions: the new features that it has added, like stories and geofilters, seem designed more to increase how much time users spend in the app than on getting new users. Some of that shift in emphasis reflects changes in how investors perceive social media companies, perhaps sobered by Twitter's failure to convert large user numbers into profits, and some of it is in Snap's business model, where adding users is not costless (since it has to pay for server space). 
These assumptions, in turn, drive my forecasts of revenues, margins and reinvestment. In my story, I don't see Snap reaching revenues of the magnitude delivered by Google and Facebook, the two big market players in the game, settling instead for smaller revenues. If Snap is able to hold on to its target market (young, tech savvy and visually inclined) and keep its users engaged, I think Snap has a chance of delivering high operating profit margins, perhaps not of the magnitude of Facebook today (45% margin) but close to that of Google (25% margin). Finally, its reinvestment will take the form of acquisition of technology and server space to sustain its user base, but by not trying to be the next Facebook, it will not have to over reach. Is there substantial risk that the story may not work out the way I expect it to? Of course! While I will give Snap a cost of capital of close to 10% (and in the 85th percentile of US companies), reflective of its online advertising business,  I will also assume that there remains a non-trivial chance (10%) that the company will not make it. The picture below captures my story and the valuation inputs that emerge from it:

To complete the valuation, there are two other details that relate to the IPO.
  1. Share count: For an IPO, share count can be tricky, and especially so for a young tech company with multiple claims on equity in the form of options and restricted stock issues. Looking through the prospectus and adding up the shares outstanding on all three classes of shares, including shares set aside for restricted stock issues and assorted purposes, I get a total of 1,243.10 million shares outstanding in the company. In addition, I estimate that there are 44.90 million options outstanding in the company, with an average exercise price of $2.33 and an assumed maturity of 3 years.
  2. IPO Proceeds: This is a factor specific to IPOs and reflect the fact that cash is raised by the company on the offering date. If that cash is retained by the company, it adds to the value of the company (a version of post-money valuation). In the case of Snap, it is estimated that roughly $3 billion in cash from the offering that will be held by the company,  to cover costs like the $2 billion that Snap has contracted to pay Google for cloud space for the next five years.
These valuation inputs become the basis for my valuation and yield a value of $14.4 billion for the equity (and you can download the spreadsheet at this link).
Download spreadsheet
Allowing for the uncertainty inherent in my estimates, I also computed probability distribution for three key inputs, revenue growth, operating margin and cost of capital, and my value for Snap's equity is in the distribution below:
Snap Simulation Details
Assuming that my share count is right, my value per share is about $11 per share. As you can see though, as is the case with almost any young company where the narrative can take you in other directions, there is a wide range around my expectations, with the lowest value being less than zero and the highest value pushing above $66 billion ($50/share). The median value is $13.3 billion and the average is $14.9 billion; one attractive feature to investors is that there is potential for breakout values (optionality) that exceed $30 billion.
  • The numbers at the high end of the spectrum reflect a pathway for Snap that I call the Facebook Light story, where it emerges as a serious contender to Facebook in terms of time that users spend on its platform, but with a smaller user base. That leads to revenues of close to $25 billion by 2027, an operating margin of 40% for the company and a value for the equity of $48 billion.
  • The numbers at the other end of the spectrum capture a darker version of the story, that I label Twitter Redux, where user growth slows, user intensity comes under stress and advertising lags expectations. In this variant, Snap will have trouble getting pushing revenue growth past 35%, settling for about $4 billion in revenues in 2027, is able to improve its margin to only 10% in steady state, yielding a value of  equity of about $4 billion.
As I learned the painful way with my Twitter experiences, the quality of the management at a young company can play a significant role in how the story evolves. I am impressed with both the poise that Snap's founders are showing in their public appearances and the story that they are telling about the company, though I am disappointed that they have followed the Google/Facebook path and consolidated control in the company by creating shares with different voting rights. I know that is in keeping with the tech sector's founder worship and paranoia about "short term" investors , but my advice, unsolicited and perhaps unwelcome, is that Snap's founders should trust markets more. After all, if you welcome me to invest me in your company and I do, you should want my input as well, right?

The Pricing Contrast
As I finish this post, I notice this news story from this morning that suggests that bankers have arrived at an offering price, yielding a pricing for the company of $18.5 billion to $21.5 billion for the company, about $4 billion above my estimate. So, how do I explain the difference between my valuation and this pricing? First, I have never felt the urge to explain what other people pay for a stock, since it is a free market and investors make their own judgments. Second, and this is keeping with a theme that I have promoted repeatedly in my posts, bankers don't value companies; they price them! If you are missing the contrast between value and price, you are welcome to read this piece that I have on the topic, but simply put, your job in pricing is not to assess the fair value of a company but to decide what investors will pay for the company today. The former is determined by cash flows, growth and risk, i.e., the inputs that I have grappled with in my story and valuation, and the latter is set by what investors are paying for other companies in the space. After all, if investors are willing to attach a pricing of $12 billion to Twitter, a social media company seeming incapable of translating potential to profits, and Microsoft is paying $26 billion for LinkedIn, another social media company whose grasp exceeded its reach, why should they not pay $20 billion for Snap, a company with vastly greater user engagement than either LinkedIn or Twitter? With pricing, everything is relative and Snap may be a bargain at $20 billion to a trader.

YouTube Video


Link to book
  1. Narrative and Numbers: The Value of Stories in Business
Attachments
  1. Snap: Prospectus for IPO
  2. Snap: My IPO Valuation
  3. Snap: As Facebook Lite
  4. Snap: As Twitter Redux
  5. Snap: Simulation Inputs & Output