Wednesday, August 12, 2015

Narrative Resets: Revisiting a Tech Trio (Apple, Facebook and Twitter)

In a post in August 2014, I examined the importance of narratives in valuation and how shifts or changes in those narratives can affect value, using Apple, Twitter and Facebook to illustrate my point. Since all of these companies have reported earnings in the last few weeks, I revisited my valuations of these companies, with the specific intent of seeing whether there is a need to update the narratives (and values) for these companies and whether, as an investor, I need to act.

I have been valuing Apple every quarter on my blog for the last four years. While I admitted in my very first posted valuation of the company that I liked the company and its products too much to ever be unbiased in my valuations, I did reluctantly sell my Apple shares when they hit $600 in early April 2012, arguing that the traders were driving the stock in ways that I could not comprehend. That turned out to be a lucky break, because the momentum shifted (as it does in pricing games), causing the stock to go into a tailspin. In January 2013, I reentered the Apple investor sweepstakes, when the stock hit $440, using this post to explain my rationale and in April 2014, I looked at the sometimes divergent paths taken by price and value at the company.

My August 2014 narrative
My last blog post valuation of Apple was in August 2014, after the stock had a 7 for 1 stock split, and the value per share that I obtained was $96. Starting in 2011, my narrative for Apple has been that it is a mature company, with limited growth potential (revenue growth rates< 5%) and sustained profitability, albeit with downward pressure on margins, as its core businesses becomes more competitive, and only a small probability that the company would introduce another disruptive product to follow up its trifecta from the prior decade (the iPod, the iPhone and the iPad). I saw no reason to change this narrative significantly, and as the stock was hovering around $100 at the time of the analysis, I considered it fully priced.

What’s happened since
The biggest news announcements from Apple came in September 2014, where they announced two new products, the Apple iWatch and Apple Pay. While I don’t see much in Apple iWatch to change my narrative in significant ways, Apple Pay offers the potential to provide a breakthrough, because the financial services business is a huge one and ripe for disruption. It is that shift that led me to hold Apple through the rest of 2014 and into 2015. In addition, Apple’s introduction of the iPhone 6 has allowed it to protect its margins much better than I had anticipated that they would. In a valuation that I did as part of my valuation class in March 2015, I revalued Apple at close to $118/share, about 10% below the stock price of $128 at that point in time, leading to a decision to sell the stock and count my blessings.

The August 2015 narrative
The last earnings report from Apple, which came out in late July, contains few surprises or twists, with perhaps the only surprising feature being the unexpectedly large jump in the cash balance to over $200 billion. That fact, while Apple continues to buy back billions in stock and pay large dividends, is a testimonial to the cash machine that Apple has created with its iPhones and iPads. In fact, just incorporating the higher cash balance and the lower share count into the valuation yields a value per share of close to $130. While you can download the valuation by clicking here, I also ran a simulation, where I allowed my assumptions on revenue growth, margins and cost of capital to vary to generate these numbers:

At the time of this post, the mood around Apple has darkened and the stock has dropped to less than $110. The purported reason for the stock price drop is the slow down in Apple sales in China, but that sounds to me like an attempt to fit a “good” reason to an old-fashioned sell off. Even allowing for a Chinese economic slowdown, Apple is starting to look like a bargain to me again but given the ebbs and flows in momentum in this stock, I would not be surprised if this round of selling leads the stock even lower, before good sense prevails. I think I will wait a few weeks before putting my buy order in but it looks like I will once more be an Apple stockholder.

When Facebook filed for its initial public offering in February 2012, I described it as the most pre-priced IPO in history, as it had been actively traded in private markets before that offering. In my initial narrative for Facebook, I foresaw a company that would tread in Google’s path in terms of generating advertising revenues, while posting substantial profit margins. That “Google wannabe” narrative yielded a value of $71 billion for the company and a value per share of $28. Needless to say, I was not tempted to buy the stock at the offering price of $38 per share, but a few months later, I was extraordinarily lucky to get the stock at $18, as investors dumped the stock after its first earnings report. Since my narrative changed relatively little in the year following, my value changed little, but the stock price recovered to $45, leading to a decision on my part to sell.. The subsequent rise of the stock to $95/share meant that I left significant profits on the table by selling too early, but better than bailing on an investment philosophy that has worked for me.

My August 2014 narrative
In my August 2014 post on Facebook, following another blockbuster earnings report, where they reported more success in their mobile advertising efforts, I admitted that my original narrative was too cramped and that Facebook was perhaps on its way to outstripping Google not only in advertising but also in generating other ways of making money of its monstrously large (and involved) user base. The expanded narrative yielded a value per share of close to $63, still lower than the price at the time ($72) and I concluded that much as I liked the company, it looked over priced to me. 

What’s happened since
In its earnings reports in October 2014, January 2015 and April 2015  in Facebook continued to impress markets with its capacity to scale up revenues, while maintaining huge operating margins. In addition, other evidence accumulated that Facebook was moving forward briskly in its business model. In May 2015, Buzzfeed and the New York Times announced that they would be posting articles directly on Facebook, cementing its status as a news source. Facebook has also turned Instagram into a powerful tool for mobile advertising, with revenues of $600 million in 2015 and expected to rise to almost $3 billion in the next few years.

The August 2015 narrative
The last earnings report on July 29, 2015, continued this trend but it also included a note of caution from Mark Zuckerberg that investors should take to heart. He was explicit in his view, just as he was in the quarters before, that growth was getting more expensive and that investors should expect larger capital investments (and acquisitions) in the future. Looking at my August 2014 narrative, I see little need to make major changes to it, since I am already building in large reinvestment needs in the future. My updated valuation yields a value of $69/share and at its current price of $95, it is still too richly priced for my taste. Again, you can download the valuation by clicking here, but the simulation yields the following results:

At its current stock price of $94, I am not tempted yet, but I am all aware that this may be more a reflection of my narrative failure than a market mistake. In my August 2014 post, I described Facebook as a company where my valuations may chase the price for a long time and that is certainly turning out to be true.

I valued Twitter for the first time in early October 2013, when the company filed its prospectus as a precursor to its initial public offering. My initial valuation of $18/share of the company is contained in this post from late October was based on the promise of advertising revenues that its large user base provided. While the initial offer price for the stock was set at $22, it was moved up to $26 and the stock itself opened for trading at $46 on the offering date. In the months after, the stock moved above $70 per share, before investors started noticing its flaws.

My August 2014 narrative
In my post on Twitter in August 2014, I stuck with my narrative of it becoming a successful but not-dominant online advertising companies, capable of commanding healthy margins, but added the concern that its management did not seem to have any control of this narrative or act in a way to make it happen. I contrasted how Twitter’s business model was a static one, relative to Facebook’s, and my estimate of value was $22.53, higher than the IPO number, but not by much. 

What’s happened since
It has been a tumultuous year at Twitter. In the aftermath of their stock price drop last year, they held an analyst meet in San Francisco in December 2014, where the CFO, Anthony Noto, tried to lay out the vision that the company had for its future. I must admit that I was underwhelmed by both how cramped that vision was and how little thought had been given to making it happen, and I posted my reaction in this post, where I likened it a bar mitzvah moment. If what has happened at the company in the months since are any indication, it looks like Twitter has a lot of growing up to do. After another bad earnings report, Twitter’s CEO, Dick Costolo, lost his job. That might have qualified as good news, but he was replaced by Jack Dorsey, who heads another company (Square). Twitter needs more than a part-time CEO and one who will represent a clean break from the status quo.

The August 2015 narrative
The last earnings report confirmed the chaos at Twitter. While the news in the report was not bad, investors latched on to the slowing growth in users as an excuse for selling off the stock. While I was disappointed in Twitter’s inability to extend its user presence especially overseas, Twitter’s bigger problem is not being able to convert its existing user base into revenues. There must be a way to monetize a social media presence that causes governments to quake, politicians to fall and breaks news ahead of established news services. My narrative for Twitter therefore is very similar to what it was in 2014. I believe that it will eventually get a management team that finds a way to convert potential to profits, stops catering to equity research analysts and expands its international presence. My valuation reflects this narrative and yields a value per share close to $26/share, and you can download it by clicking here. The simulation delivers the following numbers:

Note that the distribution of values for Twitter is much less symmetric that the distributions for Facebook and Apple, and is skewed towards larger values. IThis is not uncommon for small, high growth companies and is part of the "option" story, where you buy these companies to take advantage of the potential for breakout values. While the stock is, at best, fairly valued (at least based on my value), the optionality tilts the scale for me, and my (limit) buy orders were executed on Friday at $27/share. I am now a Twitter shareholder, and needless to say, I will keep you posted on how this investment evolves.

The End Game
Apple, Facebook and Twitter are three companies that I will continue to value at regular intervals and I will use them to remind myself of three fundamental propositions about value-based investing.
  1. Never say never: I do not want to tar all value investing with the same brush, but a substantial proportion of "value" investors draw lines in the sand. You should never invest in stocks that operate in technology businesses, they tell you, and definitely not in social media companies. Not only do these rules make no sense, but they take larger and larger proportions of companies out of your investing universe. Much as I have taken issue with Twitter's management in the past, at its current price, it looks like a good value to me. Put more generally, at the right price, I would buy almost any company, even a risky one with bad corporate governance, and at the wrong price, I would not buy even the very best company.
  2. Don't just buy and hold: The other piece of advice you get from value investors is buy great companies and hold them forever. This advice does not hold up either, since the essence of investing for value is that you buy an asset for a price that is less than its value. A consistent version of value investing would push for you to buy a a stock when the price is below value (with perhaps a margin of safety built in) but you should sell the stock when the price exceeds value (perhaps, using the same margin of safety in the other direction), even if you have held it for only a short period. If Apple continues its drop below $100, I will be buying Apple for the third time in four years and if Facebook sees a dramatic drop off in price to $60 per share or lower, I will buy it for the second time.  
  3. PE Ratios are blunt instruments: Generations of investors have been brought up on the notion that you should screen stocks, using multiples of earnings (PE or EV/EBITDA) or book (price to book), and pick companies that trade at low multiples. Even if Twitter dropped to $20/share, it will not trade at a low PE, even if with forward earnings, but I think it will be a good value.

  1. Valuation of Apple (July 2015) and Simulation Results
  2. Valuation of Facebook (July 2015) and Simulation Results
  3. Valuation of Twitter  (July 2015) and Simulation Results


Apple Facebooker said...

Great read and interesting valuation. Give me something to think about.
It would be great to hear you opinion about other tech "behemoths" such as IBM.
Thank you for your time!

Raffaele De Gennaro said...

Dear professor,
last week I value Apple and Facebook.
While I am delighted to discover that my values per share are incredibly close to yours, at the same time I feel a little bit sad because my narratives are slightly different from yours (and this let me think a lot).
But at least for the moment I will enjoy my progresses.

With endless gratefulness,
Raffaele De Gennaro

Anonymous said...

Where could we find you periodic valuations you do for Apple? You mentioned it but are these posted on your blog somewhere (has not seen it while reading your blog all the time)?


Aswath Damodaran said...

I am glad that your narrative is different from mine, I don't have (or claim to have) the monopoly narratives. The very fact that you have a narrative-based valuation (rather than a pricing or a Robo DCF) is what matters.
Take a look at my Apple post from April 2014
The valuations are at the bottom of the post.

Anonymous said...

Is there a post or place to learn more about your value simulation tool and what goes into it?

Ian said...

FYI It looks like a couple of the Excel links are dead.


Aswath Damodaran said...

Links fixed now. Sorry.

Patrick said...

Hi Professor, thanks for another great post. Considering the valuations over time as the narrative evolves (or doesn't) is a very useful exercise.
I want to understand why AAPL's valuation increases if we change the assumptions regarding the terminal growth rate & cost of capital. If we toggle cells B38 & B41 to "No", the valuation moves to $135.85. I would expect just the opposite. What am I missing?


Anonymous said...

Hi Mr. Damodaran,

Will you be doubling down on Yahoo Shares again? Since the stock price has cratered recently, does it till seem like a bargain or has Marissa Mayers killed the value in the company with all the new buyouts.


Sairam Chandrasekhar said...

Over the past few days I have gone through your talk which you gave at CFA on connecting narratives to numbers. And, now this post gives another practical insight into how to put things together.

I am going to take this learning and start valuing Indian companies which I personally try to invest in.

PS: Would you take time to also look at Indian markets and give your perspective of things. More so it would be great to see your valuation of some potentially high growth companies (some publicly traded) and some still private (such as Snap Deal where SoftBank has recently invested, Flipkart etc).

Anonymous said...

Great article! Do more of these for more biotech and semiconductors stocks, learned a lot from you, you are a great teacher :)

Anonymous said...

I would also like to learn more on valuation of biotechs since conventional financial statement analysis doesn't work. I have read a paper that you wrote where there was a section on probabilistic decision tree model and you mentioned it could be used for biotech, but I would be interested to see how you'd approach valuing a non-revenue generating Biotech.

Anonymous said...

An update on Amazon would be interesting after your very negative post last year. Thanks.

Raju Alluri said...

Good Article. Completely agree with that. AAPL will be a good buy around 100 and TWTR stock has great risk reward at this price.

Mike said...

I know that you are probably sick of justifying every input of your valuations over your career but... What in your experience suggests that the 3% estimated five year revenue growth rate that you have chosen for your July 2015 valuation is preferred over say a 15% growth rate for that time frame? Is it Apple's large size, it's new-found maturity, the fact that revenue figures/market cap simply become too large to make sense, that their avenues of growth have diminished, or something else?

Thank you so much for your time and everything that you do!

Aswath Damodaran said...

I have a post on checking narratives and one of the lines is draw is between what is possible, what is plausible and what is probable and it is a subjective one. Your job in an intrinsic value is to reflect the probable in your expected cash flows, allow for the plausible in your growth potential (but with caution) and treat the possible as icing on the cake (great if it happens, but you are not paying for it up front). Is it possible that Apple's revenues could grow 15% a year? Yes, but it is not plausible and definitely not probable and here is why. Apple derives 70% of its revenues from its smartphones/devices and that overall market growth is slowing down to about 3-5% a year. It is also getting intensely competitive and Apple cannot gain market share (and preserve margins) at the same time. Thus, at best, Apple is hoping to keep up with the market and more likely, Apple will continue to lose market share to the cheaper Androids and Chinese rip-offs. That is why, in my narrative, revenue growth is dropping (note that my revenues in year 10 are roughly where they were a year or two ago for the company).

Mike said...

Thank you for that explanation! I will be sure to research the points that you have made.

I just want to say that I have spent many hundreds of hours listening to, and watching, your Valuation and Corporate Finance lectures. I think that you are an exceptional professor and an inspiration in the field of finance as well as teaching. Thank you for the years of enjoyable lectures and all that you have taught me.

Raman Ghei said...

With respect to your Twitter valuation, how are you accounting for stock options? When I look at Twitter, and the massive use of stock options, something to the tune of 50% of sales for the current year, I do not see how the company can produce profits on a GAAP basis without a massive increase in sales, given their other costs. On that basis, and with the significant and constant increase in the share count, I come up with a potential value closer to single digits. Share count was up 15% year over year last quarter. My back of the envelope calculation shows GAAP break even if they can add 50% to revenues and perhaps 40-50 cents a share on a doubling in revenues. So the stock assuming 30% sales growth for a few years is trading at 60-70x GAAP earnings for 2019... how is that a worthwhile investment? With the stock way down I'd love to buy it but I can't make any reasonable sense of it to support the current valuation given the company's projection of almost $800 million of stock option compensation for 2015.

Aswath Damodaran said...

As you well know, I have always been wary about stock-based compensation, but I think you may be over estimating the impact of options on Twitter and here is why. First, both my starting operating loss and my target margin for Twitter already reflect the expensing of options. (I don't add back the stock based compensation to earnings. Perhaps, if I had done that, you could argue that I am over estimating the value). Also as revenues grow, stock-baed compensation as a percent of revenues will decline. So, when you say you get single digits, what exactly are you doing to reflect these options? If you are dividing by some diluted number of shares and using a DCF, you are double counting.

Raman Ghei said...

My single digits is rough, it's more putting some valuation of say 30x on 50 cents of earnings in three or four years and then bringing that forward to come up with a price one could pay now to make money. While in theory stock option as a percent of sales should decline, the counter has been true so far with TWTR projecting a sequential jump of 15% on a sequential revenue gain of roughly 10%. Year over year, though, you are correct is has come down. My thought was to hold it flat at roughly $800 million a year which is the figure they quote for 2015. Perhaps i'm overly pessimistic on margins. As noted my calculations are very rough and I do not do DCFs, just was noting the massive increase in share count (to some extent offset by cash building), the huge stock option expense and the need for revenues to be dramatically higher before GAAP earnings of any material amount kick in. It's not hard to envision shares being 800 million in a year or two, putting a market cap of close to $25 billion for a company generating in the neighborhood of $2 billion in revenues and losing money. I think the end result is that perhaps the range of potential outcomes for something like this are so wide that one really can't rely on any traditional valuation models, in that we simply have no idea how R&D, stock options, revenues etc are going to play out over the next five years. I think FB, Apple, etc are much more seasoned and you can more realistically make some sort of guess about the future, while TWTR is coin toss I think!

Anonymous said...

"The other piece of advice you get from value investors is buy great companies and hold them forever."

This seems to be a strawman. "Buy-and-hold" may be an adjunct imperative espoused by value investors, growth investors, Jim Cramer fans, "high-quality" fanboys, and even passive indexers or "Bogleheads."

If we are gonna paint with broad brushstrokes, it would be more representative to say that the driving axiom of "value investors" is to buy when the gap between price and "[intrinsic] value" is fat, and sell when it's thin. That is not buy-and-hold.

Marko said...

Dear Professor Damodaran

In all the valuations here you assume that these companies will have an enduring competitive advantage that results in returns that exceeds the cost of capital into perpetuity. Apple and Facebook at 12% and Twitter at 10%.

How can you support this assumption that has a material impact on value?

Surely if you believed that a further period of outperformance is warranted, this assumption must be made explicit by either (1) extending the discrete valuation period or (2) formulaically modelling single or multiple further outperformance periods.

As it currently stands, the assumptions of the competitive advantage into perpetuity and returns on new invested capital that continues to exceed the cost of capital indefinitely are not defendable?

I think Michael Mauboussin’s pieces explains my position and comments more articulately than I can, specifically (1) Death, Taxes, and Reversion to the Mean, (2) Common Errors in DCF Models and (3) Competitive Advantage Period “CAP”.

Kind regards,


Aswath Damodaran said...

To Anonymous (about value investing),
You are right. I was painting with too broad a brush. There are value investors who think about investing seriously and defined the way you do it, we are not far apart in our investment philosophies. The only problem is that they get drowned out by the rigid value investors. You know the ones that I am talking about..

Aswath Damodaran said...

On the excess returns forever assumption, you will notice that I tend to use more for technology companies and the reason is simple. Even with my treating R&D as a capital expenditure, I know that there are other expenditures that slip through, leading me to understate invested capital and overstate return on capital. In addition, when your stable growth rate is 2% or less, even assuming excess returns will not have a material effect on value (Try it in the valuations).

Marko said...

Dear Professor Damodaran

Thank you for the response.

(1) Materiality: Despite the low growth, the valuations are ‘incorrect’ on a terminal value basis ranging from 8% - 13%. Definitions of materiality differ but most people would agree that this is material. (Apple March valuation: 11%, Apple July valuation: 13%, Twitter July valuation: 8%, Facebook July valuation: 13%)

(2) Principle – 2 wrongs never make a right (even if they accidently do): I understand the explanation and your attempt at correction. Your method may result in an ‘accurate’ outcome, but I think that explicitly correcting for the issue you identify would be much more defendable and correct than attempting to fix and ‘error’ through the incorrect application of financial theory? Do the work and research, quantify how much of the capex is expensed, and correct appropriately? Do you not agree this would be better even if the answer is the same?

Kind regards,


Aswath Damodaran said...

I am afraid that you and I disagree fundamentally on valuation:
1. You don't measure materiality by looking at the terminal value. You measure it in value today.
2. There is no fixed percentage (5,10 or 15%) that determines material. Lawyers and accountants may have their "pre-set" measures, but that is their problem.
3. You are acting as I have violated a first principle or a law by assuming excess returns in perpetuity. That is not true. That is just as much an assumption as anything else. In fact, even if you buy into the assumption that competition will make the excess returns zero at some point in time, it does not haver to be in year 10.
I think that you search for precision is leading you to all the wrong places in valuation. If you want to disagree with the values that I have, there are far more productive places to do it.

Jeff said...

Greetings Professor,

As always, thanks for your generosity in providing your thoughts and related materials in a public forum.

I'm having an issue with the link to the Facebook valuation. Clicking the link takes me to the 404 Page Not Found message.

Could you possibly fix this? Or is the material no longer available?

Thanks again for your time and effort.

All the best,


Ryan Yang said...

Hi Professor,

I have been following your AAPL valuation since 2012. Your recent 2014 and 2015 valuations have sales-capital ratio that result in very high ROIC in Year 10. In your valuation output tab, you made a comment to check ROIC against industry average. For example, your July 2015 valuation of AAPL has ROIC at 160.04% when sales-capital ratio is set at 2. Should sales-capital ratio be adjusted in order for ROIC at year 10 to be at an industry average? Or should we use a sales-capital ratio that's close to the current industry average sales-capital ratio and ignore the year 10 ROIC figure?