Friday, February 19, 2016

Management Matters: Facebook and Twitter!

I am not a big user of social media. I have a Facebook page, which I don’t visit often, never respond to pokes and don’t post on at all. I tweet, but my 820 lifetime tweets pale in comparison to prolific tweeters, who tweet that many times during a month. That said, I have been fascinated with, and have followed, both companies from just prior to their public offerings and not only have learned about the social media business but even more about my limitations in assessing their values. The paths that these companies have taken since their public offerings also offer illustrative examples of how markets assess and miss-assess these companies, why management matters, and the roller coaster ride that investors have to be willing to take, when they make bets on these companies.

Facebook

In its brief life as a public company, Facebook has acquired a reputation of being a company that not only manages to make money while it grows but is also able to be visionary and pragmatic, at the same time. In its most recent earnings report on January 27, 2016, Facebook delivered its by-now familiar combination of high revenue growth, sky high margins and seeming endless capacity to add to its user base and more importantly, monetize those users:


The market’s reaction to this mostly positive report was positive, with the stock rising 14% in the after market.

I first valued Facebook a few weeks ahead of its IPO and again at the time of its IPO at about $27/share, laughably low, given that the stock is close to $100 today, but reflecting the concerns that I had on four fronts: whether it could keep user growth going, given that it was already at a billion users then, whether it could make the shift to mobile, as users shifted from computers to mobile phones and tablets, whether it could scale up its online advertising revenues and whether it could continue to earn its high margins in a business fraught with competition. The company, through the first four years of its existence has emphatically answered these questions. It has managed to increase its user base from huge to gargantuan, it has made a successful transition to mobile, perhaps even better than Google has, and it has been able to keep its unusual combination of revenue growth and sky-high margins. Prior to the prior year's last earnings report, in November 2015, I was already seeing Facebook as potentially the winner in the online advertising battle with Google and capable of not only commanding a hundred billion in revenues in ten years but with even higher margins than Google. The value per share of almost $80/share, that I estimated for the company in November 2015, reflects the steady rise that I have reported in my intrinsic value estimates for the company over the last five years. If anything, the story is reinforced after the earnings report, with revenue growth coming in at about 44% and an operating margin of 51.36%.

The value per share that I get for the company, with this narrative, is about $95/share, just a little bit under the $102/share that the stock was trading at in February 2016.  As with my other valuations in this series, I ran a simulation of Facebook’s value and the results are below:
At the prevailing price of $102/share, the stock was close to fairly priced on February 12, at least based on my inputs. 

I am sure that there will be others who will put Facebook under a microscope to find its formula for success, but there are two actions that are illustrative of the company’s mindset. The first was its aforementioned conquest of the mobile market, where it badly lagged its competitors at the time of it IPO. Rather than find excuses for its poor performance, the company went back to the drawing board and created a mobile version which not only improved user experience but provided a platform for ad revenues. The second was the company’s acquisition of Whatsapp, an acquisition that cost the company more than $20 billion and provoked a great deal of head scratching among value minded people at time, since Whatsapp had little in revenues and no earnings at the time. I argued at the time that the acquisition made sense from a pricing perspective, since Facebook was buying 450 million Whatsapp users for about $40/user, when the market was pricing these users at $100/user. That acquisition may have been driven by pricing motivations but it has yielded a value windfall for the company, especially in Asia and Latin America, with more than 100 million Whatsapp users just in India. 

It is true that Facebook’s latest venture in India, Free Basics, where it had partnered with an Indian telecom firm to offer free but restricted internet service, has been blocked by the Indian government, but it is more akin to a bump in the road than a major car wreck. At the risk of rushing in where others have been burned for their comments, I am cynical enough to see both sides of the action. Much as Facebook would like to claim altruistic motives for the proposal, the restriction that the free internet use would allow you access only to the portion of the online space controlled by Facebook makes me think otherwise. As for those who opposed Free Basics, likening Facebook’s plans to colonial expansion is an over reach. In my view, the problem with the Indian government for most of the last few decades is not that it's actions are driven by knee jerk anti-colonialism, but that it behaves like a paternalistic, absentee father, insisting to its people that it will take care of necessities (roads, sewers, water, power and now, broadband), while being missing, when action is needed.

On a personal note, I was lucky to be able to buy Facebook a few months after it went public at $18, but before you ascribe market timing genius to me, I sold the stock at $45. At the time, Tom Gardner, co-founder of Motley Fool and a person that I have much respect for, commented on my valuation  (on this blog) and suggested that I was under estimating both Facebook's potential and its management. He was right, I was wrong, but I have no regrets!

Twitter
If Facebook is evidence that you can convert a large social media base into a business platform to deliver advertising and more, Twitter is the cautionary note on the difficulties of doing so. Its most recent earnings report on February 10, 2016, continued a recent string of disappointing news stories about the company:


The market reacted badly to the stagnant user base (though 320 million users is still a large number) and Twitter’s stock price hit an all time low at $14.31, right after the report. The positive earnings may impress you, but remember that this is the reengineered and adjusted version of earnings, where stock based compensation is added back and other sleights of hand are performed to make negative numbers into positive ones.

As with Facebook, I first valued Twitter in October 2013, just before its IPO and arrived at an estimate of value of 17.36 per share. My initial narrative for the company was that it would be successful in attracting online advertising, but that its format (the 140 character limit and punchy messages) would restrict it to being a secondary medium for advertisers (thus limiting its eventual market share).The stock was priced at $26, opened at $45 and zoomed to $70, largely on expectations that it would quickly turn its potential (user base) into revenues and profits. However, in the three years since Twitter went public, it is disappointing how little that narrative has changed. In fact, after the most recent earnings report, my narrative for Twitter remains almost unchanged from my initial one, and is more negative than it was in the middle of last year.


Since the narrative has not changed since the original IPO, the value per share for Twitter, not surprisingly, remains at about $18. The results of my simulation are below:

My estimate of value today is lower than my valuation in August of last year, when I assumed that the arrival of Jack Dorsey at the helm of the company, would trigger changes that would lead to monetization of its user base.

So what’s gone wrong at Twitter? Some of the problems lie in its structure and it is more difficult to both attract advertising and present that advertising in a non-intrusive way to users in a Tweet stream. (I will make a confession. Not only do I find the sponsored tweets in my feed to be irritating, but I have never ever felt the urge to click on one of them.) Some of the problems though have to be traced back to the way the company has been managed and the choices it has made since going public. In my view, Twitter has been far too focused on keeping Wall Street analysts happy and too little on building a business. Initially, that strategy paid off in rising stock prices, as analysts told the company that the game was all about delivering more users and the company delivered accordingly. The problem, though, is that users, by themselves, were never going to be a sufficient metric of business success and that the market (not the analysts) transitioned, in what I termed a Bar Mitzvah moment, to wanting to see more substance, and the company was not ready. 

Can the problems be fixed? Perhaps, but time is running out. With young companies, the perception of being in trouble can very easily lead to a death spiral, where employees and customers start abandoning you for greener pastures. This is especially true in the online advertising space, where Facebook and Google are hungry predators, consuming every advertising dollar in their path. I have said before that I don’t see how Jack Dorsey can do what needs to be done at Twitter, while running two companies, but I am now getting to a point where I am not sure that Jack Dorsey is the answer at Twitter.  As someone who bought Twitter at $25 late last year, I am looking for reasons to hold on to the stock. One, of course, is that the company may be cheap enough now that it could be an attractive acquisition target, but experience has also taught when the only reason you have left for holding on to a stock is the hope that someone will buy the company, you are reaching the bottom of the intrinsic value barrel. The best that I can say about Twitter, at the moment, is that at $18/share, it is fairly valued, but if the company continues to be run the way it has for the last few years, both price and value could move in tandem to zero. Much as I would like to hold on until the stock gets back to $25, I am inclined to sell the stock sooner, unless the narrative changes dramatically.

The Postscript
Valuing Facebook and Twitter after valuing Alphabet is an interesting exercise, since all three companies are players in the online advertising space. At their current market capitalization, the market is pricing Facebook and Google to not just be the winners in the game, but pricing them to be dominant winners. In fact, the revenues that you would need in ten years to justify their pricing today is close to $300 billion, which if it comes entirely from online advertising, would represent about 75% of that market. If you are okay with that pricing, then it is bad news for the smaller players in online advertising, like Twitter, Yelp and Snapchat, who will be fighting for crumbs from the online advertising table. This is a point that I made in my post on big market delusions last year, but it leads to an interesting follow up. If you are an investor, I can see a rationale for holding either Google or Facebook in your portfolio, since there are credible narratives for both companies that result in them being under valued. I think you will have a tougher time justifying holding both, unless your narrative is that the winner-take-most nature of the game will lead to these companies dominating  the online advertising market and leaving each other alone. If  Google, Facebook and the smaller players (Twitter, Yelp, a private investment in Snapchat) are all in your portfolio, I am afraid that I cannot see any valuation narrative that could justify holding all of these companies at the same time.

Closing on a personal note, I have discovered, during the course of valuation, that I learn as much about myself as I do about the companies that I value. In the case of Facebook and Twitter, I have learned that I hold on to my expectations too long, even in the face of evidence to the contrary, and that I under estimate the effect of management, especially at young companies to deliver surprises (both positive and negative). I sold Facebook too soon in 2013, because my valuations did not catch up with the company’s changed narrative until later and perhaps bought Twitter too early,  last year, because I thought that the company’s user base was too valuable for any management to fritter away. I live and I learn, and I am sure that I will get lots of chances to revisit these companies and make more mistakes in the future.

YouTube Video


Datasets
  1. Facebook 10K (2015)
  2. Twitter - Bloomberg Summary (including 2015 numbers)
Spreadsheets
  1. Facebook - Valuation in February 2016
  2. Twitter - Valuation in February 2016
Blog posts in this series
  1. A Violent Earnings Season: The Pricing and Value Games
  2. Race to the top: The Duel between Alphabet and Apple!
  3. The Disruptive Duo: Amazon and Netflix 
  4. Management Matters: Facebook and Twitter
  5. Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!
  6. Investor or Trader? Finding your place in the Value/Price Game! (Later this year)
  7. The Perfect Investor Base? Corporation and the Value/Price Game (Later this year)
  8. Taming the Market? Rules, Regulations and Restrictions (Later this year)

17 comments:

Anonymous said...

Professor Damodaran,

What book would you recommend on Monte Carlo modelling for company valuation purposes?

Something that teaches which distributions to use, how to define ranges and variables, etc.

Yashodhan Khare said...

What about the impact of Instant Articles that FB will flag off on April 12?

Anonymous said...

Hi Aswath - appreciate everything you do in the world of valuation, and helping everybody learn more about valuation.

I read your blog on my iPad, and have difficulty seeing the embedded pictures and charts you put into the text. I think if you have them as higher resolution they would be easier too see on a mobile device,
thanks, Sam

Anonymous said...

Ignore my comment. I just figured you have to tap on the diagram, not make it bigger within the post. I shouldn't text so early in the morning,
Thanks Sam

Anonymous said...

YOu an Idiot and no nothing about investing. You write a self promoting article after the fact on Values. I am sure when twitter hits 35 you will say you hung on and predicted as such. OK coward Post this view point

steve said...

Great Post: A spreadsheet can provide a view of what one rationally thinks a company can achieve with a resultant valuation that can be compared to a market price, but it says nothing about whether any management team can execute the vision. The fact that advertisers have not viewed Twitter as compelling a vehicle for online ads as either FB or GOOG is a message in and of itself; and why i did not buy TWTR. So, the question remains why do advertisers not see TWTR as giving them a bang for the buck that they see inFB and GOOG and what if anything can change that view to support even an $18 valuation? I suggest that at this point, it is unlikely that any manager can make it work and also believe that "if you build it they will come" resonates to some degree, and TWTR advertisers are just not coming to.

Anonymous said...

Hi Aswath. Why don't you use some strategic's tools for help organize the narrative, like for example the 5 forces of Porter (it is old, but works)? For me seem be helpfull. There are many other tools: Enviromental Analysis (political, economic, social, tecnological, legal, environmental, demographic, regulatory); Competitive Analysis (stackholders, competidors, shareholders); Capability Analysis; Life Cicle, Competitive Position (Strategy Map)...etc. All of this can help build the narrative (I think) or, at least, organize the ideas better. Nice article. Best regards.

Tom said...

Hello,

I keep on wondering, what inputs you variy in the Monte Carlo simulations and what distributions you assumed and based on what basis?

Would you mind adding some commentary on this or make a specific post on that topic?

Thanks a lot.

As usual, appreciate you walking us through your thinking and how valuations can be done.

yajhakaas said...

I echo with Tom. I am also curious to know more about the Monte Carlo simulation and its setup. I couldnt find that information in the worksheet. Thanks a bunch, as always!

better edgar said...

Hi Aswath,

I am struggling to understand the role of stock-based compensation in your
valuation spreadsheet of the new crop of cloud companies (amzn, lnkd, twtr, crm) etc.

You are subtracting the value of outstanding stock-options as if it would remain
constant in the future. But the business model of the cloud companies seems to incorporate stock-options as an essential component of the employee compensation plan on an ongoing basis with no intention to stop in the future.

Another way of saying the same thing is: you are assuming that shares outstanding would remain constant, but in fact, there is continuous dilution due to stock options, and this is not accounted.

I would appreciate your insights on this.

Aswath Damodaran said...

Better Edgar,
I subtract out the existing options as a one-time deduction from the value of equity, but remember that with current accounting standards, the options granted are also an expense that are built into my expenses and my operating income. Thus, I am assuming that future option grants will reduce my cash flows and reduce my value.

Better Edgar said...

thanks, now i understand it, In your EBIT you are including depreciation,
and stock-option expenses, and therefore, stock-options get counted as an
ongoing operational expense item in your spreadsheet.

lnkd projects a new metric in the 10K called "Adjusted EBITDA" - which is the EBIT (as you count it), but adds back stock-options and depreciation expenses. That caused my initial confusion.

Enjoy your valuation narratives, keep them coming !

Brian Kehm said...

Hi Professor Damodaran. I've been a reader of yours for three years. I agree with most of your analysis. Twitter's current valuation is still a stretch. Twitter has attracted too many investors that fail to look past the business idea and product. They fail to see the crucial numbers "under the hood." I'll stick to stable businesses trading at cheap prices.

http://kehmresearch.com/2016/03/11/why-smart-investors-avoid-buying-twitter-today/

Anonymous said...

Why don't you take your own advice sell Twitter and go all in with Facebook

Bobby Jinlu YU said...

Hi, Professor

Could you help explain how you got the number of shares outstanding 2294.54 for Facebook?

In the latest 10-K, there is two places mention share number:

(1) On January 25, 2016, the registrant had 2,294,939,865 shares of Class A common stock and 551,340,611 shares of Class B common stock outstanding. (so, 2295 + 551 = 2846)

(2) Number of shares used for basic EPS computation 2,249 (A) + 554 (B) (so, 2249 + 554 = 2803)

https://www.sec.gov/Archives/edgar/data/1326801/000132680116000043/fb-12312015x10k.htm

Thanks,
Jinlu

Bobby Jinlu YU said...

Hi, Professor Damodaran

I have two questions about tax rates you used in the Facebook valuation.

(1) Why the Effective Tax Rate is 35%? The latest 10-K says "Effective tax rate was 40%" on Page 32.

(2) What the Marginal Tax Rate is 35%? The number for US on "Country tax rates" worksheet is 40%.

Thanks A Lot,
Jinlu

Bobby Jinlu YU said...

Hi, Professor Damodaran

I think I found an error in you Valuation Worksheet.

In the comment of B25 of Input sheet, you say:

"Again, look at your company's current number (divide cell B3 by the sum of cells B5 and B6)"

But actually B3/B5/B6 are not numbers at all. Do you mean B8/(B11+B12-B15)?

Thanks,
Jinlu