Auld Lang Syne: Remembering 2011

There are only a couple of hours left in 2011 in New York and it is already the new year in many parts of the world. Let me spend my last post for this year, looking back at the year that was and looking forward to the year to come, using a few of my favorite market props: cash flows/earnings, market prices, risk free rates and risk premiums.

1. It was a good year for earnings at US companies, with earnings on the S&P 500 companies rising about 16%. That makes what happens to stock prices a little puzzling, since the S&P 500 index started the year at 1257.64 and ended the year at 1257.60. As a result , the aggregate PE ratio for the index declined from 15.03 at the start of the year to 12.96 at the end. 
2. It was an even better year for cash flows: dividends on the S&P 500 companies rose 12.5%, but buybacks surged more than 80%. The total dollar buybacks in 2011 (at least for the four quarters ending September 2011) almost matched buybacks in 2006, though they still remained well below the historic highs set in 2007. While the dividend yield on the index remained anemic (2.07%) the total cash flow (including buybacks) yield on the index was 5.90%, again well above the ten-year average of 4.72%.
3. The ten year treasury bond which started the year at 3.29% ended the year at 1.87%, the first time it has ended a year at below 2% in the last 50 years. The drop in the  rates also made US treasuries one of the better investments for the year, with the ten year bond returning 16.04% for the year; the price appreciation component accounted for 12.75%. Ironic, don't you think? After all, this was the year of the great S&P downgrade of the US sovereign rating that I talked about on my summer vacation in August. Are lower interest rates good news? I don't think so and I posted on the point earlier this year.
4. As many of you know, I have been estimating an implied equity risk premium for the S&P 500 for a long time, annually until 2008 and monthly since September 2008. I back out the premium using the level of the index and expected cash flows in the future. The premium started the year at 5.20%, surged during the summer to hit a high of 7.64% at the end of September and ended the year at 6.04%. The fact that stocks were flat for the year (the return with dividends was 2.07%) had the opposite effect on the historical risk premium (where you look at the difference between annual returns on stocks and treasuries over long periods of past history), with the historical risk premium dropping to 4.10%. After a long period (1981-2007), where historical risk premiums exceeded implied premiums, this is the fourth year in a row that implied premiums have exceeded historical premiums.

So much for last year! What does all this tell us about next year? It strikes me that the numbers are sending discordant messages. The earnings and cash flows point to a recovery, at least in corporate earnings, the treasury bond market is awfully pessimistic about future growth and the stock market vacillates between euphoria and despair. I really have no idea what next year will bring, but I am willing to make a guess. I expect the treasury bond market to grudgingly acknowledge higher economic growth prospects and move up (to 3%), equity risk premiums to become less volatile and move back towards lower numbers (5-5.5%). Buybacks and dividends will stay strong but will stabilize and earnings growth will moderate. The net effect will be to make the stock market a more hospitable place to invest and the bond market a less attractive investment. So, I am adding to my equity exposure, selling my treasury bonds and praying that the Eurozone does not turn my predictions to dust.

I apologize for both the US-centric and macro nature of this post but I am starting on my annual data update this week. Over the next ten days, I will be exploring the raw data that I have downloaded on 50,000+ companies globally, since the close of trading yesterday, and will be generating my industry average tables. During that analysis, I will be looking at how equities have moved globally and world-wide trends in both valuation multiples (PE, Price to book, EV/EBITDA etc.) and corporate finance variables (dividends, debt ratios, returns on equity/capital). I will have a much more detailed post when I am done but I look forward to learning a great deal more from the numbers than from listening to expert prognostications. 

So, happy New Year! I wish you, your families and your loved ones the very best for the coming year! Be happy and healthy!

Do markets punish long term thinking? Amazon as a case study

This morning's New York Times has an article from one my favorite business writers, James Stewart, on Amazon. His focus, largely admiring, is on the fact that Amazon has made decisions that hurt it in the short term but create value in the long term. To provide at least two examples, he talks about Amazon's decisions to cut prices on products and go for a larger market share and to invest in in the Kindle, their book reader. The tenor of the article is that the market has short sightedly punished the company for its long term focus. Stewart uses one piece of anecdotal evidence to back up his claim that markets are short term: the stock price reaction to the earnings report on October 25, when Amazon announced earnings and revenues that were largely as expected but announced that it had been spending a great deal more than investors thought it had to deliver that growth.

I am no knee jerk defender of financial markets and accept the fact that markets not only make mistakes in assessing value, but also that a subset of investors are short term and over react to earnings announcements. In fact, I am sure that there are companies that you can point to that have been unfairly treated by markets for their long term focus (and other companies that have been unfairly rewarded for delivering short term results at the expense of long term value). I just don't think Amazon is the example I would use to bring this point on. Let's start with some general facts. Here is how the market has and is continuing to punish Amazon for its long term focus.

• In the last decade, Amazon has seen its market capitalization increase from $4.55 billion in 2001 to $82 billion in 2011; the market cap for Amazon at the peak of the dot com boom was only $30 billion. An investor who bought Amazon stock in 2001 would have generated a cumulated return of 1300% over the last 10 years. 
• In November 2011, after the earnings report that Mr. Stewart alludes to, Amazon was trading at 96 times trailing earnings and at two times trailing revenues. In contrast, the median PE ratio for a retail firm was about 15 and the median EV to revenue multiples was 0.8. By my estimate, Amazon is one of the most richly priced large retailers in the world.
• Over the last decade, the firm has made multiple bets on growth and asked the market to trust it to make the right judgments. For the most part, its actions have been welcomed by markets that have been willing to look past disappointing earnings reports at the future. Jeff Bezos is celebrated as a great CEO, with comparisons made to Steve Jobs.

So, why was the market reaction to Amazon's last earnings report so brutal? As someone who has valued Amazon almost every year since 1998, I think I can provide some historical perspective. Amazon has been, at alternate times, revered and reviled by financial markets. In January 2000, at the peak of the dot com boom, based on my estimate of value for Amazon at the time, it was over valued by about 60%. A year later, based again on my assessment of value, it was under valued by about 50%. During the 12 years that I have valued the company, it has been overvalued in 7 of the years and under valued in 5 of those years. Since the beginning of 2009, notwithstanding the reaction to the last earnings report, investors have been on their manic phase with Amazon, pushing the stock price up more than 300% (from $54 to over $200). At its price of almost $200/share, just before its October earnings report, Amazon was valued to perfection and beyond. In fact, for it to be worth $200/share, it would have to deliver about increase revenues to more than $200 billion in ten years, while increasing its pre-tax operating margin from 2.5% to 4%, while generating a return on capital of 70%+ on its new investments. If you disagree on these assumptions, feel free to change them for yourself in the attached spreadsheet.

It is the last item that I would draw your attention to, because the last earnings report was a sobering reminder that while Amazon will continue to grow, the growth is not going to be easy or cheap. In my view, the market is still much too optimistic about the quality of Amazon's growth going forward and I think it remains over priced. In Mr. Stewart's world, that would make me a short term investor, but not in mine. At the risk of repeating a theme that has run through my posts for the last few months, growth has value only if it is delivered at a reasonable cost and a growth stock is cheap only if the market price reflects that cost. Amazon does not look cheap to me, even with a great CEO and a long term focus!

Living within your limits: Thoughts on Research In Motion (RIM)

I have a sixteen-year old daughter who calls me "old man" and while I know she is using the term lovingly (of course.. I believe the best about my kids), the moniker still strikes home as a reminder that I am older and that age brings limits that I can choose to ignore at my own peril. I know that I can no longer go to bed late and get up early, that I have to watch what I eat and that I need my reading glasses to read restaurant menus. As I watched Research in Motion (RIM) go through painful contortions in the financial markets yesterday, I was reminded that companies also go through an aging process, and how they deal with the limits that come with age determines their value to investors.

RIM has had a pretty good run as a company, but they have a problem. Their core technology which powers the Blackberry is a cash cow but it is one that faces corrosion in market share, as smart phone users turn to Androids and iPhones, with their more open operating systems and extensive app libraries. As the CEO of RIM, you have two choices.

1. Go for growth: You can invest hefty portions of the cash flows from your core technology back into the business in R&D and new products, hoping for a breakthrough, but you are competing against two companies, Apple and Google, that have more resources and imagination than you do. You may be able to eke out growth but the amounts you would have to reinvest to generate that growth may make it a losing proposition for your stockholders.
2. Go for cash: You can accept the reality that you have a product with a limited life but solid cash flows. You invest just enough to keep this product on its feet and a cash flow generator for the near future, and give up on new products and technologies.  You also change your capital structure and dividend policy to reflect your new status as a limited life, cash cow: use more debt in your financing and you return more of your cash to stockholders as dividends or stock buybacks. You are, in effect, liquidating yourself over time, and while your stock price will approach zero by the end of the Blackberry's life, your investors would have collected enough cash flows not to care.

So, what are the value implications of your choice? In the fiscal year ended February 2011, RIM reported pre-tax operating income of $4.6 billion and net income of $3.4 billion, but this income was after R&D expenses of $$1.4 billion. While their earnings has plummeted in the last two quarters (operating income in the 12 months ended November 2011 was down to $3.4 billion), and some of the drop can be attributed to a loss of market share for Blackberries, the drop was accentuated by losses on new products such as the Playbook tablet.  In fact, let's be conservative and assume that the operating income in 2012 will come in at less than $ 2.5 billion and that RIM, if it gives up on developing new products, can cut $ 1 billion out of R&D. (The remaining $400 million or more can go to maintaining the Blackberry Franchise). That would translate into a base pre-tax operating income of roughly $ 3.5 billion and after-tax cash flows of $3 billion. Assume further that you can milk the franchise for five more years, losing 20% of your customers each year. On an after-tax basis, using a tax rate of 30% and a cost of capital of 9% (which is the cut off for the top quartile of US companies), you get a value of about $8.125 billion. At its current market capitalization of $7.3 billion and enterprise value of $ 6 billion, that would make RIM a bargain (under valued by about $2 billion). In fact, make your own estimates and judgments, using this spreadsheet. So, what can go wrong? If managers continue to operate under the delusion that they can recreate their glory days and invest on that presumption, they can very easily wipe out the $ 2 billion difference. In fact, I think that the market is building in the expectation that RIM will continue  not to act its age, investing as if it were a growth company, whose glory days lie ahead of it.

As a potential stockholder in RIM, here is my unsolicited advice to the management of the company. Rather than fight the critiques of your product (that it is closed, corporate and limited), embrace them. In fact, I have names for your next few models: the Boring Blackberry, the Blackberry Funsucker and the Blackberry Stolid. Let's face it! The primary market for Blackberries is composed of paranoid (often with good reason) corporate entities that worry about their employees revealing business secrets and playing games on their iPhone and Android Apps, and you will appeal to them with your "cant have fun with these" Blackberries. Disband your research and development teams, forget about product revamps and don't even dream about more Playbooks. In effect, accept that you are an "old company" and behave like one. Your stockholders will be deeply grateful!

How much diversification is too much?

As an investor, should you put all of your money in one stock or should you spread your bets across many investments? If it is the latter, how many investments should you have in your portfolio? The debate is an old one and there are many views but they fall between two extremes. At one end is the advice that you get from a believer in efficient markets: be maximally diversfied, across asset classes, and within each asset class, across as many assets you can hold: the proverbial “market portfolio” includes every traded asset in the market, held in proportion to its market value. At the other is the “go all in” investor, who believes that if you find a significantly undervalued company, you should put all or most of your money in that company, rather than dilute your upside potential by spreading your bets.

Cuban versus Bogle

These arguments got media attention recently, largely because two high-profile investors took opposite positions. The first salvo was fired by Mark Cuban, who made his substantial fortune (estimated by Forbes to be $2.5 billion in 2011) as an entrepreneur who founded and sold Broadcast.com for $ 6 billion by Yahoo!, at the peak of the dot com boom. Cuban's profile has increased since, largely from his ownership of the Dallas Mavericks, last year's winners of the NBA championship, and his intemperate outbursts, about referees, players and the NBA in general. With typical understatement, Cuban claimed that diversification is for idiots and that investors, unless they have access to information or deals, should hold cash, since hedge funds have such a tremendous advantage over them. In response, John Bogle, the father of the index fund business, countered that "the math (for diversification) has been proved over and over again. It's not just the first thing an investor should think about, but the second, the third and probably the fourth and the fifth thing investors should think about".

The limiting cases

So, should you diversify? And if so, how much should you diversify? The answers to these questions depend upon two factors: (a) how certain you feel about your assessment of  value for individual assets (or markets) and (b) how certain you are about the market price adjusting to that value within your specified time horizon.

·      At one limit, if you are absolutely certain about your assessment of value for an asset and that the market price will adjust to that value within your time horizon, you should put all of your money in that investment. Though this may seem like the impossible dream, there are two possible scenarios where it may play out:

o   Finite life securities (Options, Futures and Bonds): If you find an option trading for less than its exercise value: you should invest all of your money in buying as many options as you can and exercise those options to make a sure profit. In general, this is what falls under the umbrella of pure arbitrage  and it is feasible only with finite lived assets (such as options, futures and fixed incomes securities), where the maturity date provides a endpoint by which time the price adjustment has to occur.

o   A perfect tip: On a more cynical note, you can make guaranteed profits if you are the receipient of inside information about an upcoming news releases (earnings, acquisition), but only if there is no doubt about the price impact of the release (at least in terms of direction) and the timing of the news release. (Rumors don’t provide perfect information and most inside information has an element of uncertainty associated with it.) The problem, of course, is that you would be guilty of insider trading and may end up in jail... .

·      At the other limit, if you have no idea what assets are cheap and which ones are expensive (which is the efficient market proposition), you should be as diversified as you can get, given transactions costs. If you have no transactions costs, you should own a little piece of everything. After all, you gain nothing by holding back on diversification and your portfolio will be deliver less return per unit of risk taken.

Most active investors tend to fall between these two extremes. If you invest in equities, at least, it is inevitable that you have to diversify, for two reasons. The first is that you can never value an equity investment with certainty; the expected cash flows are estimates and risk adjustment is not always precise. The second is that even if your valuation is precise, there is no explicit date by which market prices have to adjust; there is no equivalent to a maturity date or an option expiration date for equities. A stock that is under or over priced can stay under or over priced for a long time, and even get more under or over priced.

There is one final point worth making. Note that how much you diversify will be based upon your perceptions of the quality of your valuations and the speed of market adjustment, but perceptions are not reality. In fact, psychologists have long noted (and behavioral economists have picked up the same theme) that human beings tend to have too much confidence in their own abilities and too little in the collective wisdom of the rest of the world. In other words, we tend to think our valuations are more precise than they really are and that the market adjustment will occur sooner than it really will.

How diversified should you be?

            Building on the theme that diversification should be attuned to the precision of your valuations and the speed of market adjustment, the degree to which you should diversify will depend upon how your investment strategy is structured, with an emphasis on the following dimensions:

a.     Uncertatinty about investment value: If your investment strategy requires you to buy mature companies that trade at low price earnings ratios, you may need to hold fewer stocks , than if it requires you to buy young, growth companies (where you are more uncertain about value). In fact, you can tie the margin of safety (referenced earlier in this chapter to how much you need to diversify; if you incorporate a higher margin of safety into your investing, you should feel more comfortable holding a less diversfied portfolio. As a general propostion, your response to more uncertainty should be more diversification, not less.

b.     Market catalysts: To make money, the market price has to adjust towards your estimated value. If you can provide a catalyst for the market adjustment (nudging or forcing the price towards value), you can hold fewer investments and be less diversifed than a completely passive investor who has no choice but to wait for the market adjustment to happen. Thus, you will need to hold fewer stocks as an activist investor than as an investor who picks stocks based upon a PE screen. Ironically, this would mean that the more inefficient you believe markets are, the more diversified you will need to be to allow for the unpredictability of market movements.

c.     Time horizon: To the extent that the price adjustment has to happen over your time horizon, having a longer time horizon should allow you to have a less diversified portfolio. As your liquidity needs rise, thus shortening your time horizon, you will have to become more diversifed in your holdings.

In summary, then, there is nothing irrational about holding just a few stocks in your portfolio, if they are mature companies and you have built in a healthy margin of safety, and/or you have the power to move markets. By the same token, it makes complete sense for other investors to spread their bets widely, if they are investing in young, growth companies, and are unclear about how and when the market price will adjust to value. So, the choice is not between diversification and active investing, since you can pick stocks and be diversified at the same time. It should be centering on  making the right decision on how much diversification works for you,.

Evidence from the field

            So, how diversified is the typical investor’s portfolo? And if it is relatively undiversified, is it undiversifed for the right reasons? And what is the payoff or cost to being undiversified? The evidence from many studies over the last decade or so is enlightening:

1. Investors are thinly diversified: The typical investor is not well diversified across either asset classes, or within each asset classes, across assets. A study of 60,000 individual investor portfolios found that the median investor in this group (which was a representative sample of the typical active investor in the United States) held three stocks and that roughly 28% of all investors have portfolios composed of one stock. In a later study, the same authors find that not only do investors hold relatively few stocks but that these stocks tend to be highly correlated with each other (same sector or type of stock).
2. Many are thinly diversified for the wrong reasons: While the lack of diversfication can be justified if you have good information or superior assessments of value, many of the undiversfied investors in this study failed to diversfy for the wrong reasons. On average, not only did younger, poorer less eductated investors diversify less, but they, as a group, tend to be over confident in their abilities to pick stocks. 
3. And they pay a price for being thinly diversified: Not surprisingly, investors who fail to diversify because they are over confident or unfamiliar with their choices pay a price. On average, they earn about 2.40% less a year, on a risk adjusted basis, than their more diversified counterparts.
4. But some undiversified investors are good stock pickers: On a hopeful note, there are clearly some active investors who hold back on diversification for the right reasons, i.e., because they have better assessments of value for stocks than the rest of the market and long time horizons. A study of 78,000 household portfolios finds that the among households wealthy enough to be diversified, those with more concentrated portfolios (holding one or two stocks) earn higher returns than those with more diversified portfolios (holding three or more stocks) by about, though they are also more volatile. The study goes on to note that the higher returns can be attributed to stock picking prowess and not to market timing or inside information.

Bottom line

Most investors are better off diversifying as much as they can, investing in mutual funds and exchange traded funds, rather than individual stocks. Many investors who choose not to diversify do so for the wrong reasons (ignorance, over confidence, inertia) and end up paying dearly for that mistake. Some investors with superior value assesssment skils, disciplined investment practices and long time horizons can generate superior profits from holding smaller, relatively undiversified portfolios. Even if you believe that  you are in that elite group, be careful to not fall prey to hubris, where you become over confident in your stock picking and market assessments and cut back on diversification too much. 

Following up on Groupon

In my last post, I made an attempt to value Groupon and came up with $14.62/share, before the voting right adjustment. Now that the offering is complete and the first day of trading is over, I thought it would be useful to take stock of general lessons that can be drawn from this deal. The offering price was raised to $20/share and the stock jumped another 40% during the course of the day. So, here are a few questions that I am fielding today...

1.     Is it possible that you are wrong in your assumptions and that other investors are far more optimistic about revenue growth/ operating margins?

There is no room for hubris in markets. Investors who do not admit to their mistakes, fix them and move on are doomed to pay a steep price. So, I will start with the presumption that I am wrong and the market is right and assess the likelihood, using two techniques.

• Implied growth/margins: The two key inputs in this valuation are revenue growth and the target operating margin. In the table below, I changed both those numbers and assessed the impact on value per share. I also highlighted the combination of growth/margin assumptions that would get me to $28/share. For instance, if Groupon can maintain a revenue growth rate of 70% a year for the next 5 years (which will give them revenues of $64 billion in ten years) and a target operating margin of 23% a year, the value per share is $39.81. Notice that there is no scenario where the revenue growth is less than 60% a year for the next five that delivers a value greater than $28/share. (There are a few odd quirks in the table, where the value decreases as the margin increases, for a given revenue growth rate. That is because the NOLs that you accumulate spill over into the terminal value. Suffice to say that if your plan with Groupon is for them to lose so much money that they will never run out of NOLs, you should think again...)

(Revenues in year 10 in brackets next to five year growth rate)

• Simulations: In the last few years, I have used an add-on to Excel called Crystal Ball to run simulations. In a simulation, you input distributions for key inputs where you feel uncertain about the future. In the Groupon valuation, I made revenue growth and operating margin into distributions – compounded 5-year revenue growth is uniformly distributed between 30% (pessimistic end) and 70% (optimistic limit) and the target operating margin is assumed to be normally distributed, with an average of 23% and a standard deviation of 4%.  I then ran 10,000 simulations, drawing from the distributions, and presents a distribution of values, shown below. Note that there is only a 15% chance that the value is greater than $28 (1500 outcomes out of the 10000 yielded values of $28 or higher). In fact, while the average value is around $14, there are far more outcomes under $10 than above... Put differently, you are not going to win on this stock most of the time, but if you do, you have to hope it is a big win.

2.     Is it a problem with the approach? Does DCF systematically undervalue young, growth companies?
     As many of you know, I am a staunch defender of discounted cash flow valuation, but here are a couple of criticisms I have heard of the model (especially in the context of valuing young, growth companies like Groupon) that I want to address.

a. DCF valuation is inherently conservative. It will under value growth companies.

An analyst that I was chatting with in the last day  was dismissive when I gave him the result of my Groupon valuation, and his claim was that  “DCF valuations always understate the value of young, growth companies”. But is that true? Those of you who have been reading my blog  and know that I valued Facebook, Skype and Linkedin earlier this summer (and found them all over valued) may very well conclude that I would find all social media companies to be over valued right now. That may be true, but it cannot be generalized to DCF as a technique. There is a bias that comes from the timing of these valuations: I chose these companies to value because they were in the news and were either going public or thinking about it. But when do companies in a sector think about going public or offering themselves for sale? It is when managers believe they will receive a favorable valuation. Put differently, I am valuing social media companies at a time when the market is most likely to be over valuing them. To provide some perspective, I valued dozens of dot com companies in the 1998, 1999 and 2000 and I found every one of them to be over valued. In 2001 and 2002, when I revisited the sector (or what was left of it), I found many of the same companies to be under valued. In the graph below, for instance, I have my value and the market price for Amazon.com each year from 2000 to 2003; notice how over valued it was in early 2000 and how under valued it looks in 2001. The bottom line: DCF is not inherently conservative, but done right, it is contrarian. You are likely to find stocks to be under valued when the market mood for a sector is darkest and stocks over valued when investors are enamored about a sector.

b. DCF valuation misses components of value

1. There is some truth in this statement and I did cover one aspect when I talked about the “option” premium in some growth companies in my earlier post on the value of growth. What am I talking about? If I had valued Apple as a personal computer company in 2000, I would have missed its expansion into the entertainment business in the last decade. Similarly, if I had priced Google as a search engine in 2004, I would not have considered its expansion into other businesses in the last few years. If Groupon is successful in its core business, could it expand into other businesses? Sure, but there are two levels at which I would be skeptical in this case. First, I am not sure what Groupon competitive edge will be in these unspecified new businesses. Second, even when I have estimated a real option premium, I have never obtained an increase of more than 20-25% on my DCF value. 
2. The other argument is that Groupon is issuing only 5% of its shares in the IPO and that the shares are therefore scarce: investors who want the stock therefore have to pay a scarcity premium. But shares in a company is not a Tiffany lamp or a Mickey Mantle baseball card. It is a claim on a set of cash flows and who generates these cash flows or how they are generated is not relevant. (As far as I can tell, a dollar you generate in cash flows from your Groupon investment buys exactly the same amount as a dollar in cash flows you generate from your Apple or Google investment.)

3.  If you  believe that the value is only $14 or $15 a share (or lower), how do you explain the $28/share price?
     My first response is that I feel no urge to explain the $28/share price, since I did not pay it. My second is that this is a snarky response and that I should be able to put myself in the shoes of those who did buy the stock today and explain why.  I could take the generous view and attribute their actions to  more optimistic assumptions about growth/profitability (and a higher value). I think that there is a simpler, more likely explanation. I would wager than most of the investors buying Groupon stock today have absolutely no idea what its value is and could not care less. They are playing a very different game than I am. With a time horizon measured in minutes, hours and days, they are buying the stock today, hoping to flip it to someone else at a higher price next week. Will some of them make money? Sure, and I don't begrudge them their profits. It is just a game I am good at and I won't even try!

   4.  If you believe that the intrinsic value is only $10-$15, should you short the stock?
In the Google shared spreadsheet that I put up in my last post, I notice that many of you, who found the stock to be over valued, plan to sell short the stock. You are far braver than I am! I did not sell short on any of the dot com companies that I found over valued in 1999 and early 2000. In hindsight, could I have made money by doing so? Eventually, yes, but eventually would have been a long time coming on some of those stocks... My problem with selling short has always been that I don’t control my time horizon; the person who has lent me the shares does. After all, even if you are right in your assessments of value, you will not make money until the market corrects its “mistakes” and that may take weeks, months or even years. With hot sectors, where prices are based on perceptions and the herd is “optimistic”, I think it is far more prudent to get out of the way and let the momentum investors have their day in the sun. My day will come!!!!

Are you ready to value Groupon?

After a series of missteps, it looks like the Groupon valuation is ready to hit the market on Friday, with the final pricing to be done on Thursday. To bring you up to date on this unfolding story, the initial talk during the summer was that the company would be valued at $20 billion or more. In the months afterwards, loose talk from management of how customer acquisition costs were not operating expenses and what should be recorded as revenues got in the way of the sales pitch. As management credibility crumbled, the value dropped by the week and it looks like the company will now go public at an estimated value of about $12 billion, though only 5% of the shares will be offered in the initial offering.

As with the Linkedin and Skype valuations that I did earlier this year, I thought it would be useful to do a valuation of Groupon. Before I put my numbers down, though, let me emphasize that I don't have an inside track on this valuation and that these are just my estimates. Rather than contest them, I would suggest that you go into the spreadsheet that I have attached with the valuation and make your own estimates.

Before I do the valuation, though, a little on Groupon’s business model. Groupon works with any business (retail, restaurant, service) allowing it to sell products/services at a discount (usually 50% or higher). Thus, a restaurant that normally would charge $50 for a meal can offer a 50% discount to Groupon customers who would buy it at $25; Groupon and the business then split the $25. With a 50/50 split, Groupon's revenues would then be $12.50. (One of the controversies over the last few month was whether Groupon could claim revenues of $25 (the discounted price of the service) or $12.50 (its share)).

Valuation of Groupon business

Current numbers

To get the current numbers, I started with the S1 that Groupon filed with the SEC in October 2011. This filing has the numbers from 2010 and for the first nine months of 2011 (as well as the first nine months of 2010), which can be used to extract the trailing 12-month numbers for the company.

Trailing 12 month = Last 10K - First 9 months, 2010 + First 9 months, 2011

Revenue growth

Rationale: This was a tough one! Groupon’s revenues increased from $312 million in 2010 to $1,290 million in 2011, an increase of more than 300%. That is going to be impossible to sustain but to make a judgment on growth rates for the future, I had to estimate the potential market. The potential market is large since it encompasses “long term excess capacity” at almost any consumer-oriented businesses. It is worth noting that this excess capacity is high right now, because of the poor state of the economy, but even allowing for halving in excess capacity across the board, there is plenty of room to grow. 

My estimate: 50% compounded revenue growth for next 5 years, declining to a stable growth rate of about 2% in year 10. Groupon’s total revenues in year 10 will be about $25 billion.

Target operating margin and reinvestment

Rationale: Groupon is losing money right now and it is doing so because its marketing and customer acquisition costs are huge. That, by itself, is to be expected, given their focus on increasing the number of subscribers. To estimate what their margins will be, if they succeed with their business model, we have to estimate what these two expenses will look like for a mature Groupon. I tried to estimate these numbers, using the very limited information that is in the financial statements for the last two years.

Since I am assuming high growth in revenues, I thought it prudent that the firm reinvest to generate this growth. I have estimated a dollar in capital invested in the business will generate $2 in incremental revenues. Since the average subscriber in Groupon generates only $11.6 in revenues for the company, continued high growth will require substantial costs in acquiring new customers and holding on to existing ones.
My estimate: The pre-tax operating margin will improve gradually over time to 23% in year 10, with operating margins staying negative through year 6. A legitimate argument against high margins is that this is a business where the competition is active and aggressive, both from established players like LivingSocial and Amazon but from new players. If you buy into this argument, you will use lower, more conservative margins.

Cost of capital

Rationale: Groupon is a small, high growth, high risk business right now. If my revenue growth and margin estimates come to fruition, though, it will become a larger, more profitable and more stable entity over the next 10 years. As that happens, its cost of capital should change.

My estimate: In the initial period, I assumed that Groupon would continue to be all-equity funded and have a cost of equity of firms in the top decile in terms of risk. (With a beta of 2, a riskfree rate of about 2% and an equity risk premium of 6.5%, this works out to a cost of capital of 15%). In its mature state, I dropped this cost of capital to the market-wide average in November 2011 of about 8%.

Steady State

Rationale: At some point in time, Groupon’s growth days will be behind it and it will be a mature company, growing at roughly the same rate as the economy. When that happens, its risk profile and cost structure will resemble that of a mature company. I am also assuming, rather optimistically, that there is a 0% chance that the firm will collapse over the next 10 years.

My estimate: Groupon will become a mature company in 10 years, growing at the same rate as the economy (2.05% in nominal terms). Its cost of capital will drop to 8%. Since it will have built up some significant competitive advantages at that point, I will assume that it can generate a return on capital of 10% in perpetuity after year 10.


Overall valuation
Based on these inputs for compounded revenue growth, target margin, reinvestment and cost of capital, the value that I obtain for the operating assets of the firm is $9.73 billion. Look at the valuation page on the Groupon spreadsheet for the numbers. It is worth noting that the present value of the expected cash flows over the next 10 years is -$5.4 billion. That reflects the expectation that the firm will need to raise fresh equity (and thus dilute your share of value) to fund it's cash flow needs over the next decade.

Valuation of Groupon equity per share

Cash: The cash balance as of September 30, 2011, was $243.9 million. To this, I added the expected proceeds of $478.8 million from the IPO, since the proceeds will be kept in the firm to meeting working capital and investment needs. (If the founders had withdrawn the proceeds to cash out some of their ownership, I would not have done this.)

Debt: Groupon has no conventional interest bearing debt but it does have some leases. Since the magnitude of these leases is small (about $91 million, see page 76 of S1), I have ignored it in both my cost of capital computation and in this stage of the valuation.

Equity options: Groupon has 18.4 million options outstanding, with an average exercise price of $1.11 and an assumed maturity of 5 years. Using the company-provided estimate of volatility of 44% and the expected IPO price of $16 as the stock price, the option value was estimated to be $275.53 million.

Value per share: The value per share can be computed now:

That is based on the presumption that all shares are equal (in voting rights). Since the shares that will be offered to the public are the lesser voting right shares, the value would have to be adjusted down to reflect that. My estimate would be that the class A shares are worth about $14/share and that the class B shares are worth about $15.50/share.

Bottom line

With my estimates for Groupon, the value per share that I get is $14.62, not far off from the low end of the IPO range of $16-$18 per share. Allowing for the difference in voting rights, I would lower the value per share to less than $14. Given the high-ball estimates that we have seen on other social media companies that have gone public in the last few months, this would suggest one of the following:

1. The market for social media companies is growing up and attaching more reasonable values for these companies.
2. The antics of Groupon management have hurt it in the market’s eyes; this is the "mismanaged IPO discount" on value.
3. The stock has been deliberately under priced because only 5% of the shares are being offered in the IPO and the company (and its investment bankers) want to see it pop on day one.

My guess is that it is a combination of all three factors. Groupon has to be credited with building an interesting business model that has a large potential market and is scaleable.  What makes this company interesting is that investing in it is indirectly a bet on the economy. Unlike most young growth companies that are dependent on the economy becoming stronger and more vibrant for higher value, Groupon's value is likely to be higher if the economy stays in the doldrums. After all, what business in a healthy economy wants to sell its products for 70% or 80% of list price?


Would I buy Groupon? No, and not just because it is over priced at $16 to $18 ... Having watched how the company's management has played games with investors for the last few months, I am unwilling to tango with them, especially since they have already telegraphed their unwillingness to accept input from me (by cutting my voting rights essentially to zero). But that is my choice. You can make your own estimates and judge for yourself...


Postscript: A few of you have already noted that I have been optimistic in my assumptions and you are absolutely right: high revenue growth, a healthy target margin, declining cost of capital and no chance of failure. My point is that even with those assumptions, I am falling short of the IPO price. Better still, I would like you to go in and make your own estimates in the Groupon spreadsheet and value the company. To keep tabs on all of our different estimates, I have created a shared Google spreadsheet where you can input estimates and value per share. Should be fun!

Growth (Part 4): Growth and Management Credibility

If you buy a growth company, the bulk of the value that you attach to the company comes from its growth assets. For these growth assets to be valuable, though, not only do you need high growth potential, but the company has to be able to scale up its growth while ensuring that it generates returns that exceed its cost of capital, while delivering this growth. That is tough to do, and it should come as no surprise that most young, growth companies do not make it through these tests. Investors who are able to look at a large group of young, growth companies, and separate those that will survive from those that will not, will see immense payoffs. But can this be done? Those who are firmly in the value investing school argue that this is the impossible dream and that there is too much uncertainty in this process and too many variables that cannot be controlled for this strategy to work. However, if this were true, how do we explain the success of some venture capitalists and growth fund managers? Are they just lucky? I don't think so. In fact, these investors share a characteristic: they are excellent judges of management at companies, since so much of the value at young growth companies comes from trusting managers to make the right choices and to follow through. Here are some of the dimensions on which managers of young, growth companies should be judged:

Does the management have a vision for the future that is grounded in the product/service offered by the company?
As noted in part 1 of this series, the revenues of a young, growth company are bounded by the potential market for its products and services. A management that defines its business too narrowly is limiting its growth potential and by extension, its value. If a management defines its business to broadly, the vision becomes unrealistic and thus not credible. In a sense, management needs to have a vision that is both large and grounded in reality at the same time... Not easy to do, but why is that a surprise? If it were easy, we would all be founder/CEOs of our own businesses!

Is there an operating plan to bring this vision to fruition?
As businesses have found through the ages, a soaring vision and/or a great product is just the first step. Without the grunt work of operations (production, marketing and distribution), commercial success will remain elusive. Since relatively few visionaries have the patience or aptitude for the "nuts and bolts" of operations, this will require having the right people in place and the willingness to delegate power to these people.

Is there clarity on the trade offs that the firm faces for the future?
It is true that the founders of young, growth companies have to sell investors on their potential for success. Many founders, though, view this mission as requiring them to sounds relentlessly optimistic and highlighting only the positives. However, the most persuasive pitches are made by founders who are open about the trade offs involved in success and the risks they face, and are willing to outline how they plan to make their choices. Thus, a CEO who talks about growth potential without mentioning how much she needs to spend to deliver this growth (and how she plans to finance it) and/or the competition she will face is less credible than one that talks about growth and then goes on to discuss how the company plans to deliver this growth and what it will cost.

Is there flexibility built into the plan?
No matter how well thought out a concept may be, young, growth firms will be buffeted by unexpected occurrences, some bad and some good: that is the essence of risk. One key test of managers in young, growth companies is whether they have contingency plans for "bad" events. It may be mark of a brave soul to embark on a mission with no second thoughts or escape hatches, but for young businesses, that could be suicidal. Just as critical a test is how well managers have prepared for success, since success will bring with it different types of tests: new competitors, financing needs and staffing requirements. In fact, you will learn a great deal about a company, when you see it navigate through its first few crises and opportunities.

Are managers willing to trust you (as investors) with news (especially bad news)?
When you invest in a young company, you know that the pathway to success is never  smooth. You recognize the risks involved and price the company accordingly. However, you do need managers of the company to keep you in their confidence, giving you both good news and bad news promptly and without shading the truth. A failure to do so only magnifies your risks. As a cynic, you may wonder why managers would ever do this. I would argue that it is in their own best interests, since so much of the value comes rests on their being credible. A growth company that burns its investors will face immense trouble getting them to believe again...

Are managers willing to trust you (as investors) with the power to challenge them?
I start with a simple presumption. If a company wants my money (as capital), it should give me a say (limited by share of the company) to how it is run. While most CEOs claim to be willing to listen to their stockholders, there is a much more tangible measure of whether they trust their own stockholders in the voting power that they grant them. In an earlier post, I noted the spread of the Google dual voting class model to other technology companies. This graph from the Wall Street Journal is telling:

By giving the founders/insiders 150 voting rights per share, Groupon effectively is issuing common shares with no voting rights. They are telling me that they want my money but not my input on how the company is run. That is their prerogative but I will exercise mine and not play this one sided game.

If you are interested in investing a young, growth company, pick up a filing for a prospective IPO or the annual report for a and review it. Make your best judgment on whether the management sounds credible, truthful and is worth trusting.. and also look for the clues on whether they trust you back. And keep updating your views, based on how the company responds to events.

Blog post series on growth

Growth and Value: Thoughts on Google, Groupon and Green Mountain

Growth (Part 1): The Limits of Growth

Growth (Part 2): Scaling up Growth

Growth (Part 3): The Value of Growth

Growth (Part 4): Growth and Management Credibility

Growth (Part 3): The Value of Growth

Consider a firm that has $ 100 million invested in capital that generated $ 10 million in after-tax income in the most recent year. For this firm to generate more income next year, it has to do one of two things:

1. Manage its existing capital (assets) more efficiently: Thus, if the firm can cut its operating expenses and increase its income to $12 million next period, it will have a growth rate of 20% for the next period. Let's call this efficiency growth.
2. Add to its capital base: If the firm can add another $ 10 million to its capital base and maintain its current return on capital (10%), its income next period will be $ 11 million, with a growth rate of 10% over the prior year. Let's call this "new investment" growth.

While both components feed into observed growth, they are not equal in their effect on value on two dimensions:

• Time: A firm can cut costs and make itself more efficient over time but only to the extent that these inefficiencies exist. Thus, a firm that is badly managed may be able to generate efficiency growth for 3, 4 or maybe even 5 years, but not forever. New investment growth is called sustainable growth because it can be continued for as long as the firm can maintain its policy on reinvestment and the return it generates on its investment. 
• Value: Efficiency growth always creates value, since no investments are needed and earnings and cash flows will go up.  Whether new investment growth creates value revolves around whether the higher earnings created are justified by the additional investment that is required to generate them. Since it costs companies to raise capital (the cost of equity for equity and the cost of debt for borrowed money), the return generated on that capital has to exceed the cost of capital for growth to add value. In the example above, introducing a cost of capital of 10% into the analysis will make the new investment growth "worthless", since what is added in value through the higher growth  will be exactly offset by the higher reinvestment (and lower cash flows) needed to generate that growth. As an exercise, you can try entering different combinations of growth, return on capital and reinvestment and measure the value effect in this spreadsheet.

Looking at any company's past, you can draw conclusions about whether the growth registered in the past was valuable, neutral or value destroying, by comparing the return on capital generated on the growth investments to the cost of capital. The return on capital itself is computed based on operating income and the book value of capital invested:
Return on capital = Operating income (1- tax rate)/ (Book value of equity + Book value of debt - Cash)
This calculation is also in the spreadsheet referenced in the last paragraph. It is the only place in valuation/corporate finance, where we use book value and we do so because we are looking at the profits generated on what was originally invested in existing assets (rather than their updated market values). There are a host of dangers associated with trusting accounting numbers and I have written about them and what to do to compensate in a paper on measuring returns.

So, how well do publicly traded companies do in terms of delivering returns? Which sectors do the best? To answer the first question, I computed the return on capital and cost of capital for all publicly traded companies listed globally in 2007 and 2008 and found the following:

While the crisis in 2008 took at toll on returns, even in 2007, a good year for most companies globally, about a third of all companies in the US and a higher proportion elsewhere generated returns on capital that were less than the cost of capital. While you may quibble with the year and have issues with how I computed cost of capital and return on capital, I think you will agree that value destruction is far more common at companies than we would like to believe and that quality growth (that increases value) is rare. To answer the second question, I compute returns on capital and cost of capital, by sector, for US companies and report them on my website at the start of every year. You can get the most recent update (from the start of 2011) by clicking here.

For those of you who do not want to go through the process of computing return on capital and cost of capital, I have a simpler proxy for measuring the quality of growth. Start by computing the capital invested thus:
Capital invested = Book value of equity + Book value of debt - Cash
Divide the change in operating income over the period by the change in capital invested over the period; the ratio is a measure of the the quality of the growth, with higher ratios representing higher quality. In the table below, I have computed the number for Google going back to 2003:

In the last column, I computed the marginal return on capital in that year by dividing the change in operating income that year by the change in capital. Based on this measure, in 2009 and 2010, Google saw a drop off in its quality of growth, a drop off I would attribute to acquisitions made by the company to keep its growth rate high. Its pre-tax marginal return has dropped to about 20%; in after-tax terms that would be closer to 13 or 14%, a good return on capital, but not a great one.  Investors have had wake up calls in Amazon and Netflix as well in recent days, as the costs of delivering growth have come to the surface. In most growth companies that disappoint, the clues are available in the years before.

Blog post series on growth

Growth and Value: Thoughts on Google, Groupon and Green Mountain

Growth (Part 1): The Limits of Growth

Growth (Part 2): Scaling up Growth

Growth (Part 3): The Value of Growth

Growth (Part 4): Growth and Management Credibility

Growth (Part 2): Scaling up Growth

As companies get larger, it becomes more difficult to sustain high percentage growth rates in revenues for two reasons. The first is that the same percentage growth rate will require larger and larger absolute changes in revenues each period and thus will be more difficult to deliver. The second is that a company's success  will attract the attention of other firms; the resulting competition will act as a damper on growth.

I know! I know! You have your counter examples ready: Apple and Google come to mind. First, note that even these exemplars of success have seen growth rates decline over time. In fact, I posted Google's revenue growth (in dollar and percentage terms) in a prior post and while growth rates remain healthy, they have declined over the last decade. Second, the very fact that you can name these great growth companies is an indication that you are talking about the exceptions rather than the rule. Could the company you are looking at right now be the next exceptional company? Sure, but do you want to value your company to be the exception? I would not, since pricing your company for perfection will open you up to mostly negative surprises in the future.

Metrick and Yasuda, in their book on venture capital, have a sobering study on the persistence (or lack thereof) of growth at high growth companies. They compared the revenue growth rates at companies at the time of their IPOs to the average for the sector to which they belong and then followed up by looking at these growth rates in subsequent years.

Reading the graph, the revenue growth rate of the  "median" IPO company is 15% higher than the revenue growth rate of other companies in the sector one year after the IPO, drops to 8% two years after, to 5% three years after and to the sector growth rate 5 years after. Put succinctly, company-specific growth at the typical high growth company dissipates in about 4 to 5 years. Even the star IPOs (in the 75th percentile) see precipitous drops in the differential growth rate over the five year period.

Given this evidence that growth decelerates quickly at companies, how do we explain valuations where analysts use 50% compounded growth rates for 10 to 15 years or longer? I think the problem lies in the "percentage illusion", where analysts feel that their growth assumption is not changing if they keep the growth rate unchanged. However, delivering a 25% growth rate is far easier in year 1 than the same firm delivering a 25% growth rate in year 9. The best way to introduce some realism in growth rates is to convert the percentage growth rate in revenues into dollar changes in revenues and consider what the company will have to do in terms of operations to deliver that change. When valuing a retail company, for instance, computing that the company will have to open 300 new stores to deliver a 25% growth rate in year 10 (as opposed to 30 in year 1) may quickly lead to a reassessment of that growth rate. I have a very simple spreadsheet that does little more than this: convert percentage growth rates into revenue changes each period. As an exercise, take any young, growth company that you want to value, put in the current revenues and try different compounded revenue growth rates. The power of compounding continues to amaze me!

Blog post series on growth

Growth and Value: Thoughts on Google, Groupon and Green Mountain

Growth (Part 1): The Limits of Growth

Growth (Part 2): Scaling up Growth

Growth (Part 3): The Value of Growth

Growth (Part 4): Growth and Management Credibility

Growth (Part 1): The Limits of Growth

When valuing young, growth companies, a key input into the valuation is the expected growth rate in revenues. For these companies to become valuable, small revenues have to become big revenues (and negative operating margins have to become positive ones...) and revenue growth is the driver of value. It is a tough number to estimate and it is easy to get carried away, especially in hot sectors. In this post, I will look at the information that can be used to put limits on this estimate, reasons why some companies may be able to blow through these limits and the disconnect that often emerges between company level estimates (made by analysts) and sector-wide estimates.

The Limits on Growth
Let's start with the fundamental question. When valuing an individual company with potential for growth, how high can the revenue growth rate be? Put differently, how big can dollar revenues become at a company, assuming that it is successful? As I noted in the Green Mountain Coffee discussion in my last post, there are at least two numbers that need to be used as sanity checks.

• The first is the overall size of the market for the product(s)/services that the company offers. Clearly, the expected revenues for Whole Foods, a company operating in a huge market (groceries) can become much larger than the expected revenues for Green Mountain Coffee, operating in a narrower market. (Whether it will or not remains a judgment call you have to make when valuing the company...)
• The second are the revenues of the largest players in that market. In effect, you are looking for the point at which revenues will plateau in a particular business. Thus, the fact that Folgers, the largest company in the coffee market, made only $2 billion in revenues in 2010 operated as a cautionary note in how much revenues you could project for Green Mountain Coffee. In contrast, Safeway,one of the largest grocery store companies, had revenues of $42 billion in 2010.

If you are valuing a company in a sector that you are unfamiliar with, you should get a sense of the revenues generated by the entire sector and how much revenues the largest company or companies in the sector had. To help, I have put together a spreadsheet that lists aggregate revenues, by business, for companies in the US, as well as the highest revenue company in each one. While my business categorization may be too broad for some of you, it should help provide some perspective on what comprises large revenues. In making these estimates, though, you will have to exercise judgment, which can cause your "limits" to be different from mine (and your valuation to be higher or lower than mine). The first judgment is the potential market for the product or service provided by the company. While that may be easy for Green Mountain, what is the potential market it for Groupon or Google? In the case of Groupon, is it a slice of the retail business (which would be huge) or it is a smaller subset? In the case of Google, is it the online advertising market or the entire advertising market or is its something else altogether? The second is the market share that you see your company gaining, if it makes it through to mature firm status. In other words,  do you see your company becoming one of the largest companies in the business or remaining a smaller player?

The Exceptions
Now, for the follow up. Over history, a few companies have surprised us be growing beyond even the most optimistic assumptions. How did these legendary growth companies bust through the limits? I see three possible sources for these "positive" surprises:

1. Expand product/service offerings: A company can increase its potential market, by altering its product/service mix. Amazon.com, in its early days in the 1990s, was primarily an online book retailer. If it had stayed in that business, the potential market would have been small and Amazon's value would have been constrained. By remaking itself as an online retailer (of pretty much any product), Amazon expanded its potential market (and with it, its value).
2. Expand geographically: While most companies initially target domestic or local markets, the potential market can be increased by expanding geographically. The list of big name companies that have rediscovered growth by going global is long - Coca Cola, McDonald's and Procter and Gamble come to mind.
3. Expand product reach: In perhaps the most interesting scenario, a company can expand the potential market for a product or service through innovations. The secret for Apple's success in the last decade has not only been a stream of winning products - iPod, iPhone and iPad, but each product has expanded what were small markets (music players, smart phones, computer pads) into much larger ones.

Can these surprises be incorporated into conventional valuation? By their very nature, I don't think they can, since they are unexpected at the point of initial analysis. (If you invested in Apple at the time of the iPod introduction, foreseeing the iPhone and iPad, you have a far better crystal ball than I do...) However, these "market expansion possibilities" can be viewed as options, where companies use existing platforms to generate new products and enter new markets, and can be valued as such. Even if you choose not go down the road of using option pricing models, these options will translate into a premium on conventional valuations, albeit one that cannot be easily quantified. You would expect this premium to be greatest in companies that have a proprietary edge (Apple, with its ownership of its operating system, is a perfect example...) and smallest when products can be imitated at low cost. As an investor, I tend not to include these "options to expand" premium in my initial valuations. If I can find a stock that is cheap relative to intrinsic value, the option premium is just icing on the cake.

From micro to macro... It has to add up.. 
One final note on growth limits. I believe that investors (and markets) generally get the macro story right but are not always consistent on the micro story. Put in revenue growth terms, optimistic investors are right that the social media businesses collectively will generate high revenues in the future. However, here is where I think that they make their mistake. First, if you add up the expected revenue numbers (that are implicit in the valuations you see for these companies) of the individual companies that comprise the social media space, the collective revenues will significantly exceed the forecasted revenues for the entire  market. In other words, your collective market share across companies will be well in excess of 100%. Second, I think that investors are under estimating the ease with which new companies can enter these businesses, under cutting margins and profitability. You can have a growing market where companies have trouble making money.
In fact, the dot com boom provides an interesting historical perspective. In hindsight, investors clearly got the macro story right: that consumers would get more and more of their products/services online. It was in the valuation of the individual companies that they made their mistakes, over estimating growth at these companies and under estimating both the ease of entry/exit into the business and the effect of competition on profitability.

Blog post series on growth

Growth and Value: Thoughts on Google, Groupon and Green Mountain

Growth (Part 1): The Limits of Growth

Growth (Part 2): Scaling up Growth

Growth (Part 3): The Value of Growth

Growth (Part 4): Growth and Management Credibility