Friday, May 20, 2011

Dual share structure: The Google model spreads

Google rewrote the book for initial public offerings in two ways. One is that they bypassed the traditional investment banking syndicate for an auction (which is a good development) and the other is that they were unapologetic about the fact that they had two classes of shares and that the founders would hold on to the shares with the disproportionately large voting rights. While shares with different voting rights are par for the course in many parts of the world (Latin America, for instance), their use in the United States was limited to a few sectors; publishing and media companies such as the New York Times and the Washington Post have used the structure to allow the founding families to control these companies, with relatively small percentages of the overall equity.

Two factors played a role in containing dual class shares: the first was that, for decades, the New York Stock Exchange barred shares with different voting rights from getting listed on the exchange and the second was the fear of an adverse reaction from investors. Google was unfazed by either concern. It listed on the NASDAQ and institutional investors were so eager to hold the stock that they seemed to overlook the voting share structure (or at least not price it in).

So, what's the big deal with voting rights? Voting rights matter because they allow stockholders to have a say in who runs the company and how it is run. It is true that most stockholders don't use these rights and prefer to vote with their feet, but the voting power does come into use, especially at badly managed companies, where a challenge is mounted on management either from within (activist stockholders) or from without (hostile acquisitions). The argument I have heard from institutional investors for their benign neglect of different voting share classes at Google is that the company is well managed and that control is therefore worth little or nothing. There is a kernel of truth to their statement: the expected value of control (and voting rights) is greater in badly managed companies than in well managed ones. However, if you are an investor for the long term, you have to worry about whether managers who are perceived as good managers today could be perceived otherwise in a few years. (A decade ago, Cisco would have been ranked among the best managed companies in the world. Today, its management is under assault after ten years of bad acquisitions and under performance).

How does this play out in valuation? Once you have valued the aggregate equity in a company, you have to estimate the value of equity per share. When shares all have the same voting & dividend rights, you can divide by the total number of shares outstanding. When they don't, though, you may have to allocate the equity value differently to different share classes. Generally speaking, voting shares should trade at a premium over non-voting shares, but that premium should be larger in poorly managed firms than in well-managed firms. How much larger? I have a paper on the topic that does try to come up with a specific premium for voting shares.

The trigger for this post was the Linkedin valuation that I did yesterday. I valued the equity of the company at approximately $ 2 billion, but I was unforgivably sloppy about getting the per share value. I used the 43.31 million shares that Yahoo! Finance listed as shares outstanding and I should have known better. Checking the prospectus for Linkedin, here is what I see:
* 7.8 million class A shares (all of the shares offered in the IPO are class A shares)
* 86.7 million class B shares (which have ten times the voting rights of class A shares)
Dividing the value of equity by 94.5 million shares yields a value per share of $21.51/share, but even that may be an over estimate. If we assume that the voting shares trade at a premium of 5% over the non-voting shares (the 5% is the average premium for voting over non-voting shares in US companies), the value per share for the non-voting shares drops $ 20.57:
Value per non-voting share = $2,033 million (7.8 + 1.05*86.7) = $20.57
Reading the prospectus, though, things get worse. Linked in notes that it has options outstanding on roughly 17 million shares, with exercise prices ranging from $6 to $23. Needless to say, all those options are deep in-the-money now and while I don't have information on vesting, it behooves us to act as if these options will be exercised. Using an average exercise price of $15, the value per share drops further to about $20.

Bottom line: Getting from value of equity to value per share gets progressively more difficult as you add shares with different voting rights and outstanding options to the mix. 

Thursday, May 19, 2011

Valuing young growth companies: A postscript on Linkedin

So, that was quite an opening for Linkedin.. The stock opened in the mid-80s, almost double the offer price. I know that some of you have used the model that I attached to my last post to value Linkedin on your own and that was exactly my point. None of us has a crystal ball that shows us the future and your estimates are as good as mine.

However, since we are on the topic of young growth companies, here is what I see in the base year numbers for Linkedin, as contrasted with Skype:
a. Linkedin is at an earlier stage in the life cycle that Skype. It revenue growth is more explosive (100% growth last year: Revenues grew from $120 million in 2009 to $243 million in 2010) than Skype's revenue growth in 2010 (20%).
b. Linkedin is already profitable. It reported pre-tax operating income of about $20 million in 2010. In contrast, Skype is still losing money.

Now, here's where the subjective component comes into play in the forecasts:
a. Revenue growth: You may disagree with me on this one but I see a smaller potential market for Linkedin than I do for Skype. While at least in theory, Skype could compete for the much larger wireless telecom market, Linkedin has a narrower focus. To provide perspective, Yahoo's total revenues in 2010 were $ 6 billion and I have a tough time seeing Linkedin generate revenues as large, even ten years from now.
My projection: 50% compounded revenue growth for the next 5 years, scaling down to 3.5% in stable growth. Revenues in 2021 will be about $ 5 billion.

b. Operating margins: I see margins falling somewhere in the middle of the range for companies in this space: Google at the top end and Yahoo towards the bottom. Competition in this space is much fiercer and the barriers to entry seem small.
My projection: Pre-tax operating margin of 15% in 2021, rising from the current margin of 8.23%.

c. Survival: The company has little debt ($2 million), enough cash on the balance sheet ($92 million) with more coming in from the IPO.
My projection: I am going to assume that there is a 100% chance that the firm will survive, though I am not sure how successful it will be.

The valuation, with these inputs, yields a value per share of $47 and I think that that number is at the upper end of the spectrum. So, the original offer price of $43 does not sound unreasonable... As for the current price in the mid-80s, I am glad I don't have it in my portfolio. (Update: It gets worse. There are two classes of shares outstanding and if you incorporate both, the value per share that I estimate drops into the twenties.. I have updated the spreadsheet as well..)

As with the Skype valuation, here is my Linkedin spreadsheet. Make your own best estimates.... and good luck...

Wednesday, May 18, 2011

Is Skype worth $8.5 billion? An exercise in valuing young, growth companies

Last week, Microsoft announced that it would buy Skype for $8.5 billion. The reaction was fast, furious and very predictable. First, there was the search for reasons for the deal and technology mavens listed a few. Second, there was the reaction from investors and analysts, which was generally not very positive. Third, it was noted that Bill Gates, the face of Microsoft for so long, was strongly in favor of the deal (thus providing cover for Steve Ballmer).

Ultimately, though, the discussion of the deal was lacking in one key respect: Is Skype worth $8.5 billion to Microsoft? A few of the analysts noted that the price paid was roughly ten times Skype's revenues in 2010, an undoubtedly rich price, but by itself proving nothing. After all, if you had been able to buy into Google at ten times revenues in 2003, you would be rich now. A great deal of attention was paid to whether Skype was the right company for Microsoft to buy and the strategic/synergistic fit of the two companies.  It has always been my contention with acquisitions that it is not the strategic fit or synergistic stories that make the difference between a good deal and a bad one, but whether you buy a company at the right price. Put in more direct terms, buying a company that is a poor strategic fit at a low price is vastly preferable to buying a company that fits like a glove at the wrong price.

So, let's get back to valuation basics. What is the value of Skype? The question is rendered more difficult to answer because Skype is a private business and we know little about the insides of the financial statements. It is widely reported, though, that Skype had operating losses of $7 million on revenues of $ 860 million in 2010. Taking those numbers as a base, I tried to value Skype, making what I thought were very optimistic assumptions:
- Continued revenue growth of 20% (which was what they had last year) for the next 5 years and a gradual tapering down of growth to 3% in ten years.
- A surge in pre-tax operating margins to 30% over the next ten years; this margin is at the very upper end of the technology spectrum (where companies like Google reside).
- A decline in the cost of capital from 12% now (reflecting the uncertainty associated with young, growth businesses) to a cost of capital of a mature company in ten years
With those assumptions, I estimated a value of $ 3.8 billion for Skype. It is entirely possible, however, that I am wrong on my key assumptions - revenue growth rates and target margins. In fact, changing those base inputs gives me the following table:

Is it possible that Skype is worth more than $8.5 billion? Sure, if you can deliver revenue growth higher than 35% and a pre-tax operating margin of 30%. Is it probable? I don't think so.

The value drivers for Skype - revenue growth, target pre-tax operating margin and survival - are generally the constants you worry about with young, growth companies. In the Little Book of Valuation, in the chapter on valuing young growth companies, I argue that these value drivers also should give you indicators of value plays in young, growth companies. Thus, when investing in a young, growth company (Tesla Motors, Linkedin, Facebook etc.), here are some of the indicators you would look at:
a. Size of potential market: Since high revenue growth is easier to pull off, when the market is large, you want to invest in companies that are entering large potential markets rather than narrower, specialized markets.
b. Competitive barriers: For margins to improve over time, you need space to grow and protection from intense competition. This can come from patents (for a young, biotechnology company), a technological advantage, a brand name or the sheer ineptitude of established competitors.
c. Survival skills: Survival boils down to two types of resources: financial and personnel. Young, growth companies with access to capital, little or no debt and large cash balances have a much better chance of surviving than companies without those characteristics. In addition, companies that are dependent on a key person or personnel with no back-up are much more at risk than companies that have a good bench.
So, take your favorite young, growth company for a qualitative spin around this track and see if it passes the tests.

You can download the spreadsheet that I used for the valuation of Skype and play with the revenue growth and operating margin numbers. You can also use the spreadsheet to value any other young, growth company. As you do these valuations, recognize that uncertainty is the name of the game and that you are making estimates for the future. You will be wrong, but so will everyone else, and at least you are trying.

Tuesday, May 3, 2011

The Little Book of Valuation

I don't like to use this blog as a publicity front, but my newest book just hit the bookstores. It is part of Wiley's Little Book series and it is titled "The Little Book of Valuation". My motivation for writing the book was simple. While I have three books on valuation - Investment Valuation, Damodaran on Valuation and The Dark Side of Valuation", they are all written for valuation practitioners. They are dense, not easy to read and require work to put into practice. I have always wanted to write a book for investors, many of seem to believe that valuation is far too complex for them to handle. That view makes them easy prey for valuation experts and analysts, who use a mixture of bombast, buzz words and numbers to intimidate.

As I started to write the book, I set myself two objectives. The first was to not short change readers, by assuming that they were not skilled enough to do valuation. I think valuation is fundamentally simple but that we choose to layer complexities on it. So, I wanted to provide investors with the tools to do a full fledged valuation of any type of company - young or old, mature or growth, cyclical or commodity. The second was to cut through the details of valuation models and identify the value drivers for any company. Even in the most complex valuation models, the value of a stock is determined by one or two key inputs. Knowing what those inputs are and how to estimate them is 90% of valuation. More importantly, if you know the drivers of value, you can create investment strategies that are built around those drivers, even if you choose not to do a full-fledged valuation. If you get a chance to take a look at the book, you will notice that the chapters are structured around different types of companies and that each chapter is centered around identifying the "value drivers" for that type of company and the "value plays" that emerge from these drivers.

Since I did write the book, I cannot give you an unbiased assessment of how well I did in accomplishing my objectives. I hope you do get a chance to browse through the book and I really hope that you not only find it useful but an easy read. If you are interested in getting the book, here is the Amazon link:
To support the book, I have put together spreadsheets and other material in a website for the book. You can visit it by clicking here.