Thursday, October 10, 2013

Twitter IPO: Why a good trade be a bad investment (or vice versa)?

In my last post, I valued Twitter at about $10 billion. I made a ton of assumptions to get to that value and I argued that changing those assumptions could give you a different value. In the last few days, I am sure that you have seen many stories about Twitter’s post-IPO worth, with numbers as high as $25 billion being offered as estimates. In fact, the gambling markets have already opened on the offering price and the players in that market seem to be siding with the higher numbers. As an investor on the side lines, I don't blame you if are probably completely confused about these competing and divergent numbers but there is a way in which you can start making sense of the process.

To set the table, I am going to go back to a theme that I have harped on before in my posts and that you are probably tired of hearing. When talking about investing, we often talk about “value” and “price” as if they are interchangeable, but they are not. In fact, in my post two weeks on Twitter, prior to its financial filings, I tried to price the company (as opposed to valuing it) and came up with a wide range of numbers, depending on my scaling metric (users, revenues etc.). That confusion between value and price lies at the heart of why it is impossible to have a conversation of how much a stock is worth, when the parties to the conversation come from different camps. So, to decipher the difference, I decided to go back to basics and tried to lay out the differences between the pricing game and the valuing game, as I see them.

The Pricing Game versus The Value Game

The Pricing Game
The Value Game
Underlying philosophy
The price is the only real number that you can act on. No one knows what the value of an asset is and estimating it is of little use.
Every asset has a fair or true value. You can estimate that value, albeit with error, and price has to converge on value (eventually).
To play the game
You try to guess which direction the price will move in the next period(s) and trade ahead of the movement. To win the game, you have to be right more often than wrong about direction and to exit before the winds shift.
You try to estimate the value of an asset, and if it is under(over) value, you buy (sell) the asset. To win the game, you have to be right about value (for the most part) and the market price has to move to that value
Key drivers
Price is determined by demand & supply, which in turn are affected by mood and momentum.
Value is determined by cash flows, growth and risk.
Information effect
Incremental information (news, stories, rumors) that shifts the mood will move the price, even if it has no real consequences for long term value.
Only information that alter cash flows, growth and risk in a material way can affect value.
Tools of the game
1.     Technical indicators
2.     Price charts
3.     Multiples & Comparables
4.     Investor psychology
1.     Ratio analysis 
2.     DCF valuation
3.     Excess Return models 
Time horizon
Can be very short term (minutes) to mildly short term (weeks, months).
Long term
Key skill
Be able to gauge market mood/momentum shifts earlier than the rest of the market.
Be able to “value” assets, given uncertainty.
Key personality traits
1.     Market amnesia
2.     Quick acting
3.     Gambling instincts
1.     Faith in “value”
2.     Patience
3.     Immunity from peer pressure
Biggest Danger(s)
Momentum shifts can occur quickly, wiping out months of profits in a few hours.
The price may not converge on value, even if your value is “right”.
Capacity to move prices (with lots of money and lots of followers).
Can provide the catalyst that can move price to value.
Most Delusional Player
A trader who thinks he is trading based on value.
A value investor who thinks he can reason with markets.

If you play the pricing game, you are a trader, and if you play the value game, you are an investor. I am not passing judgment, when I make this statement, because unlike some value investors, I don’t view traders as shallow or somehow less critical to the functioning of markets than investors. After all, a trader who makes a million dollar profit can buy just as much with that money as an investor who makes the same profit.  Ultimately, which avatar (price or value) best fits you will depend not only on your level of comfort with the tools (Are you better at reading charts or valuing companies?) but also on your personal traits. In my experience, naturally impatient people who are easily swayed by peer pressure almost never succeed as value players and excessively cerebral folks who have to weigh everything in the balance, before they make decisions, are incapable of being traders. 

This black and white view of the world may strike as some of you as extreme. After all, why not allow for shades of grey, traders who are interested in value and investors who think about the pricing process? While I will dive into this netherworld in future posts, I will not in this one, for two reasons. The first is that many of self-proclaimed hybrid investors are nothing of that sort. There are traders who pay just lip service to value, while using it back their momentum plays and investors who claim to respect markets but only until they start moving in the wrong direction. The second is that there is a danger in playing on unfamiliar turf: traders who delude themselves into believing that they understand value can undercut their own effectiveness just as much as investors who think that they can get in and  out of markets, when it suits them. A healthy market needs both traders and investors, in the right balance. A market that has no traders and all investors will have no liquidity and one that has all traders and no investors will have no center of gravity. Ironically, each group needs the other for sustenance. Trading and momentum cause prices to move away from value, creating the bargains that investors try to exploit, and in the process of exploiting them, they create the corrections and momentum shifts that other traders exploit. 
This, of course, brings me back full circle back to Twitter. If you are a trader, ignore almost everything that I said in my valuation post but do pay some attention to my pricing post. Even if you believe that my valuation assessment of $10 billion is a reasonable one, that should not stop you from buying the stock, even if it is priced at $20 billion, if you think that the market mood will take it higher. If you are an investor on the other hand, considering adding Twitter to your investment, it matters little how much hype or momentum underlies the stock. If your assessment of value is close to mine, it is not a good investment for you at a price higher than that value. As you listen to the debates about Twitter's worth in the next few weeks, recognize that if the argument is between an investor and a trader, they are talking past each other. Stealing from the title of the bestseller from a few years ago, if traders are from Venus, investors are from Mars, and if one is talking about price and the other about value, they may both be right, even with vastly different numbers. Twitter can be a good trade and a bad investment at exactly the same time!


Anonymous said...

You are spot on when talking about trading and investing as two different things.

However, I consider trading as speculation. Nothing wrong about that, though, as it is not illegal.

While there is a basis (and this could be right or wrong) for investing (valuation), trading is based on momentum and charts, which I don't think is a fair basis.

Momentum and charting direction is like gauging the moods of the market.

I am not saying this because my psyche is investing. How can one guess what the next person is going to do just by checking charts?

A trader's footing is on the wrong side - wants to make money quickly outwitting the next person - however much traders are required for investors to make money as you correctly put it, they are only guessing without a basis.

The quicker and the luckier make money. History backs when we say that a very low percentage of traders do well regularly.

But, heck! we want them and we want them badly to set the (wrong) prices.

Aswath Damodaran said...

If trading worked at making me money, I would trade. It does not work for me. If it does work for someone else, no matter what skill set they bring to the table, I won't begrudge them their profits.

Tusheet Saraf said...

Vey well explained post myself a day trader in US cash markets an completely understand how irrational pricing sometimes give me best of trades and profits

Anonymous said...

Price is what you see, but value is what you feel.
We see price but it is an illusion. We do not see value but it is real.

Anonymous said...

It would seem that understanding the conditions necessary to cause price and value to converge are nearly as important as the skills necessary to establish value.

Aswath Damodaran said...

As to the last comment, exactly. To be a successful value investor, you have to understand how the price game works. The notion that if you buy an under valued company, the returns will come is dangerous and sometimes delusional.

Game1980 said...

As r2 increases, I think investors are affected more about macro events than before, making the mood of the market a greater factor even if one is an investor.

drctypea said...

hi professor

excellent post as always.

it appears you use a discount rate of 11.2 pct to value twitter at 10b. so, even if twitter is priced at say 12b does that really mean that it should be avoided (if a value investor)? cant it simply mean the expected return is not 11 pct but is some lower return (you can backsolve for this in your spreadsheet). say that return is 9 pct - if that is still attractive to a value investor isnt that a
reason to buy twitter even though technically "over valued"? (this assumes of course the cashflow estimates and all else
are the same - just the expected return/discount rate is lower).

Unknown said...
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Unknown said...

I am not a trader, but in order to "win the game", you don't need to be right more often than wrong. You just need to make more money when you are right than you lose when you are wrong.

Aswath Damodaran said...

You are right. You can actually win very infrequently, but if you win big, you can still walk away a winner.

Anonymous said...

Your terminal value webcast documents are not downloadable. Shows error.


Twitter is a terrible stock pick. Most new public offerings make terrible investments. These stocks are usually brought to market at a huge premium to the real value of the enterprise.

Aswath Damodaran said...

I just tried the webcast and it seems to work. If you are using Google Chrome, switch to a different browser. It may be browser related.

nishant said...

Professor i remember you valuation piece on facebook too... At that time too you were of the opinion that the stock would be over priced. what is your view now? And valuing such stocks twitter and FB can be shooting in the dark as the opportunity market can be very different to what one thinks now as internet as a medium for the next generations could be very different in usage terms than what it is now! And then maybe FB and twitter might be the biggest things around...

Anonymous said...

Thanks, it is working now. I could download the webcast and other documents.

fidodido said...


Can you throw some color on how you decide on the sales to capital ratio? this is one number in the assumptions that constantly stumps me.

Leon said...

Professor, would you therefore say 'trading' is synonymous to 'technical analysis,' whereas 'investing' is 'fundamental analysis?'

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Unknown said...
This comment has been removed by the author.
Jeetendra Singh said...

Great Post! Twitter market cap is now nearing $ 10 billion, perhaps price converging to value and it did not take much long, just 2.5 years. Watch out as it may overshoot as now it would be driven by mood. For an investor to be successful, i feel patience and conviction in one's decisions are two key behaviours traits. In addition, if you are lazy in markets, it may further help as you won't get distracted when prices frequently dance up and down.