A Do-it-yourself (DIY) Valuation of Tesla: Of Investment Regrets and Disagreements!

I was hoping to move on from Tesla to my data update posts, but my last post on Tesla drew some attention, in good and bad ways, partly because of its timing. Right after I sold my shares for $640, last week (January 30), the stock took off, climbing to more than $900/share in the matter of days. As always, there were people on both sides of the great Tesla divide commenting on my valuation, with bears accusing me of wearing rose-colored glasses and making unrealistically optimistic assumptions, and bulls pointing to inputs that they felt under estimated the company’s potential. I wish that I had been clearer in my writing that the numbers that I was using did not represent “the” valuation of Tesla but that this was “my” valuation of the company, and that I not only expect disagreement, but I think it is part and parcel of a healthy market. Rather than leave that view as an abstraction, I thought I would revisit the valuation and present it in a different format, one in which you can choose your story for Tesla and estimate the value for yourself.

The Key Levers of Value

In my earlier post, I valued Tesla and presented my valuation in a picture, where I connected the story that I was telling about the company to my estimated value per share of roughly $427 per share:

Download spreadsheet

If you find the numbers off putting or overwhelming, the value is determined by four key levers:

1. The Growth Lever: The revenue growth rate controls how much and how quickly the firm will be able to grow its revenues from autos, software, solar panels and anything else that you believe the company will be selling. Rather than focus on the growth rate, I would suggest looking at the estimated revenues in 2030 (ten years out). In my Tesla story (valuation), I have estimated revenues of $125 billion in 2030, a five-fold increase over the 2019 revenues.
2. The Profitability Lever: The target (pre-tax) operating margin determines how profitable you think the company will be, once its growth days start to scale down. Since these are operating margins, not gross or net margins, they are after all operating expenses (cost of goods sold, SG&A etc.) but before any financial expenses (interest expenses). In keeping with my view that R&D is really a capital expense, I capitalize R&D, which improves Tesla’s profitability, and target an operating margin of 12% by 2025.
3. The Investment Efficiency Lever: To grow, companies have to invest in production capacity and the sales to invested capital drives how efficiently investment is done, with higher sales to capital ratios reflecting more efficiency. With Tesla, I assume that every dollar of investment (in new factories, technology and new R&D) in the first 5 years generates $3 in revenues, as it utilizes excess capacity in the early years, and that this efficiency drops back by a third, as capacity constraints hit.
4. The Risk lever: There are two inputs in this valuation that incorporate risk. The first is the cost of capital that I start the valuation with, a reflection of risk as seen through the eyes of a diversified investor in the company. The second is the likelihood of failure (or distress), where the company has to liquidate assets and lose the additional value that it could have generated as a going concern. With Tesla, I set this cost of capital at 7% and assume that given its marginal profitability and significant debt load, the chance of failure is 10%.

The value per share of $427 comes out of these assumptions and is driving my investment decisions. Since this is my story and valuation, I expect and welcome disagreement on any and all of these inputs. After all, I don’t have a crystal ball to forecast the future or a monopoly on the right estimates

A DIY Valuation of Tesla

In the rest of this post, rather than force my story on your, I would like you to make your choices on the growth, profitability, investment and risk dimensions future for Tesla, and just in case you need some help, I will offer data perspective, on each of those choices. 

The Growth Lever

To make your judgment on how much revenue Tesla will have in a decade, it may help to take a look at the overall auto business. In 2019, the collective revenues of all publicly traded auto companies in the world was about $2.46 trillion and the the compounded average growth rate in those revenues over the last decade has been about 3.5%:

Source data: S&P Capital IQ

Put simply, this is a big market, but the overall market is in slow growth. To provide some perspective on what the bigger auto companies generate in revenues, I have listed the 20 largest auto companies, in terms of revenues in the table below:

Source data: S&P Capital IQ

Tesla does make the list, coming in at the very bottom of the list, and its compounded annual growth rate between 2010 and 2019 stands out, partly the base revenues for the company, in 2010, were tiny. Since one of the Tesla stories told by optimistic is that it is a tech company, It may help in your estimation to see what large tech companies look like, and to make this assessment, I decided to focus on the giants on top of the tech heap in the FAANG stocks, with Microsoft thrown in for full measure:

Note that while the tech companies are substantially more profitable than the auto companies, in terms of margins and dollar operating income, their revenues tend to be more muted, reflecting the pricing of their products and services. Apple, the largest market cap company in the world, had revenues of $ 260 billion in 2019, and Microsoft, the largest software company in the world, by far, had revenues of $129 billion, and both companies lagged Toyota and Volkswagen, on total revenues.

With this background, I think that you have the ammunition you need to make your own revenue judgments for Tesla in a decade, differentiating your story from mine, where revenues in 2030 for Tesla are roughly $125 billion. So, with no further ado, here are your choices (pick one):

Download spreadsheet

Since Tesla’s revenue stream includes not just autos but also software, batteries and solar panels, your story may augment revenues to reflect these, but remember that these streams cannot deliver the same revenue heft as selling cars, though they may be more profitable. In addition, be cautious about growth rates, since it is almost impossible to grasp the compounding effect, without looking at the dollar values. For instance, there are some who take Elon Musk at his word that he plans to grow Tesla at 50%-100% a year; applying a 50% growth rate to Tesla's revenues would give it $470 billion in revenues, which would make it second only to Walmart on a global basis. With 100% growth, Tesla's revenues would be around $4 trillion in 2030, and if you can find a way to get there, good luck to you!

The Profitability Lever

To make your judgment on operating profitability, take a look at both the largest auto company tables and the one for FAANG stocks in the last section. There is not a single large auto company with double digit margins, and across all auto companies listed publicly, the profit picture is even more bleak:

Source: S&P Capital IQ

The picture is brighter for the FAANG stocks, where the aggregate operating margin across all five stocks is 19.87%, well above auto industry averages. That margin, though, is delivered on smaller revenues and with business models where production costs are a smaller fraction of selling prices. The marginal cost of producing an extra unit for Microsoft is close to zero on both its Office and Cloud business, and even for Apple, which derives a large chunk of its revenues from the iPhone, the cost of making the iPhone is about about 40% of the price it charges. 

This information should provide a basis for you to make a choice on a target operating margin for Tesla in the future, keeping in mind that its current operating margin is miniscule and barely positive. 

Download spreadsheet

As you make this choice, it is important that you tie it back to your earlier growth story. While Tesla sales of software/tech will have higher margins, it the auto sales that are responsible for the bulking up of revenues over time. Thus, if your argument is that Tesla will become predominantly a soft services company, you can give it higher margins, but your revenue expectations may have to be reduced. If you buy the argument of some that the costs of manufacturing will continue to drop (by about 15%), as production increases (doubles), you may think you have the basis for exploding margins, but the flaws in this argument should be obvious. First, there has to be a floor on cost savings or Volkswagen, which sells close to 10 million a year right now, should be making cars for close to nothing and generating margins of closer to 100% on the marginal car it sells (and it does not). Second, even if there are revolutionary changes in technology that allow the costs of production to decrease, unless you can show that Tesla and Tesla alone can reap these benefits, you have a business that will see the prices drop, as costs drop. Put simply, if Wright's law applies to all competitors, you and I will be able to buy electric cars at $3000/car and none of the manufacturers will be making sky high margins.

The Investment Efficiency Lever

The investment efficiency lever is one of the trickiest to navigate. Again, the place to start is with automobile companies, and the table below presents the distribution of sales to invested capital across all auto firms, at the start of 2020.

Looking across global auto companies, the median company generates $1.37 in sales for every dollar of capital invested, and at the 75th percentile, the more capital-efficient auto companies generate $2.42 in revenues for every dollar of capital invested. In fact, my estimate of $3 in revenues for every dollar of capital invested reflects an optimistic view of Tesla’s capacity to bring technological innovation to its production processes, and reduce the capital needed to fund those processes. Since Tesla, in 2019, generates $1.32 in revenue for every dollar of capital invested, my estimate is more aspirational than based on observable efficiencies, right now. Tesla bulls will counter with the tech company story, and to help the estimation process, I estimated the sales to invested capital at tech firms generally, just software firms and finally at just the FAANG stocks. None of these groups had sales to invested capital that were higher than my estimate. With that data to provide perspective, it is time to make your own judgment on investment efficiency:

Download spreadsheet

This choice will drive not only how much Tesla will have to reinvest to grow, but the extent to which it will be dependent on external capital for that growth.

The Risk Lever

The first component in the risk lever is the cost of capital, and to provide a sense of what costs of capital look like around the world at the start of 2020, let me start with a cost of capital distribution for all publicly traded companies:

Download spreadsheet

Note that the median cost of capital across all firms globally is 7.58%, and that 50% of all publicly traded firms have costs of capital that fall between 6.27% and 8.71%. It is true that costs of capital vary across different industries, and while you can get the entire list on my website, the median cost of capital for auto firms is 6.94% and for tech firms, it is 8.86%. While I used 7% as my cost of capital, you may disagree and here are your choices:

Download spreadsheet

The other component of risk is failure, where the company faces the risk of having its life truncated, either because it runs out of cash or because of debt payments coming due. While the rise in stock price has reduced its vulnerability for the moment, those who see more losses in the future and continued borrowing to fund investment may attach a higher probability of default than the 10% that I use, whereas those who believe Elon’s claims that Tesla has entered an era of positive earnings and cash flows, may decide that Tesla has no risk of failure any more:

The Valuation

I have created a front end for my Tesla valuation spreadsheet that allows the choices you made to drive the valuation. Running through the different combinations for the four variables, I have too many to list individually, but consider a subset in this table:

Download spreadsheet

Broadly speaking, there are four broad stories that I have valued here:

1. The Big Auto Story: If your story is that Tesla will emerge from its growth period as one of the largest auto companies in the world (revenues of $100- $300 billion in year 10), with top-tier auto company margins (7.42%), investment efficiency (2.42) and cost of capital (6.94%), the value per share ranges from $106/share (with BMW like revenues) to $227/share (with Daimler-like revenues) to $333/share (with VW/Toyota like revenues).
2. The Techy Auto Company Story: An alternate story is that Tesla is an auto/software/services company with tech company characteristics, giving it higher margins (10.25%) and a higher cost of capital (8.86%). With this story, the value per share ranges from $111/share (with BMW like revenues) to $212/share (with Daimler-like revenues) to $298/share (with VW/Toyota like revenues). Put simply, the higher risk nullifies the benefits of higher profitability.
3. The FAANGy Auto Company: In this variant of the tech story, Tesla not only develops a tech twist, but becomes as successful as the most successful tech companies (I use the FAANG stocks + Microsoft).  In this story, the margins approach 18.97% and with a tech cost of capital, the value per share ranges from $459/share (with BMW like revenues) to $855/share (with Daimler-like revenues) to $2,106/share (with VW/Toyota like revenues).
4. The Make-your-best Company: In this variant, I give Tesla the best possible outcomes on each variable, revenues like VW/Toyota, margins like pure software companies (21.24%), a sales to capital ratio that is higher than any of the sector averages (4.00) and a cost of capital of an auto company (6.94%), and arrive at a value per share of $2106.

For some of you, the fact that there is a value here that justifies whatever your Tesla status is right now (long, short or just watching) should not be the end of your analysis. Each of these stories may be possible, but the tests you have to run, and I will prejudge your conclusions, is whether they are plausible. With each story, there are key questions that need answering:

• With the big auto stories, the key question will be whether Tesla can climb to the very top of the heap in terms of revenues, generally reserved for mass market companies, while earning operating margins that are usually reserved for smaller luxury auto companies?
• With the techy auto stories, the key question becomes whether a company that derives the bulk of its revenues from selling cars be profitable and reinvest like a tech company? 
• With the FAANGy stories, the investment question becomes whether you should up front for a company on the expectation that it will be an exceptional company. It very well might make it to the top of the heap, but if it does not, you are set up for disappointment.
• With the MYB story, you are approaching the most dangerous place in valuation, where you pick and choose each assumption, without considering the ones you have already made. Put simply, is it even possible to build a company that generates revenues like Toyota, earns margins like Microsoft and invests more efficiently than any manufacturing company in history has ever done, while still preserving the low cost of capital of an auto company?

Conclusion

In the week since I sold Tesla at $640, the stock has gone on a wild ride, rising above $900 in two trading days. Not surprisingly, quite a few of you have asked me whether I have any regrets about selling too early. You may not believe me, but I don't. I made my decision to buy, based on my story and valuation for Tesla, and my decision to sell, for the same reason, because I am an investor who believes in value, and acting on it. If I abandon that philosophy to play the momentum game, a game that I am not good at and don’t really play well, I may make a bit more money, but at what cost?   On a different note, I have to confess that one reason that I write about Tesla reluctantly is the vitriol that seems to be part of any discussion of the stock. In a world where we face unbridgeable divides on politics, religion and culture, do we need to add investing to the mix?  If you stayed with your Tesla investment, I wish you the best, and I hope that you are holding on for the right reasons, either because you believe that its value is much higher or because you are playing the pricing game. If you sold short and lost money, I get no joy out of your losses and no inclination to do a celebratory dance. For the moment, you may have lost, but having watched this stock for as long as I have, that can change in a minute. As far as I am concerned, Tesla is a fascinating company, but it is just an investment, not a matter of life or death, and definitely not worth losing sleep, and friends, over.

YouTube Video


Spreadsheet

1. A Do-it-Yourself Valuation of Tesla

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Insights on VC Pricing: Lessons from Uber, WeWork and Peloton!

As a confession, I started this post intending to write about Peloton, the next big new offering hitting markets, but I got distracted along the way. As I read the Peloton prospectus, with the descriptions of its business, its measure of total market size and its success at scaling up revenues accompanied by large losses, I had a feeling of déjà vu, since other prospectuses that I had read this year from Lyft, Uber, Slack, Pinterest and, most recently, WeWorks, not only shared many of the same characteristics, but also used much of the same language. I briefly considered the possibility that these companies were using a common prospectus app, where given a bare bones description, a 250-page prospectus would be generated, complete with the requisite buzz words and corporate governance details. Setting aside that cynical thought, I think it is far more likely that these companies are emphasizing those features that allowed them to get to where they are today, and that examining these shared features should give us insight into how venture capitalists price companies, and the dangers of basing what you  pay on VC pricing. To keep my write up from becoming too long (and I don't think I succeeded), I will use only Uber, WeWork and Peloton to illustrate what I see as the commonalities in their investment pitches, when I could have spread my net wider to include all IPOs this year.

1. Unbounded Potential Markets

It is natural that companies, especially early in their lives, puff up their business descriptions and inflate their potential markets, but the companies that have gone public this year seem to have taken it to an art form. Lyft, which went public before Uber, described themselves as a transportation company, a little over-the-top for a car service company, but Uber topped this easily, with their identification as a personal mobility company. WeWork, in its prospectus, steers clear of ever describing itself as being in real estate, framing itself instead as a community company, whatever that means. Peloton, in perhaps the widest stretch of all, calls itself a technology, media, software, product, experience, fitness, design, retail, apparel and logistics company, and names itself Peloton Interactive for emphasis.   In conjunction with these grandiose business descriptions, each of the company's IPOs also lists a total addressable or accessible market (TAM) that it is targeting. While this is a measure, initiated with good sense , it has become a buzzword that means close to nothing for these young companies. In the picture below, I have taken the total market descriptions given in the Uber, WeWork and Peloton prospectuses:

If you believe these companies, Uber's TAM is $5.71 trillion spread across 175 countries, and obtained by adding together all passenger vehicle and public transport spending, WeWork is looking at $3 trillion in office space opportunities and Peloton believes that it can sell its expensive exercise bikes and subscriptions to 45 million people in the US and 67 million globally.  

It is no secret that my initial valuation of Uber used far too cramped a definition of its total market, and Bill Gurley rightly pointed to the potential that these companies have to expand markets, but defining the market as broadly as these companies makes a mockery of the concept. In fact, I will draw on a 3P test that I developed in the context of converting stories to numbers, to put these TAM claims to the test;

With Uber, for instance, my initial estimate of the car service market in June 2014, while defining the magnitude of the car services market then, was a constrained TAM and, in hindsight, it proved far too limited, as Uber's pricing and convenience drew new customers into the market, expanding the market significantly. It is a lesson that I have taken to heart, and I do try to give disruptive companies the benefit of the doubt in estimating TAM, erring more towards the expanded TAM definition.  That said, the total market claims that I see outlined in the prospectuses of the companies that have gone public this year, while perhaps meeting the possible test, fail the plausible and probable tests. That TAM overreach makes the cases for these companies weaker, rather than stronger, by making them less credible.

2. All about Scaling (in dollars and units)

All of the companies that have gone, or are planning to go, public this year are telling scaling up stories, with explosive growth in revenues and talk of acceleration in that growth. On this count, the companies are entitled to crow, since they have grown revenues at unprecedented rates coming into their public offerings. 

In short periods, these companies have grown from nothing to becoming among the largest players in their markets, at least in terms of revenues. While this focus on revenue growth is not surprising, since it is at the heart of their stories, it is revealing that all of the companies spend as much, if not, more time talking about growth in their revenue units (Uber riders, WeWork members and Peloton subscribers). 

In fact, each of these companies, in addition to providing user/subscriber members, also provide other eye-popping numbers on relevant units, Uber on drivers and rides taken, WeWork on cities and locations and Peloton on bikes sold. I understand the allure of user numbers, since the platform that they inhabit can be used to generate more revenues. That is implicitly the message that all these companies are sending, and I did estimate a lifetime value of an Uber rider at close to $500 and I could use the model (described in this paper) to derive values for a WeWork member or a  Peloton subscriber. After all, the most successful user-based companies, such as Facebook and Amazon Prime, have shown how having a large user base can provide a foundation for new products and profits. However, there are companies that focus just on adding users, using badly constructed business models and pricing products/services much too cheaply, hoping to raise prices once the users are acquired. MoviePass is an extreme example of user pursuit gone berserk, but it  had no trouble attracting venture capital money, and I fear that there are far more young user-based companies following the MoviePass script than the Facebook one.

3. Blurry Business Models and Flaky Earnings Measures

Most of the companies that have gone public this year have entered the public markets with large losses, even after you correct for what they spend to acquire new users or subscribers. For some investors, this, by itself, is sufficient to turn away from these companies, but since these are young companies, pursuing ambitious growth targets, neither the negative earnings, nor the negative cash flows, is enough to scare me away. However, there are two characteristics that these companies share that I find off putting:

• Pathways to Profitability: As money losing companies, I had hoped that Uber, WeWork and Peloton would all spend more time talking, in their investor pitches, about their existing business models, current weaknesses in these models and how they planned to reduce their vulnerabilities. With Uber and Lyft, the question of how the companies planned to deal with the transition of drivers from independent contractors to employees should have been dealt with front and center (in their prospectuses), rather than be viewed as a surprise that no one saw coming, a few months later. With WeWork, their vulnerability, stemming from a duration mismatch, begged for a response, and plan, from the company in its prospectus, but none was provided. In fact, Peloton may have done the best job, of the three companies, of positioning themselves on this front, with an (implicit) argument that as subscriptions rise, with higher contribution margins, profits would show up.
• Earnings Adjustments: As has become standard practice across many publicly traded companies, these IPOs do the adjusted EBITDA dance, adding back stock-based compensation and a variety of other expenses. I have made my case against adding back stock-based compensation here and here, but I would state a more general proposition that adding back any expense that will persist as part of regular operations is bad practice. That is why WeWork's attempt to add back most of its operating expenses, arguing that they were community related, to get to community EBITDA did not pass the smell test.

In summary, it is not the losses that these companies made in the most recent year that are the primary concern, it is that there seems to be no tangible plan, other than growth and hand waving on economies of scale, to put these companies into the plus column on profits.

4. Founder Worship and Corporate Dictatorships

Some time in the last two decades, newly public companies and many of their institutional investors seem to have lost faith in the quid quo pro that has characterized public companies over much of their history, where in return for providing capital, public market investors are at least given the semblance of a say in how the company is run, voting at annual meetings for board directors and substantive changes to the corporate charter. The most charitable characterization of the corporate governance arrangement at most newly minted public companies is that they are benevolent dictatorships, with a founder/CEO at the helm, controlling their destiny, and with no threat of loss of power, largely through super-voting right shares. In fact, most of the IPO companies this year have had:

• Shares with different voting classes: With the exception of Uber, every high profile IPO that has hit the market has had multiple classes of shares, with the low-voting right shares being the ones offered to the market in the public offering and the high voting right shares held by insiders and the founder/CEO. It is also revealing that Uber was also one of the few companies in the mix where the founder was not the CEO at the time of the IPO, after the board, pressured by large VC investors, removed Travis Kalanick from atop the company in June 2017, in the aftermath of personal and corporate scandals. 
• Captive boards of directors: I am sure that the directors on the boards of newly public companies are there to represent the interests of  investors in the company and and that many are well qualified, but they seem to do the bidding of the founder/CEO. The WeWork board seems to have been particularly lacking in its oversight of Adam Neumann, especially leading up to the IPO, but it is probably not an outlier.
• Complex ownership and corporate structures: When private companies go public, there is a transition period where shares of one class are being converted to another, some options have forced exercises and there are restricted share offerings that ripen, all of which make it difficult to estimate value per share. It does not help when the company going public takes this confusion and adds to it, as WeWork did, with additional layers of complex organizational structure.

In many of the companies that have gone public this year, it is quite clear that the company's current owners (founder and VCs) view the public equity market as a place to raise capital but not one to defend or debate how their companies should be run. Put simply, if you are public market investor, these companies want your money but they don't want your input. When faced with that choice with Alibaba, I characterized this as Jack Ma charging me five-star hotel prices, when I check in as an investor in his company, but then directing me to stay in the outhouse,  because I was not one of the insiders.

Reverse Engineering the VC Game

Every company that has come down the IPO pipeline this year has been able to raise ample capital from venture capitalists on its journey, with contributions coming from some public investor names (Fidelity and T.Rowe Price, to name just two). The fact that almost every company that went public this year framed its total market as implausibly big, emphasized how quickly it has scaled itself up, both in terms of revenues and users/subscribers, glossed over the flaws and weaknesses in its business model, and had shares with different voting rights suggests to me that this is behavior that was learned,  because venture capitalists encouraged and rewarded it. Bluntly put, the pricing offered by venture capitalists for private companies must place scaling success over sound business models, over-the-top total addressable markets over plausible ones and founder entrenchment over good corporate governance.

In almost every IPO this year, the basis for at least the initial estimate of what the company would get from the market was the pricing at the most recent VC round, about $66 billion for Uber, $47 billion for WeWorks on the Softbank investment and about $4.2 billion at Peloton. The strongest sales pitch that the company and its bankers seem to be making is that venture capitalists are smart people who know a great deal about the company, and that you should be willing to base your pricing on theirs. This is not very persuasive, because, as I noted in this post, VCs price companies, they don't value them, and the pricing ladder, while it can lead price up, up and away, can also bring price down, when the momentum shifts.  

This is not meant to be a broadside against all of venture capital. As with other investor groups, I am sure that there are venture capitalists who are sensible and unwilling to go along with these bad practices. Unfortunately, though, they risk being priced out of this market, as a version of Gresham's law kicks in, where bad players drive out good ones. In fact, since VC pricing takes its cues from public markets, it will interesting to see if the WeWork fiasco works its way through the VC price chain, leading to a repricing of companies that emphasize revenue scaling over all else. 

A Peloton Valuation

Since I started this post intending to value Peloton, I might as sell include my valuation of the company, especially since the company has released an updated prospectus with an estimated offering price of $26 to $30 per share. The company posits that there will 277.76 million shares outstanding (across voting share classes), but it also very clearly states that this does not include the 64.6 million options outstanding.

Business Model and Accessible Market

The Peloton product offerings started with an upscale exercise bike, but has since expanded to include an even more expensive treadmill; the bike currently sells for about $2,250 and the treadmill for more than $4,000. In fact, if that is all that the company sold, it would have been competing in  a constrained fitness product market with other exercise equipment manufacturers (Nautilus, Bowflex, NordicTrack, Life, Precor etc.). The company's innovation is two fold, first focusing on the upper end of the market with a very limited product offering and then offering a monthly subscription to those who bought, where you can take online classes and access other fitness-related services, with a monthly subscription fee of $40/month. In 2018, Peloton expanded its subscription service to non-Peloton fitness product owners, charging about $20 a month, with a membership count of 100,000 in 2018. The growth in the subscription portion of the business can be seen in the graphs below:

The fitness market that Peloton is going after is large, but splintered, currently with gyms, both local and franchised, and fitness product companies all competing for the pie. In 2019, it was estimated that the total market for fitness products was $30 billion in the United States and close to $90 billion globally.  That said, harking back to our discussion of probable and plausible markets, Peloton is trying to draw people into this market who may otherwise have stayed away and getting existing customers to pay more, hoping to expand the market further. 

Valuation Story and Numbers

I am way too cheap to own a Peloton, but my conversations with Peloton owners/subscribers suggests to me that they have created a loyal customer base, perhaps unfairly likened to a cult. They rave about the online classes and how they keep them motivated to exercise, and while I take their praise with a grain of salt, it is quite clear that the company's online presence is not only polished but looks amazing on the high resolution TV screens that are built into their bikes and treadmills. In my story, I assume that the total accessible market will grow as Peloton and other new entrants into the subscription model draw in new customers, and that Peloton's allure will last, allowing it to grow its revenues over time to make it one of the bigger players in the fitness game. In my base case valuation, I see Peloton's subscription model as their ticket for future growth, pushing revenues by year 10 for the company to just above $10 billion, a lofty goal, given that the largest US fitness companies (gyms and equipment makers) have revenues of $2-$3 billion. I also believe that the shift towards subscriptions will continue, allowing for higher margins and lower capital investment than at the typical fitness company. My valuation is pictured below:

Download spreadsheet

My equity value is $6.65 billion, but in computing value per share, I have to consider the overhang of past option issuances at the company; there are 64.6 million options, with an average strike price of $6.71, outstanding in addition to the 277.76 million shares that the company puts forward as its share count. Valuing the options and netting them out yields a value per share of $19.35, about 20% below the low end of the IPO offering. That does bring me closer to the initial offering price than I got with either my Uber or WeWork valuations, though that is damning Peloton with faint praise. The magnitude of options outstanding at Peloton make it an outlier, even among the IPO companies, and I would caution investors to take these options into account, when computing market capitalizations or per share numbers. For instance, this Wall Street Journal report this morning, after the offering price was set at $26-$29/share, used the actual share count of 277.76 million shares to extrapolate to a market capitalization of $8 billion, at the upper end of the pricing range. That is not true. In fact, if you pay $29/share, you are valuing the equity in this company at more $9.5-$10 billion, with the options counted in.

Is there a great deal of uncertainty embedded in this valuation? Of course! While some argue that this is reason enough to either not invest in the company, or to not do a discounted cash flow valuation, I disagree. 

• First, at the right price, you should be willing to expose yourself to uncertainty, and while I would not buy Peloton at $26/share, I certainly would be interested at a price lower than $19.35. 
• Second, the notion that the value of a business is a function of its capacity to generate cash flows is not repealed, just because you have a young, high growth company. If your critique is that my assumptions could be very wrong, I completely agree, but I can still estimate value, facing up to that uncertainty. In fact, that is what I have done in the simulation below:

In terms of base numbers, the simulation does not change my view of Peloton. My median value is $18.30, with the tenth percentile at close to zero and the ninetieth percentile at $38.42, making it still over valued, if it is priced at $26/share. The long tail on the positive end of the distribution implies that I would buy Peloton with a smaller margin of safety than a more mature company, because of the potential of significant upside. (I have a limit buy, at $15/share. Given the offering price of $26-$29, there is little chance that it will execute soon, but I can play the long game).

A Requiem

The flood of companies going public, and their diverse businesses, has made for interesting valuations, but there are also more general lessons to be learned, even for those not interested in investing in these companies. First, our experiences with these IPOs should make it clear that it is the pricing game that dominates how numbers get attached to companies, and that is especially true for IPOs, not just on the offering day, but in the VC rounds leading up to the offering, and in the post-offering trading. Second, to the extent that the pricing game becomes centered on intermediate metrics, say revenue growth or on users or subscribers, it can lead companies astray, as they strive to deliver on those metrics, often at the expense of creating viable business models, and the pricing players (VCs and public investors) can get blindsided when the game changes. As I noted in my long-ago post on Twitter, these companies will face their bar mitzvah moments, when markets shift, often abruptly, from the intermediate users to the end game of profits, and many of these companies will be found wanting.

YouTube

Links

1. Valuation of Peloton (September 16, 2019)

Posts on IPOs this year

1. Lyft: The First Ride Sharing IPO
2. Uber's Coming Out Party: Personal Mobility Pioneer or Car Service on Steroids
3. Meatless Future or Vegan Delusions? The Beyond Meat Valuation
4. Runaway Story or Meltdown in Motion: The Unraveling of the WeWork IPO

Posts on Venture Capital

1. Venture Capital: It is a pricing, not a value, game!