Apple: Thoughts on bias, value, excess cash and dividends

Apple is hitting or is close to hitting two significant landmarks. Its market cap exceeded $ 500 billion yesterday (2/29) and its cash balance is at $ 100 billion. The twin news stories seem to have set investors, analysts and journalists on a feeding frenzy.  I think it is ironic that a company doing as well as Apple is right now, in terms of operations and stock price performance, is receiving this much unsolicited advice (split the stock, pay a dividend, buy back stock, do an acquisition, borrow money) on how it should fix itself. As we look at these prescriptions being offered to one of the healthiest companies in the market today, we should heed the Hippocratic oath, which is to do no harm.

I am biased
I have to start with a confession. It is impossible for me to be objective in my analysis of Apple and it is not just because the stock has done so well for me over the last decade. My first computer was a Mac 128K that I bought in the early 1980s and I have bought every Apple model since (even the ill fated Lisa and the not-so-great Powerbook Duo). Why should you care? One reason that the debate on Apple is so heated is that people have strong preconceptions about the company and those preconceptions drive their suggestions about what the company should do. As you read the rest of this assessment, you should recognize that my substantial positive bias towards Apple does affect my analysis. To structure my thoughts about what Apple should do, here is how I see the choices for the company:

Is Apple's cash hurting its stockholders?
The first and most critical question is whether Apple's cash holdings are doing harm to the stockholders. Let's dispense with the reasons that don't hold up to scrutiny:
1. Cash earns a low rate of return: It is true that Apple's cash balance earns a very low rate of return. It is, after all, invested in treasury bills, commercial paper and other investments that are liquid and close to risk less. It earns less than 1% but that is all it should earn, given the nature of the investments made. Put differently, cash is a neutral investment that neither helps nor hurts investors.
2. If that cash were paid out, investors in Apple could generate higher returns elsewhere: Perhaps, but only by investing in higher risk investments. Investors in Apple, who were concerned that Apple was investing so much in low return, low risk cash could have eliminated the problem, by buying the stock on margin. Borrowing roughly 20% of the stock price to buy Apple stock would have neutralized the cash balance effect and would have been a vastly more profitable strategy over the last decade than taking the cash out of Apple and searching for alternative investments.

So, what could be defensible reasons for worrying about cash? Here are a few:
1. The "low leverage" discount: The tax laws are tilted towards debt and Apple by accumulating $ 100 billion in cash, with no debt, is not utilizing debt's tax benefits.  In fact, the gargantuan cash balance gets in the way of even talking about the use of debt at the company; after all, why would you even consider borrowing at 2 or 3% interest rates, when you have that cash balance on hand?
My assessment: By my computation, Apple's optimal debt ratio is about 40-50% (download the spreadsheet to check it out yourself) and its current net debt ratio is -20% (using the cash balance of $ 100 billion as negative net debt). Given the risk of the business that Apple operates in, I would not let the debt ratio go higher than 20-30%. Their cost of capital currently is about 9.5% and it could drop to about 9% with the use of debt. That would translate into a value increase of $20-25 billion for the company, not insignificant but that is about a 5% value increase.

2. The naiveté discount: It is undeniable that legions of investors still use the short hand of a PE ratio, often estimated by looking at an industry average, applied to current or forward earnings to get a measure of whether a stock is cheap or expensive. In the process, they can significantly under value companies that have disproportionate amounts of cash. To see why, assume that the average trailing PE ratio for electronics/computer companies is 14 and that the average company in the sector has no cash. If you apply that PE ratio to Apple's net income or earnings per share, you are in effect applying it not only to the earnings from its operating assets (where it is merited) but also to its earnings from its cash balance (where you should be using a much higher PE ratio). Thus, you will come up with too low a value for Apple.
My assessment: I would be more inclined to go along with this argument if Apple's stock price had dropped 50% over the last few years. I find it difficult to believe that after the run up that you have seen in Apple's stock price, stockholders are under valuing the company. The counter, of course, is that the PE ratio for Apple, at 16 times trailing earnings or 13-14 times forward earnings, seems low and may reflect a naiveté discount.

3. The stupidity discount: In a post on Apple more than a year ago, I referred to what I called the stupidity discount, where stockholders discount cash in the hands of some companies because they worry about what the company might do with the cash. If investors are worried that the managers of a company will find a way to waste the cash (by taking bad investments, i.e., investments that earn less than the risk adjusted rate of return they should make), they will discount the cash.
My assessment: My personal assessment in January 2011 was that, as an Apple stockholder (which I have been for more than a decade), the company had earned my trust and that I was okay with them holding my cash. I am open to a reassessment and I think any disagreement boil down to the answer to the following question: Do you believe that Apple's success and strategy over the last decade was attributable to Steve Jobs or Apple's management? If you believe it was Steve Jobs, you are now in uncharted territory, with Tim Cook, a capable man no doubt, but capable men (and women) have wasted cash at other high profile companies. If you believe that Apple's management team was responsible for its success over the period, your argument is that nothing has really changed and that you see no need to change your views on the cash.


What if there is no discount?
If the cash balance is not hurting Apple's stockholders right now, the pressure to return the cash immediately is relieved. However, you still have a follow up question to answer. Does Apple see a possibility that it could find productive uses for the cash? While Jobs never broached that question and preserved plausible deniability, I am afraid that Tim Cook has conceded on this issue, when he said last week that Apple had more "cash than we need to run the company".

Bottom line: I am inclined to believe that Apple is not being punished right now for holding on to $100 billion in cash. However, I am more concerned than I was a year ago. While I had the conviction that Steve Jobs could never be pressured (by investors, portfolio managers or investment banks) to do something he did not want to do, I am not as sure about Tim Cook. Having seen how quickly markets can turn on high flying companies (Microsoft and Intel in the early part of the last decade come to mind), in the face of disappointment or a misstep, I am worried that Apple may be one misstep away from a discount being attached to cash. Given that even Tim Cook does not think that Apple needs this big a cash balance, I think that it is time that we ask the follow up question: what should Apple do with all this cash?

What should Apple do with the cash?
In the broadest sense, Apple can either invest the cash or return it to stockholders and it seems that even Apple does not believe in the first option. Investing the cash internally in more products and projects sounds like a great idea, given Apple's track record over the last decade. In 2011, for instance, the company generated a return on equity of 42% on its investments; if you net the cash out of book equity, the return on equity exceeds 100%. If Apple could invest the $100 billion in cash at 42%, that cash would be worth $350 billion, but put those dreams on hold, because it is not going to happen. First, that high return on equity can be traced back to the blockbuster products that Apple introduced in the last decade, the iPod, the iPhone and the iPad, and those are not easily replicable. Second, there are other constraints (people, technology, marketing, distribution, production) that essentially limit the number of internal projects that Apple can take.

How about a few acquisitions? I am sure that there are willing and eager bankers who will find target companies for Apple. The sorry history of value destruction that has historically accompanied acquisitions of large publicly traded companies leads me to believe that this path of action will provide justification for those who attached a stupidity discount in the first place. So, to those who are counseling Apple to buy Yahoo!, Pandora, Linkedin or go bigger, please go away!

If Apple cannot find internal projects of this magnitude and the odds are against value creation from acquisitions, the company has to return the cash to investors and there are three ways it can do this: initiate a regular dividend and tweak it over time, pay a large special dividend or buy back stock. In my view, there are four factors that come into play in making this choice:

1. Urgency: A company with a large cash balance that has been targeted by an acquirer or activist investors has to return cash quickly, cutting out the regular dividend option. Apple's large market cap protects it from hostile takeovers and its stock price performance and profitability give it immunity from activist investors.
2. Stockholder composition: When a company that has never paid a regular dividend initiates dividend payments, it attracts new investors, i.e., investors who need or like dividends, into the company. While this "investor expansion" has been used as an argument for regular dividends, I think it should actually be an argument against regular dividends. While some of my best friends are "dividend investors", I think that they are temperamentally and financially a bad fit for Apple, a immensely profitable company that also operates in a shifting, risky landscape. If Apple initiates a dividend, the demands for increases in those dividends in future years will come and the company will find itself locked into a dividend policy that it may or may not be able to afford. 
3. Tax effects (for investors): The choice between dividends and stock buybacks is also affected by how investors in the company will be taxed as a result of the transaction. While both dividends and capital gains are still taxed at the same rate, that will change on January 1, 2013, when the tax rate on dividends reverts back to the ordinary tax rate (which could be 40% or higher). If Apple drags its feet into 2013, the choice becomes a simple one: buy back stock.
4. Valuation of stock: Finally, there is the question of whether the stock in the company is under or over valued. A company, whose stock is over valued, should pay a special dividend since buying back  shares at the inflated price hurts the stockholders who remain after the buyback. While I am normally skeptical of the capacity of management to make judgments about the "fair" value of the stock, I decided to take my best shot at valuing Apple using an intrinsic valuation model. Using what I thought were reasonable assumptions (8% revenue growth for 5 years and a 30% target margin, both significantly lower than the numbers from recent years), I estimated a value of $716 $710 per share for Apple. You can download the spreadsheet that I used to make your own judgment. Once you have made your own estimates, please enter them in this shared Google spreadsheet. A buyback at the current price would provide a double whammy: a reduction in a "too large" cash balance and a buyback at a price lower than value. (Update: As many of you have rightly pointed out, a significant portion of the cash is trapped overseas and Apple will have to pay the differential tax rate (between the US marginal tax rate and the foreign tax rate already paid) when the cash is repatriated. I have added the trapped cash input into the excel spreadsheet and factored in the additional taxes.)

Closing thoughts
Apple should announce a substantial buy back, but it should use it do so on its terms. First, the buyback should leave Apple with enough of a cash balance (my guess is about $15-$20 billion) to invest in new businesses of products, should they open up. For the moment, I would avoid the debt route, even though Apple has debt capacity. Second, Apple should follow the Berkshire Hathaway rule book and set a cap on the buyback price. While Berkshire Hathaway's cap is set in terms of book value (less than 110% of book value), Apple should set its maximum as a function of earnings or cash flows (say, 16 times earnings). Third, Tim Cook should stop talking about whether Apple has too much cash and get back to business. Make the iPad 3 a success and lets see an iTV, an iAirline, a iUniversity and an iAutomobile (think of any product you use now that is badly designed or a  business that is badly run and think of how much better Apple could do...). Apple did not get to be the largest market cap company in the world by finessing its capital structure or optimizing dividend policy. It did so by taking great investments.

Facebook: Playing the "IPO pop" game?

In my last post on Facebook, I provided my estimate of value (about $ 70 billion) and concluded that I would not be a buyer of Facebook shares even if the company was valued at close to $ 70 billion. A few of you have taken me to task for leaving what you see as easy profits on the table, noting that if I were able to get Facebook shares at the offering price, that I would be guaranteed (or close to guaranteed) a substantial profit. More generally, there is the perception that investing in IPOs at the offering price (and making money on the offering day pop) is a low-risk, high return strategy that can be used to augment your portfolio returns. Like most "sure" things in investing, this one comes with implicit assumptions and costs and is definitely not "sure". Here is my list of caveats for those considering the "Facebook IPO Pop" strategy.

1. You have to be able to get the shares at the offering price
Let's say that when the Facebook IPO does get "priced", you bid to buy shares at the offering price. One of two things will happen: you will either get your requested number of shares or you will not, and ironically, it is the former that should worry you. If you are right in your basic hypothesis, i.e., that IPOs are under priced, the demand for the shares at the offering price will exceed the supply and the investment bankers managing the IPO will have to ration the shares. If the process is fair, you should get only a proportion of the shares you asked for, with the proportion getting smaller as the shares get more under priced. If the process is fixed and the investment banks give first dibs to their preferred customers, the proportion you get, if you are not one of the preferred customers, will be even lower. Thus, the only scenario you should dread if you are not a preferred customer is one where you get your entire allotment filled, because that is an indication that the shares are over priced.

This allotment process has always been the achilles heel of strategies that try to invest across all IPO offerings. You may bid for $100,000 worth of shares of every IPO for the next year, but you will end up with a portfolio that has too little invested in the most under priced IPOs (since you will get far fewer shares than you requested in these) and too much in the most over priced IPOs (since you will get all of the shares you asked for with these).

2. The stock has to pop on the offering date
Once you have been allotted the shares at the offering price, you have to hope for a stock price pop on the offering date. You do have history on your side. Looking across all IPOs, there is evidence of an offering day increase in stock prices. The figure below graphs out the average "under pricing" across all IPOs, by year, for US stocks:

Note, though, that this return presupposes that you can invest an equal amount in each IPO, under priced or not, but it is still impressive. Over the entire 50 year time period, there have been only four years (1962, 1973-1975) where the average returns were negative, and there are periods, such as the late 1990s, where the average return is close to 100% (doubling of price on the offering date). That is good news for the "Facebook IPO Pop" strategy.

Before you get too excited, though, note that the under pricing is greatest with the smallest offerings, as evidenced in the graph below:

Given the size of the Facebook offering (even 5% of $100 billion makes this a big offering), this graph should lead you to lower your expectations of the price pop on the offering date.

There is also evidence that this under pricing is by design. The IPO pricing cookbook at most investment banks includes a "take 15% off the value" ingredient in every pricing recipe, since the positive news stories that accompany the pop are viewed as a sales pitch for future stock issues. The under pricing also is consistent with the incentives for investment banks, who generally guarantee the offering price to the issuers, and thus have fare more to lose by over pricing than from under pricing.

This IPO under pricing has been the source of angst for some, who feel that the under pricing is unfair to the founders/owners of the company going public, since they are leaving money on the table, by offering their shares at a discounted price. That argument, though, becomes less persuasive, when you recognize that only a small portion of the outstanding shares is generally offered on the offering date. The discounted price on these shares operates the same way a loss leader operates in a retail store: it is designed to whet your appetite and get you to buy more. You hope that those who buy these shares (and feel good about the profits they make) will be back in six months or a year to buy more shares in the company. So, if you are feeling sorry for poor Mark Zuckerberg on the offering date, don't worry! There are plenty more shares in Facebook that will be hitting the market in future years.

From an investor's perspective, what can go wrong? Note that the average is across all IPOs (and is skewed by the smallest IPOs) and that a subset of IPOs see a drop in price on the offering date. These are of course the IPOs where you got all of the shares you asked for. If you are not a preferred customer, your odds of making money on IPOs decrease. Even the preferred customers are offered a mixed bag. Not only does their preference stem from the large amounts that they pay the investment banks for other services rendered, but they are expected to be "good" investors. In other words, if they flip the stock soon after the offering, it may endanger their preferred status on future IPOs. More on that in the next section!

3. You have to time your exit well
Assume now that the first two pieces of the puzzle have fallen into place. You have been allotted shares in the Facebook IPO and the stock has popped 15% on the offering date. Should you sell now or should you wait? That eternal  question has particular resonance with IPOs, because the gains on the offering date can be fleeting. Remember that Groupon's 20% jump on the offering date is now all gone!

Studies that track the post-offering performance of IPOs suggest that they do are not good investments in the aftermath. In the figure below, we compare the returns in the first five years after an initial public offering, with the returns on non-IPO stocks.

The returns on IPOs lag the returns on other stocks in the market and do so much more in the first few years after the offering. Thus, if buying at the offering price requires you to hold the stock for a year or two (which may be required of you as a preferred customer), you may not be getting a great deal.

In fact, my valuation of Facebook is predicated on the assumption that you may want to hold Facebook for more than a day in your portfolio. If you do, once the buzz fades and the IPO paparazzi leave, the company will be judged increasingly by how it performs relative to expectations. If price and value are on a collision course, value always wins out.

4. You are playing a sector and momentum game, even if you don't want to...
If you bid for shares in the Facebook IPO offering, I do believe that the odds may be in your favor for winning the game, if you define winning as getting the shares at the offering price and flipping them very quickly after the IPO. Much as I am tempted to join you, I am afraid I will sit out that game and not because of any noble impulses (such as wanting to be a long term investor or not speculating).

The IPO game is a subset of the momentum game, on which I have posted before. It is a game that produces big winners but momentum always turns, and when it does, it creates big losers. To see the link, note that IPOs go through hot and cold phases, with years in which you have hundreds of IPOs and years in which you have a few dozen.

In addition, also note that IPOs in any given year tend to be concentrated in a few sectors and those sectors generally have momentum on their side (dot com stocks in the 1990s, social media companies today). Thus, the success of IPOs in a sector is closely tied to whether the sector maintains it "hot" status.

One worrisome aspect of IPOs is that they may operate as canaries in the coal mine in signaling momentum shifts; the loss of enthusiasm for dot com IPOs (and the withdrawals of some) coincided with the epic collapse of the sector that year. The momentum driving social media companies will end one day and it may very well be the day that Facebook goes public. "Unlikely", you say, and I agree, but the tough part of being a lemming is that you never know where the cliff is coming. Of course, you may be able to sense momentum change much better than I, in which case you should be able to play the game successfully.

Bottom line
A strategy of investing in IPOs at the offering price looks much better on paper than it works in practice. All of the academic studies that show the average underpricing are implicitly based upon the assumption that you can create an equally weighted portfolio of all IPOs, when in fact, a non-discriminating investor will end up  will be with too much invested in all of the worst IPOs.

The strategy can be made to work by an investor who uses analysis (valuation or information) to invest only in IPOs that are most likely to be under priced and follows through with timely selling to capture profits after the offering. Even for that investor, it is a supplementary strategy since there will extended periods where there are no or very few IPOs in the market.

So, if you are bidding for those Facebook shares, good luck. I hope you get only a fraction of the shares you ask for (see part 1 for why), that the stock price pops on the offering date, that you get out before the you-know-what hits the fan. and that you are not the unfortunate soul who helps ring in the end of the social media circus.

The IPO of the decade? My valuation of Facebook

The Facebook IPO gets closer and I don’t think I can put off this valuation much longer. While we don’t have an offering price yet, the preliminary estimates are that the company will be valued somewhere between $75 billion and $100 billion. As with my Skype, Linkedin and Groupon valuations, I will present my assumptions and valuation of Facebook, with the admission that I have no crystal ball and know that your estimates will be very different from mine. So, with that disclaimer out of the way, here are my valuation assumptions for Facebook.

1. Where Facebook stands right now: I started with the Facebook S-1 filing which contains their financials from last year. The pdf version is available here, with my highlights and annotations (just ignore my snarky comments... I cannot help them). Looking at the most recent year's numbers, here is what I see:
(a) Revenues in 2011 were $3,711 million, up  88% from revenues of $1,974 million in 2010, which, in turn, were up  150% from revenue of $777 million in 2009.
(b) The firm's pre-tax operating income increased from $1,032 million in 2010 to $1,756 million in 2011. The firm's net income increased from $ 606 million in 2010 to $ 1 billion in 2011, though a third of that net income was set aside for participating securities (convertible preferred and restricted stock units... More on that later...). Incidentally, Facebook paid 41% of its taxable income as taxes in 2011.
(c) The company is primarily equity funded and its book value of equity at the end of 2011 was $5,228 million; the only debt on the books was $398 million in capital leases. They did have operating lease commitments, which when capitalized yielded a value of $776 million. The total debt is therefor $1,174 million.

2. Future revenues: Facebook is on a "high growth" path, with revenues growing by 150% in 2010 and another 88% in 2011, but as even that sample of two observations suggests, the big question is how that growth rate will hold up as the firm becomes larger. I estimate a compounded revenue growth rate of 40% for the next five years and a scaling down of that growth rate to the nominal growth rate in the economy (set equal to the risk free rate of 2.01%)  by the end of ten years. While both assumptions may strike you as conservative, I am effectively assuming that Facebook will follow a revenue growth path close to Google's over the next 8 years, as evidenced in the chart below, where I compare Google's actual revenues in the 8 years since their IPO with Facebook's forecasted revenues for the next 8 years:

Since advertising revenues are the drivers of both firms' growth engines, and they may very well be competing for the same advertising dollars, I think a comparison of their competitive advantages is in order. Facebook's primary advantage is that they can use what they know about their users (which is a lot... scary thought!) to offer focused advertising. Google's advantage is that it has a more direct and easy business model, since its revenues come from user clicks. In contrast, Facebook has to be careful about making its focused advertising too obvious, since some users will find this creepy. Google has added other products to its mix, with the Android as the most prominent example, and Facebook also has potential avenues for expansion.

3. Operating margin: Facebook has a phenomenal pre-tax operating profit margin in excess of 45%. To provide a contrast, Google's operating margin is currently about 31% and has seldom exceeded 35%. However, Facebook's margins will come under pressure as they actively seek out more revenues and I am assuming that the pre-tax margin will decrease to 35% over the next decade. Even with this assumption, I am estimating operating income for Facebook will exceed Google's by a wide margin over the 8 years following the IPO:

4. Reinvestment: In one of a series of posts on growth, I argued that growth does not come free (or even cheap). That is true for even a company with the pedigree of Facebook. There is some information in the financial statements about reinvestment: the company had net capital expenditures of $ 283 million, an acquisition that cost $24 million and an increase in capital leases of about $ 480 million. To estimate reinvestment in future years, I assumed that the firm would be able to generate about $1.5 million in revenues for every million in additional capital investment. At this stage, it is impossible to tell what form the reinvestment may take, but looking at Google over the last few years should provide clues; the company has moved increasingly to using acquisitions to augment growth. Lest you feel that I am being too conservative, I am estimating that Facebook will generate a return on its capital of about 32% in year 10, up from just over 26% now.

5. Risk and cost of capital: Facebook is a company that is funded almost entirely with equity and while it is a young, growth company, it does have a business model that is working and delivering substantial profits. While we can start from the bottom and work up to a cost of capital, using parameters estimated for Facebook, I will employ a far simpler approach. Looking across the costs of capital of all US companies at the start of 2012 (you can find this on my website), I estimate a cost of capital of 11.42% for advertising companies. I will assume that Facebook will face a similar cost of capital to start. The median cost of capital for US companies is roughly 8% and as Facebook grows and matures, I do adjust the cost of capital down to 8%.

6. Cash and Debt: The assumptions above are sufficient to estimate the value of the operating assets. Discounting the cash flows back at the cost of capital (with changes over time) results in a value of $71,240 million. To get to equity value, I subtract out the outstanding debt ($1,174 million) and add the current cash balance ($1,512 million). While I would normally augment the cash balance with any cash proceeds from the IPO, Facebook is open about the fact (See S1, page 7) that the proceeds will be going to Mark Zuckerberg to cover tax expenses from option exercise and will not be coming to the firm.

Value of equity = $71,240 + $1,512 - $1,174 = $71,578 million

Based on my estimates, the values being bandied around ($75 billion- $ 100 billion) are not unreasonable. As with my Groupon valuation, I ran a simulation,making assumptions about distributions for my key assumptions (revenue growth, operating margin, cost of capital and reinvestment). The results are summarized below:

Note that the median value of $ 70 billion is close to the base case estimate (as it should) but there is a 10% chance that the value could be greater than $ 117 billion and a 10% chance of a value of $ 43 billion or less.

7. Value per share: At some stage in this IPO process, Facebook's investment bankers will have to arrive at a value per share (offered) and you and I will have to decide on whether to buy or not. That could be messy because Facebook has multiple claims on equity, starting with:

a. Equity options: There are 138.54 million options outstanding, from earlier year compensation schemes, with an average maturity of about 2 years and an exercise price of $0.75. My estimate of the value of these options collectively, net of the tax benefits that I see Facebook getting from the exercise, is $3,782 million. I will net this value out against the equity value to get to a value in the shares:

Value in shares = $71,578 million - $3,782 million = $67,795 million

b. Restricted Stock Units: In the last few years, Facebook (like many other tech companies) has shifted to granting restricted stock units. These are regular shares but the holders who receive have to first stay long enough with the company (vest) to lay claim to them and often face restrictions on trading. The liquidity restrictions, in particular, should make these shares less valuable than regular shares. There are 380.719 millions class B shares, in restricted stock units, that will eventually become regular shares and I will add them to current shards outstanding.

c. Class A and Class B shares: After the IPO, there will be 117.097 million Class A shares (with one voting right per share) and 1758.902 million Class B shares (with ten voting rights per share). Other things remaining equal, the latter should trade at a premium on the former, though I don't think that the expected value of control in this company is significant.

If I take the equity value, net of the value of options, and divide by the total number of class A, class B and RSU shares outstanding, the value per share that I get is $29.05. Allowing for a slight discount (3-5%) on the non-voting shares, I would anticipate that the class A shares in the IPO will have a value of about $28 (assuming that my share count is right... I will wait to get a firmer update as we get closer to the offering, before I close in on a per share value). You can access the excel spreadsheet with the numbers by clicking here. If you don't like my inputs or assumptions, don't stew about them. Go in and change them and see what you get as the aggregate value of equity in Facebook. If you can post it in the Google spreadsheet that I have created for this purpose, even better... Let's see if we can get a consensus value for the company.

If you are investing in Facebook, give credit to the company for being upfront and honest about where the power rests in this company. On page 20 of the filing, you will find this "Mr. Zuckerberg has the ability to control the outcome of matters submitted to our stockholders for approval, including the election of directors and any merger, consolidation, or sale of all or substantially all of our assets. In addition,  Mr. Zuckerberg has the ability to control the management and affairs of our company as a result of his position as our CEO  and his ability to control the election of our directors. Additionally, in the event that Mr. Zuckerberg controls our company at  the time of his death, control may be transferred to a person or entity that he designates as his successor." A little later on page 31, you will find this "We have elected to take advantage of the “controlled company” exemption to the corporate governance rules for publicly listed companies. Because we qualify as a “controlled company” under the corporate governance rules for publicly-listed companies, we are not required to have a majority of our board of directors be independent, nor are we required to have a compensation committee or an independent nominating function." Let's be clear about this: this is Mark Zuckerberg's company and you and I are just providing him with capital.

For those of you who are familiar with my valuations of Linkedin and Groupon, you will note that I am more positive about Facebook than those companies. Part of that can be attributed to Facebook being further along in developing a business model that works and delivers profits. Another reason, though, is that Facebook has a real chance at being the next “winner take all” company. What am I talking about? In conventional businesses, a company that gets a large portion of the market is subject to competitive assaults that cap the market share and reduce profitability over time. In some parts of the technology business, controlling a large share of a market seems to give the winner the capacity to take over the whole market. Consider three big winners from the last 30 years. Microsoft started off in the “office suites’ competing with many players in the word processing, spreadsheet and presentation program businesses, but at some point, its dominance drove the competition out. To a lesser extent, Amazon’s dominance of online retailing and Google’s ownership of online advertising (so far) reflect similar “winner take all” phenomena. I am not suggesting that Facebook has a lock on social media advertising, but it has a chance to get a big chunk of it, and if it does, the value that I estimated will be too low. Note that the simulation does yield values of $120 billion or higher for the company, if the stars align.

Would I buy Facebook stock, if its equity were valued at $75 billion? No, and not because I believe that the price is outlandish, but for two other reasons.

• The first is that the price reflects the expectation that Facebook will become a phenomenal success. Anything less than superlative will be viewed as a failure.
• The second is that what Facebook is brazen about the fact that they don't see any need for input from stockholders. In effect, they want my money but don't want me to have any say in how the company is run. This does not jell with the notion that stockholders are part owners of the companies that they owned stock in. You may be comfortable with Zuckerberg as CEO for life but I am not. I am sure that I am in the minority on this one, but different strokes for different folks....

In closing, Facebook has immense promise as a company and it is being priced on the premise that the promise will be delivered. Could it be worth $ 100 billion? Sure, but you are fighting the odds as an investor. Social media companies today collectively and Facebook in particular resemble stores with tremendous foot traffic (850 million users in the case of Facebook) but with nothing on the shelves. You are buying access to the foot traffic and hoping that you can get something on the shelves that they will stop and look at and buy. Given that social media is still in its infancy, we really don't know whether this promise will pan out, and that remains the basis for the uncertainty, and why short cuts that are based on value per member (a metric that I see with social media companies all the time) are fraught with danger.

Options and Taxes: Is a "Facebook" tax next?

Facebook is in the news and I will do my usual pre-IPO valuation and posting in a few days on the company but I want to focus in on an interesting story in this morning's New York Times about option exercise and taxation (at both the individual and corporate levels).

The story itself focuses on two tax issues. The first is that Mark Zuckerberg is planning to exercise about $ 5 billion of options ahead of the offering, resulting in a tax bill of roughly $ 2 billion for him, about $1.5 billion in federal taxes and $ 500 million in California taxes.  The second is that Facebook will be claiming a tax deduction of roughly the same value, which will shelter them from taxes this year and allow them to claim tax refunds of about $ 500 million from prior years. All of this has some in Congress in full "indignation" mode, with Senator Carl Levin saying "“When profitable corporations can use the stock option tax deduction to pay zero corporate income taxes for years on end, average taxpayers are forced to pick up the tax burden,” he said. “It isn’t right, and we can’t afford it.” Before we embark on another tax policy change predicated on a sample of one (Facebook), it is worth examining the broader question of how employee options get taxed, especially at the corporate level.

At the moment, if you are a company that grants options to its employees, the accounting laws require you to value those options as options (rather than at exercise value) and expense them when you grant them (though you can amortize these expenses over a period of time). Thus, what you see reported as operating or net income for a company today is after employee options have been expensed. This, of course, is a sharp reversal of accounting policy prior to 2006, when firms had to show only the exercise value of the options at the time of the grant. Since at the time of the grant, employee options were usually at the money (strike price = stock price), this effectively meant that option grants had no effect on earnings when they were granted. However, if and when the options were exercised, companies were required to show the difference between the stock price and the strike price as an expense. 

To illustrate the difference, assume that you grant 100 million options with a strike price of $10, when the stock price is also $ 10, in 2008. Let's also assume that the options get exercised 2 years later when the stock price is $ 40. With pre-2006 accounting, you would not have shown an option expense in 2008 but you would have shown an expense of $ 3 billion [$40 - $10) (100)] in 2010. In the post-2006 time period, the company would have had to show an option expense in 2008, with the expense computed by valuing the options at the time. (For instance, an at-the-money option with five years to expiration on a stock with a price of $ 10 and a standard deviation of 40% would have a value of $3.36. Carrying this through, the company would have to record an expense of $336 million in 2008 and revisit this expense in subsequent years, as stock prices go up or down.  If you want to, you can try your hand at valuing options with the attached spreadsheet).
[Update: I have been taken to task by the accountants among my readers for being simplistic (and wrong) on the accounting rules, since they are far more complex than what I have described in this example. I confess to the crime but I feel no remorse. I think that I am being truer to the underlying accounting principle of matching expenses up to revenues than the current accounting rules claim to be. My point is that accounting has moved grudgingly to accept the fact that options have to be expensed when they are granted and not when they are exercised, though the accounting obsessions with smoothing and back filling finds their way into the rules. In fact, more on that in my next post]

So, what does this have to do with today's story? While the accounting treatment of options changed in 2006, the tax treatment did not. In effect, the tax authorities still use the pre-2006 convention, not allowing companies to expense options when they are granted but only when they are exercised. This creates a disconnect between accounting earnings and tax earnings, which can make valuation more difficult. But is it a loophole? Seems like it, if you only consider Facebook, which will save a billion dollars in taxes because its options will be exercised at a time when its stock price is sky high. But let's add to this sample of one. Take a company like Cisco, which has granted hundreds of millions of options over the last decade. Since the stock has stagnated over the period, many of these options are now under water and will either end up un-exercised or exercised for far less than the value at the time of the grant. If Cisco had been able to deduct these options at the time they were granted (at option value), they would have saved hundreds of millions of dollars, which they may now will lose forever, if these options remain under water. In the aggregate, with the current tax treatment of options, the government collects less in taxes from Facebook and more in taxes from Cisco.  

Do I think that the tax rules on options should be changed? Perhaps, but it is not because the tax law is unfair or because I think it creates a loophole. As I see it, here are the three choices:

1. Continue with the existing policy of taxing options when they are exercised. The net effect is that the most successful companies (at least in terms of creating market value) will get bigger tax deductions from option expensing than the least successful companies.
2. Change tax law to match accounting law and allow companies to expense options in the year that they grant them. It will smooth out tax collections, level the playing field across companies and create more consistency. But here is the follow up question that gives me a little pause:  Should employees who receive the options then have to show them as income in the year that they receive them? If you are being consistent, the answer is yes, but where will they come up with the cash to pay the taxes? After all, employee options are not liquid and the employee while wealthy (in terms of options) may be cash poor.
3. If you follow Senator Levin's logic that this is a loophole, and you try to craft legislation, I am not sure where it leads you. Should we ban the expensing of options by companies? I would accept that, if you stop taxing employees who receive these options. (If that had been in place this year, Facebook would have to pay about a billion more in taxes but the government would be collecting two billions less in taxes from Zuckerberg...)

As someone interested in valuation, I have wrestled with options and their effect on value for a while. I think that options are mishandled in many valuations, with flawed arguments (Options are non cash expenses...) and perilous short cuts (treasury stock and fully diluted value approaches) overwhelming common sense. In fact, I wrote a paper on the topic that you can download by clicking here. 

Moneyball and Investing: Data, Information and my 2012 Update

I loved Moneyball, both the book, by Michael Lewis, and movie starring Brad Pitt, because they bring together two things I love: baseball and numbers. At the risk of shortchanging the book, the central story in the book is a simple one. For most of baseball’s hundred plus years of existence, insiders (baseball managers, scouts and experts) have used stories and narratives to keep themselves above the riff raff (which is where you and I as fans belong). Thus, scouts claimed to have special skills (based on their long history of having done this before) to find potential superstars in high schools and the minor leagues, and managers justified their personnel decisions and game day choices with gut feeling and baseball instincts. Billy Beane, the general manager of the Oakland As, a storied but budget-constrained franchise, upended the game by shunting hoary tradition and putting his faith in the numbers.

I think that financial markets and baseball share a great deal in common. Equity research analysts are our baseball scouts, asking us to trust their story telling skills when picking stocks. Executives at companies are our baseball managers, flaunting their industry experience and asking us to trust their gut feeling and instincts, when it comes to big decisions. Like Billy Beane, I trust the numbers far more than either analyst stories or managerial instincts, and it is for that reason that I started gathering raw data on individual companies about two decades ago and computing industry averages for a few key inputs into investments: risk, return and growth. Initially, it was a limited exercise, where I looked at only US companies and  a handful of statistics. I put those numbers online, not anticipating many downloads, but was pleasantly surprised at how many people seemed to find the data useful (I won’t flatter myself. The fact that it was free did help…)

Each year my coverage has expanded, driven partially by external demand and mostly by easier access to raw data. Starting in 2003, I went global and a year or two later started providing data on the individual companies as well. So, here is where the long windup is leading. I have just finished the January 2012 update to my data. You can get to it by going to the updated data page on my website:
http://www.stern.nyu.edu/~adamodar/New_Home_Page/data.html
My sample includes all (a) publicly traded firms, (b) listed on any global exchange and (c) have data on the data sources that I use (Value Line for US companies, Capital IQ and Bloomberg for non-US companies). In January 2012, there were 41,803 companies in my overall dataset.

 I have computed industry averages for about 35 variables, covering a wide range of inputs:
a. Risk measures and hurdle rates: Betas and standard deviations, as well as costs of equity and capital, by sector.
b. Profitability measures: Profit margins (net and operating), tax rates and returns on equity and capital.
c. Growth measures/ estimates: Historical growth rates in revenues and earnings, as well as forecasted growth rates (where available)
d. Financial leverage (debt) measures: Book value and market value debt to equity and debt to capital ratios.
e. Dividend policy measures: Dividend yields and payout ratios, as well as cash statistics (cash as a percent of firm value).
f. Equity multiples: Price earnings ratios (current, trailing, forward), PEG ratios, Price to Book ratios and Price to Sales ratios.
g. Enterprise value multiples: Enterprise value to EBIT, EBITDA, revenues and invested capital.
I generally stay away from macro economic data but I do report equity risk premiums (historical and implied) over time and marginal tax rates across countries.

You are welcome to use whatever data you want from this site, but please keep in mind the following caveats:
1. Data yields estimates, not facts: In these days of easy data access and superb tools for analysis, it is easy to be lulled into believing that you are looking at facts, when you are really looking at estimates (and very noisy ones at that). Every number that is on my site, from the historical equity risk premium to the average PE ratio for chemical companies is  an estimate (and adding more decimal points to my numbers will not make them more precise).
2. Data has to be measured: That is again stating the obvious, but implicit in this statement are two points. The first is that someone (an accountant, a data service, me) is doing the measurement and imposing his or her judgment on the measured value. The second is that there can be error in measurement. Thus, with my data, you can be assured that there are errors and mistakes in the final numbers. While I can blame some of these mistakes on the data services that I get my raw data from, many are mine. So, if you find a mistake or even something that looks like a mistake, please let me know and I promise you two things. First, I will not be defensive about it and will take a look at the issue you have raised. Second, if I do find myself in error, I will fix the error as soon as I can. (With a staff of one (me), this data service can get stretched sometimes… So, please have some patience).
3. Data for post-mortems versus data for predictions: As I see it, data can be used in two ways. The first is to generate post-mortems (about past performance) and the other is make forecasts for the future. Given my focus on corporate finance and valuation, I am more interested in the latter than the former. Thus, my data definitions are more attuned to forecasting than to after-the-fact analysis. Just to provide an example, the cost of capital that I am interested in computing for a company is the cost of capital that I can use for the next five years, not the one for the last three years. 

4. Data anchoring: Whether we like it or not, our instinct when confronted with a number, and asked to decide whether it is high or low, is to compare it what we consider reasonable numbers (at least in our minds). Thus, if I came to you with a stock with a PE of 10, your determination of whether the stock is cheap or expensive will depend largely on what you think the average PE is across all stocks and what comprises a high or low PE and all too often, in the absence of updated and comprehensive data, these are guesses.  It is for this reason that analysts and investors create rules of thumb: a EV/EBITDA of less than six is cheap, a PEG ratio less than one is cheap or a stock that trades at less than book value is cheap. But who comes up with these rules of thumb? And do they work? The only way to answer these questions is to look at the data across all companies and make your own judgments.

There is one final point generally about data that I have to make, and it relates back to Moneyball. Much as I agree with Billy Beane on the importance of data, I think that his mistake was focusing far too much on the data. The data should be the starting point for your assessments, but not the ending point. Stories do matter, if they can be backed up by the data, or to draw implications from it. The secret to great investing is a happy marriage between plausible investment stories and numbers, with the recognition that even the best sounding stories have to be abandoned at some point, if the numbers don’t back them up. So, explore the data and make it your own!!

My small challenge to the "university" business model

I am not a great fan of the university business model as a delivery mechanism for learning. The model can be traced back to the middle ages and is built around physical location and arbitrary requirements for graduation (that have less to do with learning and more to do with maximizing university revenues and faculty comfort). I know! I know! I am a beneficiary of the system and I gain from the low teaching loads and a tenure system that is indefensible. With four children, I am also a consumer of the same system and I am flabbergasted at how little accountability is built into it. How many classes have you taken (or your children taken) where you should have received your money back because of the quality of the learning experience? How often have you been able to get your money back?

For hundreds of years, we (as consumers) have had no choice. Universities have operated with little competition and substantial collusion. There is no other way that you can explain how little variation there is in tuition fees across US universities and the rise in these fees over time. Outside the US, the fees may be subsidized by governments, but the quality of the learning experience is often worse, with the rationale being that if you paid little or nothing for your education, you should eat whatever crumbs fall of the table in you direction. But I think that the game is changing, as technology increasingly undercuts the barriers to entry to this business. I am not just talking about online universities (which, for the most part, have gone for the low hanging fruit) or the experiments in online learning from MIT, Stanford and other universities. These are evolutionary changes that build on the university system and don't challenge it. I am talking about a whole group of young companies that have made their presence felt by offering new tools for delivering class content and learning. I am convinced that the education market is going to be upended in the next decade and that the new model is going to do to universities what Amazon has done to brick and mortar retailers.

To back up my point, I am running an experiment this semester with the classes that I am teaching at the Stern School of Business: Corporate Finance, a first-year MBA class, and Valuation, an elective. I have taught these classes for more than 25 years now and have tried to make the material and the lectures available to the rest of the world, but I have never formally tracked those taking these classes online. In fact, if you were not an MBA student in the class, taking the class online would have required you to forage through my website for materials and keep track of what's going on. And I would have no idea that you even were taking the class... So, I want to change that..

Last semester, I used a company called Coursekit to package and organize my class and was impressed with their clean look and responsiveness to my requests. This semester, which starts in a few days, I have created a coursekit page for each class that is focused on just online students. I will use this page to deliver content (lecture notes, handouts and assignments that those who are in my physical class get), webcasts of lectures (though not in real time, but the links should show up about an hour after the actual class ends ) and even the exams (you can take them and grade them yourself). The site also has a social media component, where you can start or join discussion topics, which I hope will provide the element of interaction that is missing when you do an online course. When you do get to the home page for Coursekit, you will notice my mugshot in the entry way. I promise you that I have zero financial interest in the company but I really want to see it succeed, because I think the education business needs to be shaken up.

The first session for both classes is on Monday, January 30. If you want to take these classes online, here is what you need to do:
a. Corporate finance class
What is it? This is my "big picture" class about how financial principles govern how a business should be run. It looks at everything that a business does, through the lens of finance, and classifies them into investment, financing and dividend decisions.
Who can use it? I am biased but I think that everyone can use a corporate finance class: entrepreneurs starting new businesses, managers at established businesses and investors valuing these businesses.
How do you join? Go to the site (http://coursekit.com/finance). Enter RWHZYG as your code and you can then register for the class. Once you are registered, you will automatically be put into this page, every time you enter the site.

b. Valuation

What is it? This is a valuation class and it is about valuing any type of business: private or public, large or small and across markets. My focus is on providing the tools that will allow you to create your solution to valuation challenges, since new ones keep popping up.

Who can use it? While investors interested in valuing companies may be the obvious target, I teach the class more generally to be useful (I hope) to managers running the businesses and those who are just curious about value.

How do you join? Go to the site (http://coursekit.com/app#course/b40.3331.damodaran). Enter EH7WZN as your code and you can then register for the class. Once you are registered, you will automatically be put into this page, every time you enter the site.

Just to be clear, my first obligation is to the students in my MBA classes and I will not stint or compromise on that obligation, but I view delivering a great learning experience to those taking the class online as a close second. Note also that you will not get any credit from NYU for taking this class. While I will give you the grading templates to grade your own exams and evaluate your own assignments, I will not be able to give you direct feedback on your work. But then again, the price (at zero) is set right. So, these classes definitely come with a money back guarantee. In fact, the more the merrier... So, pass the message in this post on to any friends who may be interested. See you in cyber space on Monday.

Snowmen and Shovels: Investing Lessons?

I live near New York and woke up this morning to our first snowstorm of the winter (we had a freak one in the fall but no snow in November and December). As I looked out of my window, I heard two sounds. The first was of small children squealing in delight, as they tromped through the snow and started building snowmen and throwing snowballs. The second was the grating sound of snow shovels being used by their (mostly morose) parents to clear the snow from their driveways. Three things came to mind. The first was the oddity of the same phenomenon (a snow storm) evoking such different reactions from two different groups. The other was the irony  that the parents were one day (long ago in the past) happy to see the snow and today's  happy children will one day grow up and be wielding their own snow shovels. The third is that a week from now when it warms up, the snowmen will melt away, and the unshoveled driveways will look just as good as the shoveled ones.

I am sure that there are some deep life lessons in this phenomenon but I am not a philosopher. I do see some investing and valuation lessons in snowmen and shovels. After all, you can divide the world of active investors into two broad camps: growth investors and value investors. Consider the extremes in each camp. Extreme growth investors (you know the ones.. they go for momentum, love IPOs and are dazzled by high growth) remind me of the happy children, looking at snow and seeing snowmen, whereas extreme value investors (and you also know these ones.. they love net net investing and read Ben Graham's Security Analysis for inspiration)  more closely resemble the snow-shoveling parents. Each group views the other with disdain. Extreme value investors consider growth investors to be dilettantes, unserious and unwilling to grow up, who see the world through rose-colored lens. Extreme growth investors view value investors as boring, stuck-in-the-mud pessimists, who see only the dark side of things.

So, which side is right? I think both sides are right and both are wrong. While each side sees a portion of reality, each side is also missing a piece of the real world. While the value investing group is right in its view that most growth companies will not make it through the challenges of the real world, the growth investing group is also right in its view that some of these growth companies will be the big winners of the future. By staying dogmatic, both groups open themselves to significant investing/valuation mistakes. A growth investor who closes his eyes to the very real likelihood that a growth company will not survive will over value that company. By the same token, a value investor who insists on incorporating only the worst case scenarios, estimates cash flows “conservatively” and then applies a huge “margin of safety” before investing will never find growth companies to be bargains.

The key to investing, as in so much in life, is to maintain balance, recognizing that dreams sometimes come true, while keeping your feet grounded in reality. Put in valuation terms, the key to valuing a company well is to estimate what will happen (to earnings and cash flows) not only in good scenarios (let’s call these the snowman scenarios) but also in bad ones (the shovel scenarios).  It is a challenge I face whenever I do valuation. As I value a company, I have to constantly stop and look at the assumptions I am making and whether I am tilting too much to one side (snowman or shovel). If I find myself tipping too much into the “snowman” camp, I have to bring in some of my “shovel” side to play to get back to synch. If, on the other hand, I am letting my pessimistic shovel side dominate, I have to consciously force my fun snowman side come into play. 

So, here is how I am going to start today’s path back to balance. I shoveled this morning, just before I came in and wrote this post. My kids are too “old” to enjoy building snowmen, but I am not. I am going to go out and build a snowman, make a snow angel and perhaps throw some snowballs. Why should those kids have all the fun?