A Disruptive Cab Ride to Riches: The Uber Payoff

On June 3, news reports carried the story that multiple investors (including big name institutional investors like Wellington & Fidelity) had invested $1.2 billion into Uber, a technology company that matches consumers to car services in many cities around the globe. Based on the investment (and the percentage of ownership that these investors were getting in exchange), the imputed value for Uber (pre-money, i.e., prior to the influx of $1.2 billion) was $17 billion, a mind-boggling sum for a business that generates a few hundred million in revenues and has little to show in terms of operating income. That said, Uber has lots of company in this high-value space, with Airbnb and Dropbox being two other companies that in recent months have been valued at more than $10 billion by investors. With all these companies, the key selling point is disruption, the latest buzzword in strategy, with company owners arguing that they are upending existing ways of doing business (hailing a taxi, with Uber, and finding lodging, with Airbnb) and given the sizes of the businesses that they were disrupting, that the sky is the limit on value. 

If you are old enough to remember market fevers from past booms, you are probably inclined to dismiss both the claims and the valuations as fantasy. I do believe, however, that there is a kernel of truth to the disruption argument though I think investors are being far too casual in accepting it at face value. As I attempt to attach a value to Uber, I have to confess that I just downloaded the app and have not used it yet. I spend most of my of life either in the suburbs, where I can go for days without seeing a taxi, or in New York City, where I find that the subways are a vastly more time-efficient, cheaper and often safer mode of transportation than taxis. 

Uber: The business model

Uber is not in the taxi business, at least in the conventional sense, since it owns no cabs and has no cab drivers as employees. Instead, it plays the role of matchmaker, matching a driver/car with a customer looking for a ride and taking a slice of the fare for providing the service. Its value comes from the screening that it does of the drivers/cars (to ensure both safety and comfort), its pricing/payment system (where customers choose the level of service, ranging from a car to a SUV, are quoted a fare and pay Uber) and its convenience (where you can track the car that is coming to pick you up on your phone screen). The figure below captures the steps in the Uber business model, with comments on what it is that Uber offers at each stage and whether that offering is unique:

Uber has been able to grow at exponential rates since its founding in 2009 by Garrett Camp and Travis Kalanick, with the latter (who is new CEO) claiming that it is doubling its size every six months. While we have no access to the company's financials, there have been periodic leaks of information about the company that allow us to get a sense of its growth. Here, for instance, was a picture that was widely dispersed in December 2013 of a five-week period in late 2013:

While the company claimed to be outraged by the leak, it played nicely into the narrative of growth that it was selling to its investors. In fact, the December leaks suggested that the company generated gross receipts (the fares paid by customers for cab rides) of $1.1 billion, which would translate into revenues of $220 million (based on the 20% slice that Uber claims for itself). That was a few months ago and at the rates at which the company is growing, I would not be surprised if the updated values for both numbers are higher; I will be using $1.5 billion for the gross receipts and $300 million as revenues for Uber as base year numbers.

There was no information that I could find on the company's expenses and income, but according to public sources, the company has 900 employees in its different locations and that it pays them reasonably well. Uber has been active in both marketing its service and offering deals to attract firms time customers and has an active technology department (doing the equivalent of R&D). In summary, these expenses are likely to have been much larger than the revenues (of $300 million) posted during the period. Since the company can legitimately argue that some of these expenses (such as the R&D and customer acquisition costs) are more in the nature of capital expenditures than operating expenses, I will assume (generously) that the company generated an operating income of $10 million in the most recent 12 months. (The effect on value of changing this number is relatively small).

An intrinsic valuation of Über

There are many who will argue that this too young a company and that there is too much uncertainty for an intrinsic valuation. I have argued in prior posts and in this paper that this argument is a cop-out, since not dealing with uncertainty does not make it go away. Having said that, I would hasten to add that what follows is my estimate of value for Uber, not the true value.

A. Potential Market: Size and Growth

For my base case valuation, I am going to assume that the primary market that Uber is targeting is the taxi and limo service market, globally. I know that there is talk (some from Uber's management and some from analysts) that Uber could extend its reach into other businesses (car rentals, moving and even driverless cars), but I don't see any evidence that it has succeeded in making any breakthroughs  (yet) and will come back to this question later in my post.

The global market for taxis and car services may be a big one but it very splintered, with lots of small, local operators dominating each city. In many cities,  this is also a cash business where there are no easy ways to track the total revenues generated by all operators. However, there is data that we can build on. For instance, there seems to be consensus that the most lucrative cab market in the world is in Japan, where revenues are estimated to be about $20-$25 billion annually just in Tokyo, followed by the UK (with revenues of $14 billion, with the bulk from London) and the US (with $11 billion overall and about $3 billion in New York). Making a judgment that taxi revenues currently in the rest of the world will add another $50 billion to this total, I arrive at a total market for taxi and limo services of $100 billion.

It is true that many cities, especially in Asia and Latin America, are under served currently and that the taxi business globally will continue to grow at  well above the 2-3% rate that we have observed in the US, Japan and UK, and that services like Uber will contribute to the faster growth. I will estimate an expected growth rate of 6% a year for the next decade, increasing the overall market to $183 billion in 2024.

B. Status quo, competition, market share and Über's slice (revenues)

The taxi and limo market currently is dominated by small, local players and is regulated in most cities. The cities restrict entry into the market and in return, they regulate the prices that cabs can charge their customers (more effectively in some cities than others). While Uber has only a minuscule slice of the overall revenues currently, the market share that it can aspire to get will depend upon the following factors:

1. The efficiency of the status quo or producers/consumers:  Under the existing system, cab drivers get a relatively small share of the taxi revenue pie (5-10%) and customers in many cities (which are under served) either find themselves without taxis, have to wait a long time or have to pay outlandishly high prices (as attested by the carfare from Narita airport in Tokyo into the city). Thus, both cab drivers and customers may be open to a different way of doing business.
2. Competition: Uber uses technology to deliver car services to customers, but it is not the only company that is doing so. Other competitors like Lyft aad Hailo also provide similar services and they have their own deep pocketed investors. As I said up front, I am not familiar enough with these different services to have any preferences, but this article compares the experiences of Wall Street Journal reporters with different services and does not find a dominant one.
3. Regulation: The cities where Uber and its competitors are trying to generate their revenues are regulated at the moment, and the the existing players (taxi owners, taxi drivers in traditional companies, city regulators) will make it difficult for these new players to compete. These difficulties will affect the speed with which these services are able to penetrate these markets and increase the costs of operating in the business.

Even an optimist on Uber will have to accept that the combination of regulatory restrictions protecting the status quo and the stream of me-too competitors will make it difficult for the company to dominate this market. Even in an optimistic scenario, the former will add costs to Uber's business model and the latter will put pressure on Uber (as it already seems to be doing in some markets) to reduce it's slice of the gross receipts from 20% to 10-15% or even lower. My estimate that Uber will get a 10% market share of the overall market is at the optimistic end of the spectrum, especially if you view it in conjunction with my assumption that Uber will continue to be able to keep its slice of these gross receipts at 20%.

3. From revenues to profits

To get from revenues to operating profits, we have to consider what Uber's operating expenses will be, once it hits steady state, i.e., does not have to incur large expenses attracting new customers. The structure of the business is such that the operating expenses are largely on creating the infrastructure to provide taxi services in different cities and that once established, the cost of these services should decline relative to revenues. This should lead to healthy operating margins, similar to those earned by other established technology companies. I will assume that Uber's operating margin, in steady state, will be 40%,  towards the top decile of technology companies. 

4. Investing for growth

Right now, Uber does not own the cars that the drivers use and the bulk of the investment is in technology infrastructure (R&D and related expenses). At first sight, this would suggest that the company should be able to grow at high rates, with relatively little reinvestment. However, our experiences with technology companies (including Google, Twitter and Facebook) suggest that Uber will be forced to reinvest, especially as it scales up, and that this reinvestment will take the form of acquiring new technologies and companies. (Consider how much Facebook has spent on acquisitions just in this year)

The metric that I will using for reinvestment is one that you may be familiar with, if you have seen my other young company valuations, and it is the sales to capital ratio. This number measures how much incremental revenue you expect to generate for each incremental dollar of investment; the higher this number, the less capital investment is needed to expand this business. The median value for technology companies on this is about 2.50, the median value for all US companies is about 2.00 and a really high number would be about 10.00. I will assume that the sales to capital ratio for Uber will be 5.00, towards the high end of the spectrum.

5. Risk

Is there a lot of risk in investing in a young, start-up like Uber? Of course, but much of the risk in the investment is survival risk (i.e., that the company will not make it as a going concern) and not operating risk. The discount rate, the primary mechanism for adjusting for risk in a discounted cash flow valuation, is designed to capture the latter and is ill-suited for reflecting the former, notwithstanding venture capitalists'  attempts to push it into a target rates of return. 

Looking at the operating risk side of the equation, the taxi business is a cyclical one, with revenues tied to economic growth. There are only a handful of publicly traded cab companies in the world, but the cost of capital of companies in the transportation business in US dollars is about 7.08% for US companies and 6.93% for global companies.  As a young, start-up with higher fixed costs, Uber is undoubtedly more risky than the average company in this sector and I will assume that its cost of capital is 12% (the top decile of US companies). As it matures and becomes a larger, more profitable company, I will assume that the cost of capital will decline towards 8%, the median for US companies. (I don't think that Uber will carry the debt that a typical transportation company carries and thus will not be able to push its capital towards the industry average of 7%.)

On the risk of failure, Uber has passed its most critical tests. It has a product/service that is generating revenues, has relatively little debt or fixed commitments and most importantly, it has access to capital. In fact, the $1.2 billion in cash that it will raise in its latest round of capital should provide it with enough of a cash cushion to survive leaner times, at least in the near term. As a result, I will assume that there is only a 10% chance of failure in Uber and that the company's liquidation value will be zero.

6. The value

With these pieces in place, I arrive at a base case valuation of $5.895 billion for Uber, as shown in the figure below:

Valuation of Uber, June 8, 2014

The value of $5,895 million is a value for the operating assets and any existing cash would have to be added back and debt netted out. Given that neither debt nor cash is likely to be a large number right now, it is directly comparable to the value that venture capital investors are attaching to the company now. As with my other valuations, you can download this one and make your own judgments on what the future holds for Uber. (This is a generic spreadsheet that you can use to value any start-up and you can try it on Airbnb and Dropbox, if you are so inclined.)

7. Break even points

The imputed value for Uber, based on what investors demanded for their $1.2 billion last week, is $17 billion, well above my estimate of value. It is entirely possible that the error is mine and that I have under estimated a key input into value. In particular, there are three key drivers of Uber's value:
(a) the potential market, which I estimated to be $100 billion

(b) the market share that Uber will command of that market (my estimate is 10%) and

(c) the slice of gross receipts that Uber will get to keep (which I have left at 20%)

Changing any or all of these assumptions will change value. In the table below, I hold the gross receipt slice constant, at 20%, and change the potential market size and Uber's market share to arrive at the following numbers:

Value of operating assets for Uber, keeping revenue slice at 20% and other inputs fixed

The shaded numbers indicate the combinations of total market/market share that you would need to deliver. In particular, the total market has to be either three times bigger than my estimate (around $300 billion) or the market share has to be more than twice my estimate (20% and higher) to justify the $17 billion value.

Holding the market share fixed at 10%, I looked at the effect on value of changing the potential market and the percent of gross receipts that Uber receives, and the effects are summarized below:

Uber operating asset value, holding market share and other inputs fixed.

The effects of a reduced market slice are more devastating to value, with even a $300 billion total market (with a 10% market share) being insufficient to break even, with a $17 billion value, if Uber keeps less than 20% of gross receipts.

The bottom line: Viewed as a car service company, even with optimistic assumptions about market growth, market share and profitability, Uber's value is about $6 billion. The combination of assumptions that you would need to get to $17 billion is improbable, at least in my view. It is possible that I am missing the value of new markets that Uber may be able to enter but I will reexamine that possibility later in this post.

Pricing Uber

As I have argued in many of my blog posts over the last two years, the value of an asset can be very different from its price. The former is determined by the interplay of fundamentals (cash flows, growth and risk) whereas the latter is a function of demand and supply. To price an asset, you follow two simple steps. In the first, you look for a metric that the market is scaling the price to; that metric can be an operating number like revenues or earnings or an intermediate number like number of users or customers. In the second, you identify "comparable" companies, i.e., companies that are like the one that you are valuing and compare the scaled price (the multiple) across these companies. Most investors and analysts are more comfortable pricing assets, rather than valuing them, and this is especially the case with young companies like Uber. So, is that what investors are doing to arrive at the $17 billion price for Uber? To make that judgment, let's look at the choices when it comes to pricing metrics and comparable firms.

Pricing Metric

You cannot compare values or market capitalizations across companies, because companies can vary in terms of size and scale. Dividing the estimated value by a scaling variable creates a multiple that can be compared across companies. With mature companies, you scale market value (equity or enterprise) to measures of earnings, dividing market capitalization by net income to get to a PE ratio or enterprise value by operating income or EBITDA to get an enterprise value multiple. With young companies, where earnings are often negative or minuscule, earnings multiples either cannot be computed or are not meaningful. In fact, the only current operating number that is consistently positive at those companies is earnings, explaining why revenue multiples are so widely used at this stage in the life cycle. The fact that revenue multiples can be computed does not necessarily mean that they are useful in valuation. Dividing Uber's value ($17 billion) by the revenues ($300 million) yields a revenue multiple of 56.67, an outlandishly high number but one that tells you little about the pricing of the company, partly because investors are pricing these young companies on potential, not current performance.

One solution to the problem with current numbers not reflecting potential is to use expected future revenues or earnings in computing multiples. Thus, you could divide the enterprise value today by the expected revenues in five or ten years and compare these forward multiples across companies. Applying this approach to Uber, I divided the enterprise value of $17 billion by my expected revenues in ten years ($3.59 billion) to yield 4.75, still a high number and one that should be compared to the same multiple (enterprise value to future sales) computed for other companies. The problem with this approach is two-fold. The first is that you need to forecast revenues for each company in your sample, not just the company that you are valuing. The second is that these multiples are only as good as your revenue forecasts, making this a joint test of the multiple and your forecasting ability.

In my post on Whatsapp and Facebook's valuation of it, I noted that the metric that best explains the difference in values across companies is not revenues or earnings, but the number of users. While that may strike some as being irrational, it is not unreasonable to assume that companies with more users are better positioned in terms of potential. If Uber, Lyft and Hailo (all of which operate in the taxicab market) were all publicly traded, what equivalent metric would investors focus on? It could be the number the subscribers to the service, the number of rides taken by these subscribers or even the number of cabs covered  by the service.  For the moment, though, we are still in the dark about all of these statistics for these companies.

Comparables

In pricing, the choice of companies that you compare your company to is critical. In fact, one simple way to tilt the pricing in the direction that you want it to go is to change the firms that you use in your comparison. In the case of Uber, we will first try to value it, relative to other publicly traded young technology firms and then try again, relative to private technology companies that have received venture capital infusions in the last year.

If we define Uber's comparable companies as young, technology companies that are being priced on potential, the most obvious subset of companies that we can compare it to are social media companies. In the table below, I update the numbers for social media companies, with key multiples  computed in the last four columns:

Enterprise and market values from June 2014, Trailing 12 month numbers

Since the only number that we have some measure of (and a rough one at that) is Uber's revenues ($300 million), applying the median multiple of 9.22 yields a value of $2.766 billion for Uber. Even applying the highest value (Twitter's EV/Sales of 21.82) yields a value of $6,546 million, well below the  $17 billion estimate. Uber reports the number of cities that it operates in, but it provides no detail on the exact number of subscribers to the service and the number of rides that it provides. Even extrapolating from the leaked report (shown towards the top of this post), that shows up 90,000 new users signing up each week, I get 4.68 million sign ups for a year and perhaps 15 million subscribers overall. Applying the median value of $70/user to this number leaves you with $1.05 billion and even applying the high (Netflix's $568/user) yields a value of just over $8.5 billion.

It is possible that the investors in Uber are comparing its pricing to the imputed pricing of the other non-public "big" companies in this space. In the table below, I have highlighted the largest private technology companies with VC investments in the last 12 months, the imputed valuations and the revenues in 2013 (or at least the best estimates that I could find):

VC investments, imputed valuations and revenues in 2013

Even in the rarefied air of VC valuations, Uber's $17 billion dollar value stands out as an outlier. Applying the median multiple of revenue (32.14) across just these companies to Uber's revenues would still leave you with a valuation just under $10 billion. 

The bottom line: Even if I use the most favorable pricing metric (revenue) and comparable firms (other favored VC targets), it is difficult to justify a price greater than $10 billion. 

Uber, the disruptor

This brings us back full circle to the disruption argument. When Clayton Christensen coined the term "disruptive innovation" a few decades ago, I am sure that he never foresaw its popularity with investors, analysts and companies. Christensen draws a contrast between sustaining innovations, which advance the status quo (and established players) and disruptive innovations, which new entrants introduce to disrupt the status quo. With the latter, Christensen's story mirrors David and Goliath, with the new entrants winning out over larger, entrenched entities, partly because they have little to lose from upending the status quo.

While I admire the big picture perspective that strategists like Michael Porter and Christensen have brought to business, I am, by nature, a skeptic and feel the urge to tie the big picture to the bottom line. As I see it, disruptive innovation affects value at two levels. In the first, it allows a new entrant to enter a targeted market, disrupt the status quo and then capture the excess profits in that market. That can be captured in a discounted cash flow valuation, which is what I attempted to do in my intrinsic valuation of Uber. The second level at which disruptive innovation affects value is more subtle. Assuming that the disruptor is able to succeed in its targeted market, success in that market may allow the disruptor to enter new and potentially larger markets in the future. The fact that these markets are undefined at the moment and the odds of success are low mean that the intrinsic value added from this possibility is small. However, the fact that the disruptor does not have to commit to investing in these new markets until the outcome from the initial market is known, as well as the potentially large profits from this expansion, give it the characteristics of an option. I do not want to entangle myself in the mechanics of option pricing in this post, but the value of this disruption option is an add-on to the intrinsic value and will increase with the size of the potential markets, the uncertainty/risk in these markets and the competitive advantages that the disruptor brings to these markets.

Applying these very general concepts to Uber, the attraction to investors is clear. Uber's contention is that it is targeting the car service market for the moment but its intention is to use success in this market to expand into other markets. While we can be skeptical and uncertain about its chances of success in these fuzzily defined markets, that uncertainty, which would reduce intrinsic value, increases the value of the disruption option. To give Travis Kalanick, the co-founder and CEO of Uber, credit, his subtle pitch that Uber is in the logistics business plays into the option narrative, as does the fog that the company has created around specifics. 

It is easy to see the allure of the option argument, where uncertainty becomes your ally and big markets beckon, but as investors, we need to understand that most deep out-of-the-money options never get exercised and that the company owners/managers cannot be given free rein over narratives. I am not privy to the questions that investors in Uber asked before they made their investment, but I would hope that they pushed Mr. Kalanick to be specific about his expansion plans, the details of  growth and what it is costing to deliver that growth, and most importantly, what will give Uber the exclusivity to be able to advance into new markets faster and more profitably than its competitors (both current and new).

Bottom line: Can the disruption option explain the difference between the assessed value ($17 billion) and the estimated value ($6 billion, with intrinsic valuation)? It is possible but not probable. For the option to be worth $11 billion, the potential markets that Uber can enter, assuming it is successful in the car service business, will have to be at least four times larger than the base market (the $100 billion taxicab market). I know that there is talk of Uber becoming a player in a futuristic world of driverless electric cars, but even if that scenario unfolds, I don't see why Google and Tesla would let Uber have anything more than crumbs off the table.

The end game

The numbers seem to indicate that Uber is being overpriced by investors who have valued it at $17 billion. Since these investors are presumably sophisticated players, how would I explain their pricing? I will not try, since I did not pay the price, but it is worth remembering that even smart investors can collectively make big mistakes, especially if they lose perspective. The tech world is a cloistered one, where the leading players (venture capitalists, managers, serial entrepreneurs) immerse themselves in minutiae and know and talk to each other (and often only to each other). Not surprisingly, they develop tunnel vision where technology (or at least their version of it) is the answer to every problem, the status quo is both inefficient and easily disrupted and 50 times revenues is cheap! If history is any guide, tech geeks are just as capable of greed and irrational exuberance as bankers are.

Attachments
Intrinsic Valuation of Uber
Uber Pricing: Multiples and Comparables

Ballmer's bid for the Clippers: Investment, Trade or Expensive Toy?

Now that he has stepped down as CEO of Microsoft, Steve Ballmer has both plenty of time and moneyon his hands, and he put the latter to use last week, when he announced his intent to buy the Los Angeles Clippers, that city's second favorite NBA team, for $ 2 billion. Since that was more than three times higher than any other NBA team had sold for and matched the price tag for the most expensive sports franchise sale in US history (the sale of the Los Angeles Dodgers in 2012), the bid raised questions about whether a sports franchise can be valued, how it is priced and whether there is an ego premium embedded in this particular offer. I am not a Clippers fan, but I love sports, and these questions not only deserve answers but have broader implications for valuing entertainment and media businesses.

The value of a sports franchise

Much as we like to glorify the beauty of sports and praise it in its purest forms, it is increasingly a business. Like any business that is expected to generate profits and cash flows, it can be valued, based upon these expectations.

1. Revenues: From gate receipts to media contracts!

My favorite sports team, the New York Yankees, was sold for $460,000 in 1914. At the time, it was a struggling franchise, with $20,000 in debt, and the new owners turned it around with two big investments: the storied acquisition of Babe Ruth from the Boston Red Sox for $100,000 and the construction of Yankee stadium for $3.1 million in 1923. In 1924, the Yankees reported EBITDA of $441,640 on revenues of $1.1 million, almost all of it generated from gate receipts. Until 1946, the revenues for the Yankees (and almost every other professional team in sports) came from the revenues generated at games from ticket sales, concessions and parking, with some supplementary revenue from radio broadcasts. In 1946, the Yankees became the first team to sign a local television contract, netting them $75,000 for the season. It is fitting that the Yankees owe their current status as one of the most valuable sports franchises in the United States to an updated local television contract, which generated more than $100 million in revenues for the team in 2012.

The last two decades, in particular, have seen a shift in revenues from gate receipts to media right across sports, with the shift more pronounced in some sports than others and for some teams within each sport. In the table below, I break down total revenues in six sports - baseball (MLB), football (NFL), basketball (NBA), North American hockey (NHL), European soccer and Indian cricket (the IPL), using information from 2012:

For European soccer, I use only the top 20 firms in terms of value (according to Forbes). The IPL numbers are my best estimates, based on news stories.

Of the six sports, baseball is the most dependent on gate receipts, perhaps because it has a 162-game schedule, and the NFL is least so. The IPL and the NFL are the two sports most dependent on media rights (TV and digital broadcasting), while European soccer gets a larger slice from sponsorship than do the other sports. (The fronts and backs of player uniforms are prime sponsorship territory in Europe, making it different from US professional sports where that is not the practice. The IPL follows the European model.)

While broadcasting revenues are now a much biggest slice of the total revenue pie in every sports, the structure of revenue sharing varies across sports, with profound consequences for franchise value. The NFL and IPL have a shared revenue model where all teams get an equal share of the television broadcasting revenues of the sport, but the IPL keeps 40% of broadcasting revenues for itself (up from 20% in the first few years of the contract). Baseball, basketball and hockey all have mixed models, where the teams share equally in the national television contract revenues but are allowed to enter into and keep all or a large portion of the local contract revenues. Not surprisingly, this generates higher revenues for teams in larger media markets, with the New York Yankees generating media revenues ($158 million) in 2012-13, almost four times larger than the Seattle Mariners ($42 m), in baseball, and the Los Angeles Lakers ($150 million) drowning out the Oklahoma City Thunder ($20 million), in basketball.

2. Expenses and Operating Profits

The biggest expense associated with running a sports franchise is player expenses,   and it should come as no surprise that each of the sports has gone through turmoil (including strikes and shut downs) around controlling these expenses.

Player expenses as % of Revenues
IPL Player expenses based upon teams at salary cap of Rs 60 crores ($9 million) each

Players receive just over 50% of total revenues in the NFL and NBA, a little less in baseball and hockey and much less in soccer and cricket. Note that, with the IPL, there is little information at the franchise level, since many of the franchises are subsumed into much larger corporate organizations. 

How much have these ratios changed over time? With baseball, which is where we have the longest history, player expenses, as a percent of total revenues, jumped after free agency in 1974, peaked in the early 1990s and has been declining since:

MLB: Player Expenses as % of Revenues

Since this is the statistic that most fights between players and owners have fought over (and have had strikes over), it is controversial. Note that the expenses in major league baseball peaked in 1994, just before the longest strike in baseball history, and have fallen since. In 2010, the NFL shutdown was predicated on both what this statistic was (with owners and players using different base numbers) and on what it should be in the future. In the final agreement, the owners agreed to give the players 55 percent of national media revenue, 45 percent of all NFL Ventures revenue, and 40 percent of local club revenue.

There are a host of other expenses that are of less import but aggregate to take a big bite out of income. These include team expenses (associated with the logistics of transporting and accommodating the team), player development costs and stadium maintenance expenses. In many sports, the richest teams also pay luxury taxes that can add substantially to their expenses, with the amount of the tax tied to how much their player payrolls exceed league caps. Given the paucity of financial information from sports teams Forbes does a good job of estimating the EBITDA of these franchises (though it does bother me, from a semantics standpoint, that they call it operating income). In the table below, I list the EBITDA values and EBITDA margins, by sport, as well as the percentage of teams in each sport that reported negative EBITDA in the most recent time period.

Revenues and EBITDA - Most recent year

European soccer, the NFL and the NBA are the most profitable sports, with baseball bringing up the rear. Again, the absence of stand-alone information on IPL teams makes it difficult to measure how profitable these franchises are to their owners. While the IPL as a league overall looks like it generates a profit, the league takes a disproportionate share of these profits (40% of broadcasting revenues, 20% of gate receipts and worst of all, 10% of initial franchise price as an annual franchising fee!) and keeps it for itself. Since the IPL is more a political body than a business entity, the potential for mischief and corruption is huge. (The more I look at the IPL's profit sharing arrangements, the more I am struck by how greedy the BCCI has been in structuring this league and how risk the franchises are at, financially. If cricket is the goose that lays golden eggs, the IPL seems to be looking for ways to kill that goose!)

There are a host of reasons why we should be cautious about the reported earnings at all of these franchises. The first is that sports franchise accounting is an art form, with the wild card being "bad" player contracts, and the way they are written off or amortized can have profound consequences for reported profitability. The second is that most of these sports franchises are privately owned and tax considerations can lead to systematic understatement of income. The third is that critics have long argued, with some basis, that teams over state their expenses, so that they can plead poverty, either to extract larger subsidies from the cities in which they play or to put caps on player compensation, in collective bargaining agreements.

3. Risk

How much risk is there in investing in or owning a professional sports team? While you can make a laundry list of potential risks, the best way to assess these risks is not by looking at anecdotal evidence on individual teams but at the collective performance of sports franchises over their history.  The challenge that you face is that most of these teams are privately held, transactions are too infrequent for conventional risk measures and accounting earnings numbers are either unreliable or unavailable over long periods. While beta may not be the best measure  of risk when valuing sports franchises for private sale, we can use traded franchises (which are primarily European soccer teams) to get a risk profile for these investments:

Betas estimated against local indices, using 5 years of monthly data: May 2009-May 14

Based on these traded franchises, it seems reasonable to conclude that sporting teams tend to be below average risk.

To get a broader measure of the risk in these investments, we looked at the operating data of each sport. The consensus view seems to be that professional sports is recession proof and that neither attendance nor aggregate revenues are affected much by the economic environment. We have information on aggregate revenues at each sport going back in time and can measure how responsive these revenues have been to macroeconomic variables.

Correlation of annual revenue growth at sport with macroeconomic variables: 1990-2012
T statistics in brackets under correlations

Looking at the correlations, the statement that sports franchise revenues are unaffected by macroeconomic factors seems to be mostly true, with a few caveats. First, while the correlation between annual revenue changes and real GDP growth is low and not statistically significant in any of the three sports that I was able to get historical data for, some sports seem more recession proof than others. In particular, the NFL seems to be the most recession-resistant sport (at least during this period), with a lower correlation with real GDP growth than either MLB or the NBA. Second, some streams of revenues. within each sport, are less affected than others (television revenues are usually contracted for long periods and are immune from recessionary pressures but luxury box sales may be more sensitive to economic conditions). It stands to reason, therefore, that the European soccer clubs and IPL teams will share the recession-resistance of the NFL, since all three sports derive the bulk of their revenues from media rights. Overall, though, the risk of investing in a sports franchise is low and market indicators from the few sports teams that trade seems to back up this proposition.

There is also the question of how much debt these franchises carry. While the conventional debt load is low, at least on average, at all of the sports, that understates the true financial leverage, since many player contracts offer guaranteed money over long periods. Capitalizing these player contracts, as I did in this post for the New York Yankees in 2009, dramatically increases the financial leverage at these teams and with it, the risk. 

We may be guilty of survivor bias in our focus on the MLB, NBA, NFL and NHL, all of which have survived multiple scares during their lives. The list of professional sports leagues that have failed is long, and while the risk of failure may be small, it is not non-existent. The other risk that we are not factoring in is on the legal front, which can manifest itself in multiple ways. For instance, the growth and profitability of the MLB can be traced, at least in part, to the fact that it has been granted a special exemption from antitrust laws, and removing that exception could have disastrous effects on franchise value. With the NFL, the recent spate of publicity about head injuries and long term brain damage to players may very lead up to a class-action lawsuit with the potential to bankrupt even this most powerful of sports leagues.

Valuing the Clippers

With that long lead in, we are in position to value a sports franchise, and in keeping with the news story that initiated this article, I will try to value the Los Angeles Clippers. In doing this valuation, I will make a couple of simplifying assumptions, which you are welcome to change. Given the risk discussion in the last section, I will attach a cost of capital of 7.50% for investing in the Clippers, at about 25th percentile of all US firms. I will also assume that once I reassess the numbers for the Clippers, given my expectations  of changes (in TV contracts, revenues and costs), the cash flows will grow at roughly 2.5% a year in perpetuity. Finally, I will assume that with the NBA's protection from competition in place, the Clippers will be able to generate a 25% return on capital on their investments (which will allow them to generate the 2.5% growth with a 10% reinvestment rate).

Intrinsic Valuation of Clippers: Actual, Median, Laker-like & Best Case

In this table, I value the Clippers, first using their 2012 numbers (which I know are too low), next using the median revenues and EBITDA margin for an NBA team, then giving the the revenues and margins of their more lucrative neighbor in the city (Los Angeles Lakers), and finally with a combination (best-best) of the league's highest revenues (which belong to the Lakers), the best pre-player expense margins in the business (Knicks) and the lowest payroll of any team in the sport (the Utah Jazz). Even with this improbable mix, the value that I estimate for the Clippers is $1.61 billion, well below the $2 billion paid by Mr. Ballmer. You are welcome to download the spreadsheet, which has in it the key numbers, by team, for all NBA teams and do your own assessment.

The Pricing of Sports franchises

In keeping with the recent posts I have had about the divide between the value of an asset and its pricing, it is worth examining how sports franchises are priced. In fact, that is the reason why I did not talk about the well-publicized Forbes valuations of sports teams, even though I did use the raw data that they so helpfully provide on individual teams. The Forbes valuations are really franchise prices that they estimate based on the most recent transaction prices in each sport. You can see the latest Forbes value estimates for teams in five of the six sports in this link. They are rigorously done, but they don't pass the valuation test.

Market traded sports franchises

As we noted earlier, most sports franchises are privately held and are not traded. The exceptions tend to be European soccer firms, where there are about a dozen that are traded primarily on mainland Europe. In the table below, we list the values attached by the market to these teams, both in terms of equity value and enterprise value, and relate these values to operating measures for each team:

Enterprise value, Equity Value and Multiples: Traded Sports Franchises

At the outset, it is worth noting that many of these firms are in poor financial health, with negative earnings and high debt ratios. With that concern in mind, we still computed multiples of revenues and earnings, and concluded that the median sport franchise, at least in European soccer, trades at about 2.13 times revenues and 9.31 times EBITDA. While the median PE ratio is 22.7, note that almost half the sample has negative net income.

Transaction-based pricing

While sports franchises are privately held, there are transactions that occur, albeit infrequently, where a team or a portion of a team is sold. It is difficult to compare transactions prices over time and across franchises, partly because they have to be inflation adjusted (which is easy to do) but more because the revenues and earnings potential for franchises change over time. The best way to control for this is to convert the transaction prices into multiples of levels of operating variables at the time of the transaction. In the table below, I list the current owner of each NBA franchise, the prices paid to acquire the franchise, the revenues of the franchise in the acquisition year and the resulting revenue multiple.

Revenues are from year of transaction. NA= Not available

Looking across all 30 teams, the median multiple at which a franchise has traded at historically is 3.30. It is worth nothing that the two most recent transactions, the sale of the Sacramento Kings in 2013 and the Milwaukee Bucks in 2014, were the first to occur at more than five times revenues.

While the history of franchise sales in the NBA is limited by the fact that the league has a shorter history, the history of franchise sales in major league baseball go back more than a hundred years. Using information partly from Michael Haupert's excellent treatise on the economic history of major league baseball and partly from public records, I show the change in franchise values for MLB franchises over the decades in the table below, as well as some the more recent transactions involving MLB teams, scaled to the revenues of these teams at the time of the transactions:

Franchise values from 1910-1999 from Haupert, rest from public information

It goes without saying that a long term owner of a baseball franchise has been rewarded richly for the investment, but the increase in value for much of the last three decades can be attributed to increases in revenues, rather than a surge in the multiple of revenues that buyers are willing to pay. For much of the last three decades, buyers have been willing to pay about 3 times revenues for a baseball franchise, with the sale of the Los Angeles Dodgers for $ 2 billion (more than 6 times revenues) representing the outlier.

Completing the story with the NFL, the table below lists transactions involving NFL teams, with revenues from the year of the transaction and multiples paid on each one.

NFL Franchise Trades with Revenues from year of trade

On average, NFL franchises have sold for higher multiples of revenues than either NBA or MLB franchises, trading at just over four times revenues, though the recent surge in NBA valuations may have put that league ahead right now.

Looking across the sports, there is a pattern that emerges, with NFL and NBA franchises historically being priced at the highest multiples of revenues (about four times) though the NBA's recent surge may have given it the lead. Major league baseball brings up the rear, with franchises typically selling for three times revenues, and that ranking is consistent with the profitability margins we reported in the last section; the NBA had a median EBITDA margin of 11.29%, the NFL was close behind at 10.93% and baseball had the lowest EBITDA margin at 2.71%.

Pricing the Clippers
With this information on how investors/buyers have priced franchises in hand, I tried to price the Clippers using a rudimentary combination of variables: the annual revenues of the franchise and a multiple of revenues gleaned from the historical transactions:

EV/Sales from NBA transactions in last 20 years

As with the intrinsic valuations, it is difficult to justify a $2 billion price tag on the Clippers, even with assumptions that stretch credibility. You can download this spreadsheet as well and see if you can derive your own price.

There may be more fanciful multiples that deliver a price closer to $2 billion. For instance, you could divide the transaction prices by the population of the metro area served by the team and then scale this up to reflect the larger LA media market. Thus, taking the $550 million that was paid recently for Milwaukee which has a media market one tenth the size of the LA media market, and assuming a 50:50 split of the LA market with the Lakers, you would arrive at a value of $2.75 billion for the Clippers. Go figure!

The Clippers as a play toy

We may be spinning our wheels, trying to find rational (and financial) explanations for why Steve Ballmer paid the price that he did, when the  answer may be much simpler. He has really wanted to own an NBA team, especially one in a glamorous media market. Last year, he was thwarted in his bid to buy the Sacramento Kings and this time, it looks like he is leaving nothing to chance. In effect, he is paying an premium over even the most optimistic value or price assessment for the team, to have an expensive play toy. How expensive? Given the media revenue potential of the Los Angeles market and the global growth of the NBA, I would be hard pressed to attach a value (or a price) of more than $1.2 billion for the Clippers, leaving me with an 800 million-dollar toy. While that would be well beyond the reach of even a regular billionaire, it is affordable to a man who is worth $20 billion.

Looking at the ownership lists of the six franchises, the trend towards multibillionaire owners is more pronounced in some leagues than others. Of the top 20 European soccer teams, about a third have been acquired by billionaires who either made their wealth elsewhere or inherited it. Among US professional sports leagues, the NBA leads the list, with about a quarter of the firms in the hands of wealthy toy-seekers. As a fan,  I will never be wealthy enough to be able to spend a few billions to buy my favorite team, but I don't begrudge someone who does, especially if he or she acts in a way to make my team a winner. If it troubles you to see your favorite team become a plaything, you should be far more horrified if you are a fan of an IPL team. The wealthy individuals who own IPL teams do so through publicly traded corporations that they control, thus using stockholder money in these firms to advance a personal interest. The opacity on both the governance and the financials, both at the franchise level and the league level, is troubling, making it  difficult to pass judgment on the financial well being of the league and may be contributing to self-dealing and potentially illegal activity.

I would hasten to add that while the desire to acquire glamorous assets and pay ego premiums may be clearly visible in sports franchise acquisitions, they are not restricted to them. In my post on acquisitions little over a year ago, I drew attention to the hubris hypothesis for acquisition premiums, relating them to ego and pride. If Steve Ballmer is over paying for the Clippers, he is at least over paying with his own money. When as CEO of Microsoft, he paid $8.5 billion for Skype, it was Microsoft stockholders who were put at risk from over payment.

Downloadable data/spreadsheets
Intrinsic valuation of Clippers
Pricing of Clippers
Raw data on MLB teams
Raw data on NFL teams
Raw data on NBA teams
Raw data on NHL teams
Raw data on European soccer teams
Raw data on IPL teams
Forbes pricing of sports franchises (2013)

Yahoo! A puzzle, a mystery and an enigma

In my last post, I estimated Alibaba's value and concluded that its growth and profitability put it on a pathway to make it one of the most valuable IPOs in history. In this post, which I view as a companion, I am looking at Yahoo, a company that has effectively become a proxy for Alibaba, especially leading up to the initial public offering. To illustrate, Yahoo’s quarterly earnings came out on April 15, and it reported flat revenues and declining earnings. Bad news, right? However, its stock price jumped on the earnings report, as embedded in it was good news about Alibaba's revenue growth in the last quarter of 2013. In fact, in the context of valuing Yahoo! in my valuation class, I borrowed phraseology from Winston Churchill and described Yahoo! as a puzzle, coupled with a mystery and wrapped up in an enigma. Yahoo!, the parent company, is the puzzle (especially in how quickly it lost its dominance in the United States, and why), with a mystery (its 35% stake in Yahoo! Japan, which is prospering while the parent struggles) and an enigma (the 22.1% share of Alibaba). 

Note: Press stories estimate Yahoo's holdings at 22.6% or 24%, depending on whether you use diluted or primary shares. I used the 523.6 million shares that Yahoo owns in Alibaba and my estimate of 2368.67 million shares outstanding in Alibaba, including restricted stock units, in Alibaba to arrive at 22.1%.

Setting up the valuation

To value shares in Yahoo, you have to estimate the value of its US operations, but that is only a small piece of the overall value, since Yahoo owns 35% of Yahoo Japan and 22.1% of Alibaba. Neither holding is consolidated, and the way in which the accounting works effectively means that the key operating numbers that you see in Yahoo’s financial statements (revenues, operating income) will not reflect either of these holdings. To illustrate the tangled web of values, here are the steps to get to the value of equity in Yahoo:

Yahoo: The sum of the parts

Thus, to value equity in Yahoo, you have to value Yahoo, Yahoo Japan and Alibaba separately, and after aggregating your holdings in each company's equity (100% of Yahoo, 35% of Yahoo Japan and 22.1% of Alibaba), you also have to net out any taxes that will come due on capital gains if Yahoo plans to or is required to sell any of its holdings. In the case of Alibaba, it has no choice, at least on a part of the holding, since it will be required as part of a prior agreement to sell 208 million shares after the IPO. 

If you are interested in Yahoo as an investment, there are three ways in which you can approach the analysis.

1. You can estimate an intrinsic value for each of the three pieces and add them together to come up with a composite intrinsic value. Now that Alibaba has filed its prospectus, you have the financial statements for all three companies.
2. You can price each of the three pieces, by looking at a key metric (revenues, earnings, book value) and applying a multiple to it, based on how other companies like it (and that is a subjective call) are being priced in the market. 
3. You can cheat and use the market pricing of one or more pieces to see how much you are paying for the rest of the company. In other words, you can check to see if the market is being internally consistent in its pricing of the pieces.

The Puzzle: Yahoo and its fall from dominance
I started with the parent company, a pioneer in the online search/advertising business that has long since been pushed to the sidelines by Google. Revenues have been declining at Yahoo! (US) over the last few years, going from $7.2 billion in 2008 to $4.68 billion in 2013 and the contrast with Google over the last decade is striking:

Yahoo versus Google: No mas!

The much heralded ascension of Marissa Mayer to the top of the company has not resulted in a turnaround in revenues, though the company continued to be profitable, generating $590 million in 2013 (translating into a pre-tax operating margin of 12.6%). If there was any positive news about Yahoo! in its most recent report, it is that ad revenues have stopped falling and that they increased 1.7% over the same quarter in the last year, though total revenues declined slightly and operating income dropped; the company generated $422 million in operating income on revenues of $4672 million in the twelve months ending March 31, 2014.

Intrinsic valuation: Assuming that Yahoo! will return to dominance or even get back to moderate growth is a reach. I will, however, assume that Ms. Mayer will find a way to stop the bleeding and that the company will muddle along as a mature company with stagnant revenues and stable margins. I assume a nominal growth rate of 1% for the next 5 years for Yahoo!, increasing to 2.75% in year 10, I estimate a value of $4.38 billion for its operating assets, but adding its substantial cash balance of $4.6 billion and netting out its debt of $1.6 billion, I derive a value of equity of $7.37 billion for the parent company.  You can download the parent company valuation by clicking here. (I used the last 10K filed by Yahoo and updated the numbers using the most recent 10Q).

A relative valuation (pricing): You can anchor your relative valuation of Yahoo! to revenues, EBITDA or operating income. Perhaps, the simplest way to do this would be to apply the median EV/Sales or EV/EBITDA  multiple for the sector (internet software and services) to Yahoo's metrics to estimate a value for just the parent company's operating assets. 

Yahoo: Estimated Enterprise Value using Median Multiples from Internet software & services

While it is tempting to apply these median multiples in the sector in internet software & services business to Yahoo’s revenues, you will get absurdly high values, since most of the companies in this sector are expected to have high revenue growth in the future,  and Yahoo! has little or no expected growth. In particular, we would expect Yahoo to trade at a much lower revenue multiple than its competitors. To get an adjusted revenue growth, we plotted EV/Sales against revenue growth for all internet stocks in the chart below:

EV/Sales versus Expected revenue growth: Internet software & services

There are outliers in this relationship, with higher revenue growth companies trade at higher multiples of revenues. (Twitter is one of the outliers in the graph, but this graph was prepared before Twitter's fall from grace last week. It is not as much of an outlier any more.)  In fact, the best fit line yields the following (and you can download the raw data used for the regression here):

EV/Sales = -0.94 + 21.21(Expected revenue growth) + 15.06 (Operating Margin)

R squared = 54.5%

Given Yahoo's expected revenue growth rate of 1% and current operating margin of 9.02%, we would forecast an EV/Sales ratio of only 0,63 for Yahoo .
EV/Sales Yahoo = -0.94 + 21.21(.01) + 15.06 (.0902) = 0.63

Applying this multiple to Yahoo’s revenues ($4.672 billion) yields $2,948 billion for Yahoo’s enterprise value, and adding the cash balance ($4.6 billion) and subtracting out debt (1.6 billion) yields a value of equity of $5.9 billion. Note that this is the value of only the parent company, since the revenues from the cross holdings (Yahoo Japan and Alibaba) are not incorporated into Yahoo’s revenues.)

Market price: Given the stock price of $33.76 at the time of this post, we have a market capitalization of $34.8 billion for Yahoo in May 2014, but that reflects the market’s assessment of the value of equity in the company with its cross holdings.

The Mystery: Yahoo! Japan
While Yahoo! has struggled in the US market, Yahoo! Japan has had more success in the Japanese market, as evidenced in the graph below:

Yahoo! Japan - Historical Performance

While there was a slowdown in 2012 and 2013, the company has been able to post a compounded annual growth rate of 22% in revenues and earnings in the last decade.

Intrinsic valuation: Estimating an intrinsic value for Yahoo! Japan, with a 5% growth rate in revenues for the next 5 years and much higher operating margin (40%) than Yahoo, yields an intrinsic value of $17.9 billion for the operating assets and $21 billion for its equity. You can download the valuation of Yahoo Japan by clicking here.

Relative valuation/pricing: Using the same regression on online companies that I used to value the parent company, I estimate an EV/Sales multiple of 7.91 for Yahoo! Japan, based on its expected revenue growth of 5% and operating margin of 51.72%.

EV/Sales Yahoo Japan = -0.94 + 21.21(.05) + 15.06 (.5172) = 7.91

Applying this multiple to the revenues of $3,929 million in 2013, we estimate a value of $31.1 billion for Yahoo! Japan’s operating assets. Adding cash and subtracting debt yields a value of equity of $34.2 billion for Yahoo! Japan.

Pricing: Yahoo! Japan is a stand alone and publicly traded entity, with a market capitalization of $23.2 billion in May 2014.

The Enigma: Alibaba

The final piece of the valuation is Alibaba, in whom Yahoo! has a 22.1% stake. Until last week, we were valuing Alibaba primarily through the financials that Yahoo was reporting for the company, since it was private and unlisted. With the prospectus now in the public domain, we can be more specific in both the intrinsic and relative valuations of the company.

Intrinsic value: Rather than rehash the intrinsic valuation of Alibaba, I will direct you to my last post, where I valued Alibaba's equity at $145 billion, post IPO. That valuation is built on the assumptions of revenue growth slowing to 25% (on an annual, compounded basis over the next 5 years) and a target operating margin of 40% (below the current operating margin of 50%). You can download the Alibaba IPO valuation spreadsheet by clicking here.

Relative valuation/Pricing: The second is to use the revenue and net income numbers, in conjunction with estimates multiples obtained by looking at other companies in the business and adjusting for Alibaba’s higher growth and profit margins. The table below lists PE and Price to Sales (which is a inconsistent multiple, but one we are stuck with since we have no debt and cash numbers) for sectors that may or may not match Alibaba’s business model:

Median Multiples: Advertising, Retail and Online Retail

The range of values that you obtain, using these multiples for Yahoo!, is immense, from a low of $6 billion (using EV/Sales of general retail) to a high of $285.6 billion (using a PE ratio of US online retailers). The bankers will undoubtedly gravitate towards earnings-based multiples and samples of internet firms as comparable firms during their roadshow. Using the EV/Sales regression that I used to value Yahoo! and Yahoo! Japan, with an expected revenue growth of 27% (from valuation) and operating margin of 49.07%:
EV/Sales Alibaba = -0.94 + 21.21(.27) + 15.06 (.4907) = 12.18

Applied to Alibaba's revenues of $7,911 million in 2013, adding the value of cash, cross holdings in Weibo & other online ventures and expected IPO proceeds of $27,963 million and netting out debt ($6,670 million) yields a value for Alibaba's equity of $117,623 million.

I would not be surprised if Baidu, the only other large, publicly traded Chinese online company that is structured similarly to Alibaba (as a Variable Interest Entity) is used for comparison and its pricing ratios are applied to Alibaba's metrics to arrive at value.

Baidu Multiples Applied to Alibaba; Enterprise values adjusted for cash, cross holdings and debt

On second thoughts, given how low these values are, relative to the rumored IPO numbers, it is entirely possible that bankers will avoid talking about Baidu as much as they can, since it will not fit their pricing story. 

Pricing: Alibaba is not a publicly traded company yet, but there is no shortage of estimates of how much the company will be valued at after its IPO. The rumored IPO estimates of equity value (http://www.bloomberg.com/news/2014-02-05/alibaba-s-average-valuation-rises-to-153-billion-after-earnings.html) range from $150 to $200 billion.

The Bottom line

At this stage, we have three paths we can follow to estimate the value per share in Yahoo, which entitles you to a full share in the parent, 35% of the equity of Yahoo! Japan and 22.1% of the equity in Alibaba. In each case, I have netted out the taxes that Yahoo will have coming due on the 208 million shares of Alibaba that it will have to sell. Pulling together the numbers for all the valuation/pricing of the individual companies, here is where we stand:

1. All intrinsic value: Using the intrinsic value estimates that we have for the three companies in the mix, we can estimate an intrinsic value per share for Yahoo:

The taxes were computed based on the capital gains, the difference between the assessed equity value for Alibaba and the book value (from Yahoo's 10K) for these shares. Using intrinsic value estimates for all three companies, the value per share is $41.19, making it under valued by 18%, relative to the prevailing price per share ($33.76).
2. All relative value: Using the relative value estimates that we have for Yahoo, Yahoo Japan and Alibaba, we derive a relative value per share for Yahoo:

On a relative value basis, the value per share is $39.19, making it under valued by 14% at its current price.

3. Pricing break-even: There is a third twist that can be used to value Yahoo's equity. You can use the market pricing of Yahoo Japan and Alibaba to back out the value that the market is attaching to the parent company's operating assets. Since Alibaba is not public yet, this will require use of the estimated IPO value numbers (I will use $150 billion for the base case), but once Alibaba becomes a public company, the pricing will be the market value.

Using the expected IPO value of equity of $150 billion, the conclusion you arrive at is that the market must be attaching a negative value to the parent company's operating assets. To the extent that this may just reflect the possibility that we are misplacing the Alibaba IPO, I estimated the value of Yahoo operating assets as a function of the value of Alibaba equity after the IPO.

Imputed value versus Intrinsic value

The results here are consistent with both the intrinsic and relative value assessments. Unless the Alibaba post-IPO equity value is less than $104 billion, it looks like Yahoo is mispriced, relative to how its holdings are being priced. 

What next?

While I remain concerned about the overall valuation of companies in the sector, Yahoo seems mispriced on every basis, intrinsic, relative and market pricing. I am aware that there are risks (as with any investment) and there are three concerns that I have:

1. Cross holding complexity: Yahoo is a case study in why valuation becomes difficult in the presence of cross holdings. In particular, the accounting for cross holdings, though it has its own internal logic, creates inconsistencies across financial statements that both confuse and trip up investors. In the case of Yahoo, the cross holdings in Yahoo Japan and Alibaba are recorded using the equity approach. The net result of the accounting is that the operating numbers for Yahoo (revenues, EBITDA and operating income) reflect nothing from these holdings whereas the net income and book value of equity do reflect the cross holdings . So what? For those investors who are dependent upon enterprise value multiples (EV/EBITDA or EV/Sales), applying either of these multiples to Yahoo numbers, adding cash and subtracting debt, i.e., following conventional practice, will yield a value of equity far lower than the market capitalization of the company because you are effectively attaching no value to its cross holdings. It is true that you may be able to use net income as your base, since it includes the income from the cross holdings, and apply a PE ratio to it, but that PE ratio will have to reflect the composite expectations across three companies (Yahoo, Yahoo Japan and Alibaba) on growth and risk.
2. The tax bite may get larger: I have assumed the minimum tax bite in my valuations, since it really makes no sense for Yahoo to liquidate its cross holdings now, unless it is forced to, as it is in the case of the 9% of Alibaba that it has to sell. It does not need the cash, its investors should get the pass-through value and it certainly does not want to pay the tax bill early. There are two scenarios, though, where this assumption may break down. First, if the market prices for Yahoo Japan and Alibaba skyrocket and Yahoo's price does not, the gap that we highlighted in the last section may get bigger. In fact, if it gets big enough, Yahoo may be forced to monetize the gap, i.e., sell its holdings in Yahoo Japan and Alibaba, pay the taxes, and still have money left over for its stockholders. The second relates to Yahoo's relationship with Alibaba. It is possible that Alibaba may be uncomfortable with Yahoo's continued large stock ownership and find a way, legal or extralegal, to get Yahoo to sell. 
3. The "do something quickly" discount: There is a bias both among analysts and financial journalists towards CEO action over inaction, towards quick action over more deliberate choices and towards growth over retrenchment. Leading into the Alibaba IPO, there has been a drumbeat of articles like this one, this one and this one that are full of advice for Ms. Mayer about what she should do with the cash windfall that Yahoo will have after the IPO. Most of these articles suggest ways in which Ms. Mayer can use the cash to return Yahoo to its glory days. I think that Yahoo has lost the fight to Google and should concede gracefully. Rather than throw good money after bad, my suggestion is that Yahoo do the following: (a) concede that growth in its core business will be too expensive to go after, cut back on growth investments and run itself as a mature business (essentially what I have assumed in the intrinsic valuation), (b) work on making the performance and the pricing of its cross holdings more transparent to investors and (c) return the excess cash to investors. The upside of doing this will be that the gap between price and break up value may shrink, benefiting stockholders. The downside is that Ms. Mayer loses a chance (albeit one with low odds) to go down in history as the CEO who brought Yahoo back from the dead.

The cross holdings and the confusion they breed among investors it both an ally and a hindrance, an ally because it is one reason why the stock (in my view) is mispriced and a hindrance because it may take a while for the mispricing to become evident. Alibaba's IPO may seem an obvious catalyst but market corrections don't always follow the logical path. The tax issue is a nagging problem, but the company seems cognizant of the tax overhang and negotiated with Alibaba to reduce the number of shares that it would have to sell after the IPO. Finally, Ms. Mayer seems to be saying all the right things, talking about how how she plans to be a "good steward of capital", but talk is cheap and the pressure to go for bigger and better will be difficult to resist. On balance, none of these risks is enough of a deal breaker for me. Not only is there a gap between price and value with Yahoo but there is one between price (that the market is attaching to Yahoo) and price (that the market is attaching to Yahoo! Japan and Alibaba) and as a newly minted Yahoo stockholder, I am hoping that one or the other of these gaps will close.

Yahoo! Equity Valuation: Master spreadsheet (is linked to individual company valuations below)

Yahoo! Parent intrinsic valuation

Yahoo! Japan intrinsic valuation

Alibaba IPO intrinsic valuation

Raw data for relative valuations (Online companies - fundamentals and multiples)