May 27th, 2012
by Andrew Butter
Post-IPO the experts are jostling for space on Prime Time; many are saying they all knew Facebook was outrageously overvalued; or as Peter Schiff put it, “It’s the Valuation Stupid”. None are saying $38 is cheap these days.
Some say they felt it in their bones. Some say it’s all about the alignment of Jupiter with Mars or perhaps the Fibonacci constellation; some are talking about Fair Value as is $38 just wasn’t “fair”. Theories abound but not many theorists were bold enough to put a number down that they might live to regret, even fewer shared their pristine ideas about what the future held in store…prior to the Big Day.
This is a range of hard-number value estimates I found trawling the internet, there are surprisingly few…there may be more, but if so they were hiding.
Prior to the IPO the average was pulled up by call options, which I guess, if someone is buying, is in a sense an estimate. I don’t imagine anyone is buying options at $60 to $70 now.
So, on average, it looks like the analysts were right, for now at least. That’s obviously a good way to do a valuation, just take the average of the analysts, and BINGO!!
Looking under the bonnet of the valuations, there is an excellent article by Aswath Damodaran in Forbes explaining the difference between “Value” and “Price”, which is about doing a poll to work out the price that everyone thinks is good and then taking a view. That’s basically how the underwriters figure out the price they will go to market at.
Another way of looking at that is the Good-Old-Boy-Wall-Street saying that value is the price you can sell something for to someone dumber than you; which is how they used to value mortgaged backed securities and synthetic collateralized debt obligations like ABACUS in the good-old-days…”mark-to-market”.
Except thanks to the magic of Facebook this time, the poll could determine not just who the dumbest person on Wall-Street is, but instead, who’s the dumbest person in the Whole Universe represented by 900 million friends!!
In that regard, I was explaining the idea of an IPO to my Facebook-addicted daughter and she asked “So how much to buy one share”? When I told her “$38” she said “Cool, I’d pay that!”
So how come so many different opinions….and which approach is “right”?
You would think that by now valuation ought to be easy, they teach it business schools (sort-of) and the world is full of MBA’s who will tell you how to arrive at what International Valuation Standards calls other than market value, and some people call Fair Value. The idea there is that eventually the price will go up, or down to Fair Value, so if it’s above your estimate, you sell; and if it’s below, you buy…do that a few times in a row and you will be as rich as Warren Buffet.
In this instance, the valuation to get “Fair Value” comes down to some sort of income capitalization valuation, you project earnings ten years into the future, apply a discount rate, press the button for NPV on your Excel sheet…and BINGO!! What could be easier than that?
Not many of analysts put up an explanation for how they got to their answer, but out of the few who did, the differences in opinion say a lot about where the different valuations came from:
1: The Discount Factor
Everyone who explained what they were doing used a discount factor of 11% to 12% of future earnings so that’s average 11.5% which is +/- 5% of the average.
Pre-tax margin as a percentage of revenues ranged from 25% to 35%, i.e. +/- 20% of the average. Aswath Damodaran said 35% like Apple; personally I disagree, for me Facebook’s core business is “Selling-Advertising-On-The-Internet” plus, like Google, anything they can pick up from here and there, so that’s where their margins should be headed.
The big difference was revenues in ten year’s time. Aswath Damodaran who’s Fair Value was in the range $20 to $29 pegged revenues at $44 billion in 2022 based on 40% compounded growth for five years followed by a transition down to nominal GDP growth. StarMine said average 10.8% growth over ten-years which gives you $10.5 billion revenues in 2022, which is one-quarter of the number Damodaran was using.
The way I looked at it Facebook will grow following an “S-Curve”, just like Google did until they got a second-wind, except there is no reason today to suppose Facebook will have a second-wind. My view is that curve can be predicted pretty accurately from the first years of operation, that ends up at about $30 billion in 2022 except the revenues come earlier-on which is why my Fair Value estimate ($11) is higher than StarMine ($9.6).
In that regard, Henry Blodgett (Fair Value estimate $16 to $24) pointed out correctly that Facebook is not doing as well as Google did in terms of growing revenues at this point in its development.
I didn’t see much actual market analysis, the point there is that Google already grabbed the low-hanging fruit out of advertizing, and Facebook is Johnny-Come-Lately in that market, and in markets typically the #2 always stays #2. That’s just the Immutable Laws of Marketing...Facebook may have changed a lot of things, but the Immutable Laws are well…immutable.
Then of course there is China and the story about Facebook’s lookalike, the point is, Facebook is not there, nor is Google which probably explains why the look-alike is doing so well. Nadeem Walayat’s arguments also center round future revenues, he’s pegged Facebook going down to $6 to $8 on the basis that with 900 million users they have saturated the market already.
Where that ends up is that opinions on future revenues range from about $10 billion in ten-years time (or less of you listen to Walayat although he is not specific), up to $44 billion if you listen to Damodaran and perhaps $60 billion of you listen to the likes of Needham who are pegging $40, although they are more waffle than quantitative specifics.
So…assuming the credible valuations, as in the ones where some sort of coherent explanation was offered, range from Leung ($48) down to Walayat ($6) that’s an average target price after the hype evaporates off, of $28 plus or minus $27 at say two standard deviations out i.e. +/- 100%.
So, ball-park, the uncertainty is +/-5% on the discount factor +/- 20% on the profitability and +/- 100% on the future revenues. That’s why, if you are doing a valuation, the hardest part, by far, is projecting the revenues in the future. When I do a valuation, I spend 90% of the time thinking about that, although on reflection, looking at the ratios I ought to spend more time thinking about profitability than the 5% I do these days.
Interestingly I was looking at the program for a course put out for bankers to learn how to do a valuation that arrived un-solicited on my e-mail and was also a banner on some Google sites I visit. I noticed that less than 5% of the coursework was devoted to working out what markets are going to do in the future.
By the same token, when I pitch to bankers and venture capitalists about doing valuation, and I start talking about how to figure revenues in the future, their eyes glaze over. The banks just say…tell me the LTV today and the DSCR in year-two, and venture capitalists just ask about how much they will get when they exit.
Do you wonder why there was a credit crunch?
So Which of the many Guru’s you can chose from…is Right?
Well, time will tell. Although there is always the Black Swan Caveat that we gurus keep in reserve just in case. So if our valuation (that’s what we are talking about here) turns out to have been wildly wrong, we can say that was not a reflection on either our genius or on our divine powers to predict the future, it was a one in 3.4 million 5-Sigma chance event.
Turning that around, the probability that Butter’s divine theory is wrong equals, according to that logic, one in 3.4 million…assuming it turns out Butter is right…I hope that’s clear?!!
I remember years ago my young wife got into gurus and she trotted off to India with my daughter aged-four to spend some time in an Ashram….she lost a lot of weight!! What I never understood is, if all the gurus in India were right, how come they all disagreed with each other about what precisely was the correct divine path…and how do you chose? I learned pretty quickly that, if you ask that sort of stupid question, best case you don’t get any dinner and worst case your conjugal rights get suspended…women can be so…sensitive!!!
But sticking with the subject of gurus, we have a range of Fair Value of $54, from $6 to $60. So if I predicted $11 plus or minus say 20% ( $9 to $13 for a range of $4) then assuming the chances of coming up with that using the technique of arranging numbers from $4 to $62 on a dart-board (allowing for a “spread” at each end), and then I got my faithful pet-chimpanzee assistant to throw one dart at the board, the chances that one dart would hit my genius prediction would be 4/56 = 7%.
What that means is even if it turns out Facebook gravitates down to that range, the chances Butter’s wonderful theory was wrong, and that I could have just got that result starting off with the chimp and working backwards, would be 7%.
Sounds pretty impressive eh!! Except Paul the Octopus managed to predict the results of eight World Cup matches in a row (win or loose, draw is not an option because they have penalty shoot-outs if it’s a draw), the chances of that are 0.39%. That would prove, based on one trial by me (assuming it turned out to be right), that a common octopus from Weymouth was 17.9 times more intelligent, or psychic, than I am.
That sounds about right. But apart from that, it illustrates that even if in a year or two my “answer” was right I would have to do that six times in a row to achieve the probability hurdle of one in 3.4 million they set for deciding correctness of the theory about the Higgs Boson, based on doing similar “experiments”.
Just so you know, valuation is a science, but not a very exact one.
In that regard, on the subject of choosing your guru, the best bet is to look hard at the explanation they give for how much revenue they are going to grow in the future, and forget about the rest, that’s just noise.
More by Andrew Butter
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About the Author
Andrew Butter started off in construction in UAE and Saudi Arabia; after the invasion of Kuwait opened Dryland Consultants in partnership with an economist doing primary and secondary research and building econometric models, clients included Bechtel, Unilever, BP, Honda, Emirates Airlines, and Dubai Government.
Split up with partner in 1995 and re-started the firm as ABMC mainly doing strategy, business plans, and valuations of businesses and commercial real estate, initially as a subcontractor for Cushman & Wakefield and later for Moore Stephens. Set up a capability to manage real estate development in Dubai and Abu Dhabi in 2000, typically advised / directed from bare-land to tendering the main construction contract.
Put the unit on ice in 2007 in anticipation of the popping of the Dubai bubble,defensive investment strategies relating to the credit crunch; spent most of 2008 trying to figure out how bubbles work, writing a book called BubbleOmics. Andrew has an MA Cambridge University (Natural Science), and Diploma (Fine Art) Leeds Art College.