Thursday, July 14, 2011

One Man's Tweet is Another Man's Treasure (maybe.......)

One Man’s Tweet is Another Man’s Treasure

To value a company at 40 times revenue suggests a growth of the order that usually is note seen among public companies, at least not those that survive.  Not a direct indictment of Twitter and its investors which, according to media reports, placed a value on the company of approximately $8 billion, but it does beg some serious question in my mind, the biggest one being what if anything does Twitter’s value show us.

As finance guy, anytime I hear or read about those grand valuation for companies, thanks to my undergrad finance and econ professors, I immediately try to figure out what type of growth these investors are expecting to justify these “lofty” valuations. And at the end of the day that’s what you’re supposed to be buying as a shareholder – a share of the cash flows generated by a company.  The basis of capitalism is risk and return, where those who risk capital are more handsomely reward than those who do not, but the reality today is that we also reward timing and opportunity (sometimes to a greater degree) and it is hard at times to assess the extent to which timing skews or obliterates fundamentals.  But the reality is fortunately or unfortunately depending on your perspective finance fundamentals and valuations always, and I mean always losses out to supply and demand, which is the definition of a bubble.  But almost by definition few people see bubbles in the midst of the bubble and hindsight is always 20/20.

But let’s talk about Twitter for second.  I just did some back of the envelope calculations, that took me right to where I thought I would be.  Now this is based on the reported numbers which may or may not be accurate, but if the numbers are even close the conclusion is the same.

Twitter has an estimated value of $8 billion based on revenue of approximately $200 million and close to breakeven profitability.  This is a price to sales ratio of 40x (by comparison  I read Zynga has valuation of 33 or 37x sales, which for my money is just the same).  As a shareholder you  buy Twitter with some expectation of return/price appreciation over your holding period.  So if you  assume a 15% annual return over 5 years, the market capitalization would need to roughly double to $16 billion, which may seem possible over 5 years.  But in five years the price/sales ratio will have declined (it usually does for companies) due to the company’s growth (hopefully); as an example Goodle has a pricse/sales equal to roughly 6x.  But if in 5 years Twitter had higher growth prospects that Google today (on a relative basis) and traded at a 10x price/sales ratio, sales would need to reach $1.6 billion  to justify the $16 billion value, which is a growth rate of 8x current revenue (Google’s revenue has grown 10x since its IPO).  Not saying Twitter isn’t the next Google, but does Twitter have the same value proposition for advertisers (who knows), will they be able to find a new revenue stream other than advertising (maybe), will they have future competitors (it’s possible or not).  The reality is that as an investor you are buying into certain assumptions for the future if you buy Twitter.

One reality is that everyone doesn’t have a 5 year holding period and a lot of the investors will do just fine selling their shares after the IPO for what will surely be a return of several multiples on their initial investment, and because of the timing of their sell and the opportunity of their purchase everything will be just fine for them.

So at the end of the day what does Twitter’s valuation tell us about finance, or the state of the economy, or the technology 2.0 bubble – nothing.  All it tells us is that the value of Twitter is $8 billion today and to buy in now you have to hope to seem some pretty impressive things if you plan to hang on to it after the IPO.

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