Thursday, July 20, 2017

And Then You Pull the Switch

       A great many tech companies, Amazon is the most famous example and Snap is one of the most recent, are valued on what I call an "and then you pull the switch" basis.  By this I mean during phase one the company's goal is to build market share.  During this phase, the market focuses on subscriber growth and locking in subscribers, not current cash flow.  Then in some future phase two, the company is assumed to "pull the switch" and start making big profits from those locked in subscribers.  Ironically, 20 years after its IPO, Amazon is still widely interpreted as being in phase one.

       The critical valuation question is whether there will actually be a phase two in which the company pulls the switch and raises prices to customers and advertisers and, thereby, starts generating big cash flows or whether counterparties will pull their on switch and jump to another company.  I think Netflix is particularly vulnerable in this respect.  I do not see the customers being locked in sufficiently to justify the company's massive multiple of 230.  It is too easy for customers to switch if Netflix raises prices.

       In all of this it is critical to remember that value comes from cash flow, not customers.  For a comapny to have huge value today with small current cash flow, the switch they are planning to pull must be a big one indeed.  And when that big switch is pulled all the customers must stay with the company.

Wednesday, July 19, 2017

What is Driving the Aggregate Market Up?

       In a rational economic model, there must be new news about expected future real cash flows for the market to rise substantially.  I say real cash flows because in rational models inflation appears in both the numerator and denominator of a DCF model and cancels out.

        What is it about economic expectations that keeps the market rising?  Quite frankly, I don't have a clue.  It seems to me that all potential good news about the recovery, about Trump, and about growth was more than discounted months ago.  If anything, the new news seems to be that growth is more anemic than was previously anticipated and Trump is performing more poorly than hoped.  I keep thinking this has to end.  And end unpleasantly.  But day after day I am surprised as the market inches upward.

Tuesday, July 18, 2017

Even the Best Companies can be Overpriced

        Amazon, Netflix and Google.  Three great companies whose products I use with regularity.  They are profitable.  They are growing.  They have a dominant market position.  They have great management.  They are innovative.  For all those reasons, they should trade at a high price.  The question is how high.  And no matter how good a company is there comes a point where it is too high.  In my view, all three have reached that point.  This is not to say I would recommend being short.  Who knows how long the enthusiasm will last?  But at current prices, I would not touch any of them on the long side and would take profits on outstanding positions.  For Amazon and Netflix in particular, the P/E ratios are astonishing - 192 and 241, respectively!  Those sort of multiples imply market expectations of extraordinarily rapid growth in future cash flows.  It is hard for me to see those multiples expanding further and easy for me to see them contract considerably.  At this level, the risk/return tradeoff is far too weighted on the side of risk.

Wednesday, July 12, 2017

True Believers and Stock Pricing

            Back in 1977 Edward Miller wrote an article that still resonates today and provides insight into what I call “true believer” stocks like Tesla and Snap.  To see how Miller’s analysis works, take a look at the graph below.  The y-axis of the graph shows the estimated value of the company.  This varies from investor to investor.  The x-axis shows the number of shares investors are willing to hold.  The number of shares outstanding (net of any held by index funds), N, is depicted by the vertical line.  The key component of the graph is the downward sloping line.  This shows how many shares investors are willing to hold as a function of price.  As the price declines, more and more investors are willing to hold the stock.

            Market equilibrium exists when the N shares are held.  The graph shows that this occurs at a price, P.  This would be the market price.  Notice that P is above valuation of the median investor, M.  Miller’s key insight is that as long as the outstanding shares, N, are held by a relatively small number of “true believer” investors (small compared to all possible investors), the price will exceed the average assessment of value.  In that sense, the company will be overpriced.

            If price exceeds the average assessment of value, why don’t the pessimistic investors sell short?  Well some do.  For instance, Tesla and Snap are among the most heavily shorted large cap companies.  But even for those two companies, the short interest is only about 20% of the shares outstanding.  In terms of the graph, short selling moves the vertical line for N to 1.2*N.  That is still an amount of shares that can be absorbed by true believers.  (Why there is not more short selling is a question I postpone for another day.)

            By true believers, I mean investors who think that the subject company has growth options that will “disrupt business as usual” and “change the world.”  The problem with such investors is that it is hard to know what they base their beliefs on, or, more importantly, what would cause them to abandon them.  As I have stressed in earlier posts, beliefs regarding growth options can change overnight and if they do a death spiral can result.  Without the ability to sell securities at high prices to true believers, the company becomes starved for cash, operations run into difficulty, key people leave, customers flee, etc.  It is the story of eToys, My Space, and Groupon that has happened so many times.

The Rush to Short Snap

     Sometimes shorting a stock can be difficult and expensive.  In order to sell a stock short, you must first borrow the shares.  Because there is not a centralized lending market for stocks when there is a big demand to short a stock the lending market can become congested.  When it does so, the rebate rate can skyrocket.  For those of you who aren't familiar with the rebate rate it works like this.  Say I borrow Snap to short it and then sell the stock for say $100,000 dollars.  The rebate rate is the rate the I receive on the $100,000.  In many cases, it is zero.  But in some cases, when there is a big demand to short the stock, it can turn negative.  In the case of Snap, the rush to short it in recent days has been so great that the rebate rate has exploded to a NEGATIVE 60% per year!  (See the link below.)  That means I would have to pay 60% interest on the $100,000 while I was short Snap.  Clearly, I would not do so unless I expected the stock to crater in the near future.  But that is exactly what many investors have been doing in recent days.  The next few weeks leading up to the expiration of the lock-up on Snap shares at the end of July will be interesting days indeed for Snap investors.

Article on the Snap rebate rate

Tuesday, July 11, 2017

Growth Options One More Time - The Case of Snap

       In my previous discussion of growth options, I used Tesla as an example.  A better example is Snap.  Before saying why, a word of disclosure.  My godson, Evan Spiegel, was one of the founders of Snap.  That said, I know nothing about the company other than what I get from public sources.  One thing that is clear from those sources is that the value of Snap is almost entirely growth options.  Based on current operations, the company has large losses and negative cash flow.  For Snap to have any meaningful value, it has to grow and grow profitably.  That means exercising growth options.

        The problem is that no one can say with any certainty what Snap's growth options are let alone how valuable they might be.  As a result, the market value of the company can swing wildly as perceptions change regarding the growth options.  And swing it has.  Starting from an IPO price of $17 the stock shot to $25 and has since dropped almost 40% to 15.52 on virtually no fundamental information.  Does the lower price mean the stock is now "cheap?"  Not at all.  It still depends entirely what you think about the growth options.  The stock could be worth anywhere from basically zero to nearly $50 depending on those growth options or lack thereof.  Talk about risk.

A DCF for Apple

      Despite the amount of time I have spent discussing it, Apple is actually a suprisingly easy company to value for two reasons.  First, it has a lot of cash whose value is unambiguous.  Second, the company has grown so large that it reasonable to expect it to mimic the aggregate economy.  That is the assumption I build into my DCF.  I project 10% growth in 2017 based on the introduction of new iPhones, but after that expected growth is equal to that projected for the U.S. economy.

      To be sure Apple could surprise on the upside with new innovations.  But it also could surprise on the downside if innovation slows and margins contract.  Remembering that DCF models rely on expected values, the assumption of mimicing economy growth seems like a good one.

       Using that growth rate and a discount rate of 9.00%, the value of Apple comes to $172.  A bit higher than the market price, but not exceptionally so.  As always, I urge my readers to play with the assumptions.  Relatively small changes in expected growth or the discount rate can have a meaningful impact on the final valuation.

Apple DCF

Monday, July 10, 2017

A DCF for Fitbit

       In the past, I have complained about people posting investment analysis without real analysis - that is without a complete DCF model.  Unfortunately, this criticism applies to me as well.  Therefore, in the next few week s, I will be posting Excel versions of DCF models for companies that I have discussed on this blog.

        Here is one for Fitbit.  Notice that my assumptions are quite pessimistic.  For instance, the company is assumed to make no profit for the next three years.  After that, it turns marginally profitable but is able to grow only at the rate of inflation.  With these assumptions the DCF value comes to $5.31 which is almost equal to the market price.  This gives you a good feeling for what the market is expecting for Fitbit.

         Remember that the cash flows in a DCF model are statistical expectations.  As sucy, they reflect a number of future possible scenarios weighted by the probability of those scenarios.  In one such scenario the company may do markedly better than the projection, but in another it may fritter away its cash and go backrupt.

Fitbit DCF Valuation

An Updated DCF model for Tesla

      It still has aggressive assumptions for growth and profitability but comes in at $128.  Enjoy playing with the assumptions to see what valuations you get.

Tesla DCF Valuation

Wednesday, July 5, 2017

Growth Options and Risk

      Stewart Myers of MIT coined the term "growth options" to refer to future projects a company has the opportunity to undertake.  Because the projects have not yet been undertaken, and in some cases may not yet be envisioned, the market valuation of growth options is prone to large swings.  It depends on the perceptions of investors regarding what a company might be able to profitably do in the future.  And those perceptions are likely to be mercurial because they are, by necessity, based on speculation regarding future businesses rather than the performance of actual businesses.

       Investor perceptions regarding the growth options of Tesla have been the reason that I have been wrong about Tesla's stock price this year.  I thought it was overvalued at $300 because I did not see many growth options in the competitive automobile industry.  There were enough investors that disagreed with me to drive the price over $380.

       What makes investing in companies whose value is derived in large part from growth options so risky is that perceptions can change much more rapidly than the economics of operating businesses.  If perceptions do change, the market valuation of growth options can disappear virtually overnight.  Again Tesla is an example.  In a week, it has dropped from over $380 to about $335.  (I still expect it to fall below $300).  Of course, perceptions can change again if Mr. Musk makes some dramatic announcements.  Such volatility is likely to continue until Tesla matures to the point where more of its value is based on actual operations.