Editor’s note: Aswath Damodaran is a Professor of Finance at the Stern School of Business at New York University, where he teaches corporate finance and equity valuation. Follow him on Twitter @AswathDamodaran.
As the offering date for Twitter approached, the bankers could not seem to make up their minds on the pricing, with the offering price rising from $17-$20 barely two weeks ago to $23-$25 last week to $26 yesterday. The stock opened today, about an hour later than expected, at an eye-popping $45.10 a share, up 73 percent from the offering price. As you watch this process unfold, with a mix of wonder, greed and cynicism, the question that is begging for a response, is whether you should try to partake in this frenzy.
Assuming that you were not able to buy the shares at the offering price, should you buy now? And if you did get the shares at the offering price, is it time to cash out? The answer depends upon not only what you think about the company and its prospects but also on whether you view yourself as a trader or an investor, since it is not only possible but likely, in my view, that Twitter was both underpriced and over valued at its offering price.
In the pricing process, bankers gauge market mood and momentum, trying to determine the “right” price for the stock, not wanting to relive the Facebook fiasco, where the stock went into a tailspin after the offering, but also not trying to avoid the LinkedIn scenario, where the stock doubled on opening day.
The preferred script for both the bankers and the current owners of the company (founders, VCs) is for the stock to have a healthy “pop” on the offering date, the former because it reduces their underwriting risk and the latter because it acts as a lead-up to their cashing out on their holdings, months later. At a 75 percent jump on the opening day, Twitter’s price jump is uncomfortably close to LinkedIn territory, but the effect of the underpricing on the existing owners (founders, VCs) is mitigated by the fact that only about 12 percent of the shares were available to the public in the IPO.
If you were one of the lucky (or preferred) clients who got the shares at $26/share, you have nothing to complain about, but what if you were not? You can still try to play the trading game hoping that the positive news stories from the offering will draw in investors from the sidelines, carrying the stock higher, and wait to sell just before the tide turns.
What are the odds? I know that they are not good for me, since I am hopeless at sensing market mood swings or momentum shifts. The answer may be different for you, but if you do trade, I hope that your timing is impeccable and that you are not operating under any delusions of caring about value.
In the valuation process, you are trying to assess the value of Twitter as a business. In making this assessment, there are three key estimates that will drive your value:
- Potential revenues: While Twitter generated only $543 million in revenues in the most recent 12 months of its existence, the company has two key components working in its favor. It has more than 235 million users, some more active than others, giving it a reach and visibility that is difficult to match. The second is that the company is entering an online advertising market that is growing fast, often at the expense of old-time media advertising. In 2013, the online advertising market generated $117 billion in revenue and could potentially grow to be $200 billion or larger in the next decade.
- Profitability: Twitter reported an operating loss of $135 million in the last year, largely because of R&D expenses incurred during the year. Assuming that Twitter is able to get its users to click on sponsored tweets and generate ad revenues, the company still has to generate profits. While we have no idea what these profit margins will look like a few years from now, Facebook, the company closest to Twitter in its user model (immense user base, focus on advertising revenues), generates a pre-tax operating profit margin of 30 percent.
- Investment requirements: To grow its revenues, Twitter will have to reinvest not only in R&D but also in acquisitions of promising technologies that will allow it to monetize its user base. While Twitter has generated only about $0.50 to $0.60 in revenues for every dollar of investment in the last couple of years, the average for social media companies is closer to 1.40, and that number may rise a little over time, as the companies mature.
My valuation of Twitter yields a value of $18 per share and assumes that revenues will climb to about $11.5 billion in 2023 (giving Twitter about 5 percent to 5.5 percent of the online advertising market then), that the pre-tax operating margin will increase over time to 25 percent (about 5 percent lower than Facebook but about 5 percent higher than Google) and that a dollar in additional capital invested will generate $1.50 in incremental revenues.
To justify the $45 per share, you would need the company to reach much higher. By my calculations, Twitter will have to generate about $32 billion in revenues in 2023, giving it, by my estimate, about 15 percent of the online advertising market in that year.
If you are interested in Twitter as an investment, I think you should make your own judgments about these variables, notwithstanding your uncertainty about the future, and come up with your own estimate of value. Arguing, as some do, that there is too much uncertainty to even try to value companies like Twitter strikes me as an abdication of a fundamental responsibility of investing.
I think Twitter is a good company, with the potential to be a great one, but based on my views of the company, it is not a good investment for me at $27, $35 or $45 a share. There are two potential developments that can change that conclusion. The first is if the company finds a new market to enter or an innovative way to break away from its online advertising competitors, which increases potential revenues and value.
The second and more likely scenario is that the company stumbles in delivering expectations and that the same momentum investors, who bid it up, abandon it in droves, causing its price to collapse. For the moment, I have my popcorn ready and plan to watch the circus. It should be fun!
Image: Yiying Lu
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