Somewhere along the line, it got assumed that value investing requires shunning the tech stocks that receive the overwhelming of media attention. This assumption might be true for the value investors that only want to purchase current cash flows that are being sold at a discount. But I’ve always had a much broader view of value investing: it’s about locating the best risk-adjusted future profits at the best price available.
The issue with the stocks that have become media darlings is that there is no way to make the numbers work even if you adopt an optimistic view about future earnings and future valuations.
Take Facebook, for example. If hitting a low of $17 in 2012, the stock has flown straight to the $100 mark (most recently trading slightly lower at $98). You can find no shortage of analysts that recommend it. I could never do that. It is currently valued at $281 billion. That is extraordinarily absurd (you could purchase The Hershey Company outright 21 times over for the equivalent value in Facebook).
This isn’t just “yeah, popular companies that are growing fast deserve a premium and you need to pay a bit more than you’re comfortable if you want to participate.” It’s moved far beyond that–right now, Facebook makes $3.5 billion. Let’s make an outrageous assumption and assume that Facebook were to become the most profitable company in the United States and generated $50 billion in profits fifteen years from now.
What’s a reasonable multiple for the largest non-cyclical company in the country, 20x earnings? That would make Facebook a $1 trillion company, compared to the current $281 million. Think about it like this–if Facebook increases its profits by 1,408% in fifteen years, you will only increase your wealth by 355%. Those are terrible terms given the level of ridiculousness in my original premise.
Take something more realistic but ultimately optimistic. Imagine that Facebook doubles its profits from $3.5 billion to $7 billion in three years, and then doubles them to $14 billion. At the close of this seven-year period, Facebook trades at 25x earnings. In this scenario, you are looking at a $350 billion valuation.In other words, profits would have to quadruple in seven years, a very lofty premise, and you would only end up with 24.55% cumulative returns over a seven-year period. That’s a compound annual growth rate of 3.19% even if profits quadruple in seven years and the stock trades at the high end of sane value level. That’s not just an intelligent way to arrange your affairs–and as we saw with Under Armour recently–even a double-digit earnings gain can still accompany a justified 30% price drop if the valuation is high enough.
The real problem with Facebook is that it has a P/E ratio of 77, which is very troublesome for a company already valued at $281 billion. When the P/E ratio of the stock is eventually destined to compress down to the 20-25x earnings level, you can understand why the current valuation at Facebook seems like it has flown off the pages of Security Analysis as the type of company to avoid at all costs for valuation reasons.
This valuation predicament that currently exists with Facebook is something that also existed with Twitter during each time I have previously analyzed it. After trading in the $70s during 2013 and 2014, and then trading in the $50s last year, I couldn’t even make the numbers work using optimistic assumptions. Now that the stock is down to $19 per share, a case can be made if you are optimistic about Twitter’s future.
The short-hand version? If you assume that Twitter generates $6 billion in revenues five years from now and makes $1 billion in profit, and trades at 25x earnings, then you would come up with a valuation of almost $25 billion. Compared to the current $13 billion price tag, that would create a 92% capital gain in five years for a compounded annual return rate of 13.97%. I am not saying that this is going to happen, but rather, I write this to note that a relationship now exists where reasonably high hopes for Twitter’s performance now corresponds to reasonably high returns for Twitter itself.
The reason why I, personally, would not buy shares in Twitter is because tech companies pay a significant amount of compensation in the form of stock options and my personal estimates of share dilution for Twitter have been way off. When I read Twitter’s financial statements at the time of the IPO in 2012, Twitter had 569 million shares outstanding. I calculated all of the then-existing commitments, rounded up a little, and imagine that Twitter would have around 600 million shares by the end of 2015. That’s not the case–Twitter had 676 million shares outstanding at the end of 2015. That means each dollar of profit has to be diluted 12.66% more than my initial estimates that I thought gave some leeway for more dilution than anticipated.
This begs the question: With the stock now at $19, how many shares will be issued to Twitter’s directors and officers beyond what has already been indicated in previous filing forms? If the share count continues to dilute the existing base at a fast rate, you could have a situation where the profits eventually come but the dilution eats up an uncomfortably high percentage of the eventual profits and thereby diminishes returns. That’s my hesitancy.
But the Twitter experience is yet another anecdote to add to the file that vindicates Benjamin Graham’s advice to avoid IPOs altogether because of the exuberance tied to initial public offerings that will disappear in a hurry the moment a company fails to meet lofty expectations. When Twitter was trading in the $70s, it couldn’t be justified. Even reasonably high optimistic assumptions would only call for a $40 stock price by 2020. Now, here in 2016, with Twitter at $19 per share, the terms have shifted. That same $40 prediction for 2020 still holds, but it is a lot more fun for a shareholder to travel to that price point from $19 instead of $74.
Twitter, like Facebook and Apple, benefit from the escalating commitment of the user base. As people log more life moments onto the site, and pick up followers, it creates more emotional attachment to the brand. It is hard determining how entrenched a product will be that didn’t even exist a decade ago, but a lot of the nonsense and irrationality has been wrung out of the share price. At $19 per share, Twitter may not yet be a conservative investment, but I would now consider it fair to be labelled an intelligent medium-term speculation. If you run the numbers, it no longer has that ridiculous flavor you get when you try to calculate future values for Facebook, Tesla, or Amazon.