Investors in Twitter stock have recently learned the hard way how volatility strikes when you decide to purchase a company that has no readily identifiable profits under its umbrella—in other words, its valuation is inherently speculative because investors are entirely measuring the company based on what it will be like in the future, rather than what it is doing now. After crossing the $74 threshold the day after Christmas in 2013, the price of the stock has fallen to $35.
The financials of the company, as they stand right now, remain unimpressive. Twitter lost $1.13 per share in 2013, and this year should figure to be more of the same. That works out to an annual loss in the $600-$700 million range.
If some were contemplating a long-term investment in Twitter, they would need to ask themselves two questions: What would Twitter’s valuation have to be in the long run? And what are the implications there for Twitter’s profits?
I’ll use Visa as a comparison as I believe that is the publicly traded company that has the highest justified stock market valuation. Right now, Visa trades at $214 per share and earns somewhere around $8 per share in current profits, for a valuation of 26.75x earnings. Because Visa, though, is growing at a 13-17% annual rate—profits 18 months from now might be over $10 per share, and continuing to grow higher thereafter, the price is justified.
So let’s put Twitter in Visa terms: If Twitter were to sustain its current valuation of $21 billion, how much should it be making in profits? Given that Twitter trades at $35 per share, if its valuation were to be at 26.75x profits, the company would need to make $1.31 per share in net profits to be justified.
Right now, the analyst consensus for the next five years is that Twitter will be making $0.60-$0.70 per share in net profits (keep in mind, though, the certainty of a prediction like this is inherently speculative. This isn’t a situation where an analyst is trying to predict PepsiCo or Kraft’s net profits five years from now—macaroni and cheese and potato chips have a profit-generating potential that is easy to predict. When we start making five-year predictions for a company that didn’t even exist ten years ago, we should be upfront about the fact that we are speculating. Speculating is not evil, it’s just that we need to acknowledge the lower probabilities of being right that comes with the territory).
So, to analyze Twitter, let’s put it this way: If Twitter were to trade at Visa’s lofty valuation in 2019, it would need to turn in profits that are double what analysts expect over the next five years, just to tread water with the $35 price tag that the company wields in 2014. This says nothing about actually earning 10% annual returns or something of that nature with Twitter; we are speaking hear solely of what it would take for Twitter to be worth $35 five years down the road.
Of course, there’s no guarantee when the party might end. I have no idea the full context in which Warren Buffett said the following, but it’s a quote I like to apply to speculative stocks that do not have an understandable connection between reasonably expected profits and current valuation: “The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities—that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future—will eventually bring pumpkins and mice. But they nevertheless hate to miss a single minute of what is otherwise one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”
In the case of Amazon, the party has been going on for fifteen years: Amazon is trading at $335 per share while making $0.60 per share in profit in 2013. Even if you’re optimistic that the company will make $1.25 per share in profit this year, you’re still looking at a company trading at well over 200x profits. That’s where you step in and say, “This might continue for another five, ten, fifteen years, but I’ll let someone else make that money. This one’s not for me.” Why would you adopt that attitude? Because nothing feels worse than getting burned by something that looks stupid on its face. If something like Coca-Cola were to ever burn you, you can hold your head high—it traded at 20-25x earnings for most of the later 20th century, grew profits linearly, raised its dividend for half-a-century, had a stable of 500 brands in over 200 countries earning 28% returns on equity, and offers a current entry price of 20x earnings. If that fails, well, you acted intelligently. If Amazon, on the other hand, gives you a quick and dirty 50% haircut, you can’t blame Buffett. You can’t blame Munger. You can’t blame Lynch. You can’t blame Neff. You think any of those guys would have endorsed the idea of paying well over 200x profits for a stock?
With Twitter, it seems the best approach is “Don’t go there.” It may have fallen over 50% in the past six months, but that’s not proof of value. If you tie it to something like Visa’s valuation, you can see that Twitter would have to perform in excess of expectations for the next five years to prevent you from losing money based on its $21 billion valuation. In the short term, who knows what will happen? Twitter could go to $100 this Christmas, and cross $200 the year after that. I don’t think too many people saw Amazon continuing its valuation disconnect this long, and there is nothing preventing Twitter from doing the same. But you must ask yourself the question: Do you want to be left with the stock tucked away in your brokerage account when the day of reckoning comes in which the price of the stock becomes tied to the actual honest-to-god profits that Twitter generates?
Originally posted 2014-06-11 22:47:52.