Latepost Twitter Announces Ipo: The Pricing Game Begins

I withdraw maintain a Facebook account, but I almost never post. I also withdraw maintain a Linkedin account, but it is a non premium, largely because I am non that interested inwards finding out who is looking at my profile or endorsing me (often for skills I don't have). I do withdraw maintain a Twitter concern human relationship in addition to acre I don’t postal service really often, I simply similar the ease alongside which it lets me põrnikas thousands of people. All of this is of course of study a atomic number 82 inwards to the storey that I am certain volition dominate the fiscal tidings for the side past times side few weeks: Twitter is planning its initial world offering in addition to everyone has an catch on what it volition live priced at.

While I volition attempt to value Twitter when the fourth dimension is right, I am going to usage this postal service to cost Twitter, non value it, for 3 reasons. First, Twitter’s fiscal statements are all the same inaccessible, a upshot of the JOBS Act (passed lastly year) that allows “emerging companies” (with revenues < $1 billion) to usage a confidential procedure for filing alongside the SEC. Unlike some who are worked upwards nearly the resulting lack of transparency, I am non inwards high dudgeon nearly this non-disclosure. The fellowship volition withdraw maintain to supply a total prospectus a few weeks earlier the shares are priced (and offered) in addition to in that location volition live enough of fourth dimension for me to do my due diligence. Second, the atomic number 82 investment depository fiscal establishment (Goldman Sachs) volition live pricing the fellowship for the offering, non valuing it, in addition to I desire to usage this postal service to convey a expression at that process. Third, if y'all withdraw to play this IPO game, to win, y'all withdraw maintain to live able to play the pricing game well, non acquire the value right. 

The tools/inputs of Pricing
To value a business, y'all start alongside raw information from a company’s fiscal statements, depict on measures of opportunity in addition to operating efficiency for the concern inwards which it operates, brand estimates for the futurity in addition to usage a valuation model (with my preference existence for a discounted cash flow (DCF) model). To cost a company, y'all depict on a dissimilar ready of inputs in addition to tools, alongside the next standing out:

1. Current price: This may audio circular but the key input into the pricing procedure is the electrical flow cost of the asset. After all, inwards pricing, y'all are accepting the market’s judgment of cost every bit the entirely number that ultimately matters. With publicly traded companies, this dependence on the cost takes the cast of charts in addition to technical indicators, which tin in addition to so live mined for clues nearly futurity cost movements.  Looking at a all the same private fellowship similar Twitter, this approach may seem similar a non-starter, since it has no world market, but in that location withdraw maintain been transactions inwards the past times that supply clues nearly its price. Some of these transactions involve venture uppercase investments, where y'all tin extrapolate from the investment in addition to the percentage of the fellowship received past times the venture capitalist to the overall cost of the fellowship is. Others involve private sales past times 1 investor to another, where 1 time to a greater extent than the transaction cost provides clues every bit to the the overall price. The next graph, drawn article/SB10001424127887324755104579073562166634226.html">mostly from a Wall Street Journal tidings storey on the company, imputes prices for Twitter based upon trades over the lastly few years on the company’s equity.

Note that the imputed cost of equity inwards Twitter was $100 1000000 inwards 2008 in addition to that the cost has surged over the lastly 3 years, rising from $ 1 billion inwards belatedly 2009 to $ nine billion early on this yr in addition to $10.5 billion a calendar week ago. Much of the surge occurred inwards the latter one-half of 2011, subsequently Linkedin sale of 15% of the fellowship to Blackrock, alongside an imputed cost of $9 billion for the company. That transaction was inwards Jan 2013 in addition to both the marketplace in addition to social media companies withdraw maintain risen inwards price, since then; the S&P 500 is upwards 20%  since Jan in addition to Facebook & Linkedin, the 2 social media companies that are viewed every bit closest to Twitter, withdraw maintain gone upwards fifty-fifty to a greater extent than over the same fourth dimension catamenia (Linkedin has doubled in addition to Facebook has gone upwards nearly 67%). Applying fifty-fifty the marketplace alter (20%) to Twitter would yield a value of $10.8 billion, in addition to applying the social media appreciation number would growth that value to $16-$18 billion.  In September 2013, simply a few days ago, Twitter bought MoPub, a mobile advertising exchange, in addition to issued stock to comprehend the transaction cost. Imputing the value of Twitter from the percentage number leads to an imputed cost for Twitter gauge of at to the lowest degree $10.5 billion. Thus, simply based on these 2 private transactions, the cost of Twitter should live at to the lowest degree $10.5 billion in addition to maybe a scrap more.

2. Relative value: The other commonly used tool inwards pricing is relative value, where y'all ready the cost for an property past times looking at the prices at which comparable companies are traded at inwards the market. The procedure of applying this approach to cost a fellowship similar Twitter tin live complicated past times 2 factors. 

a. Scaling variable: Since the units into which y'all split upwards value (number of shares) is past times its nature arbitrary, y'all demand to scale the cost to a mutual variable. That, of course, is the locomote of a multiple, whether it live PE, Price to Book or EV/Sales. In the context of young, growth companies, where earnings in addition to cash flows are ofttimes negative in addition to mass value is meaningless, analysts either focus on revenues, and/or scale the cost to some mensurate of operating success (users, subscribers etc). With Twitter,  a revenue multiple tin live utilized to gauge value, fifty-fifty if its fiscal statements study a network loss or EBITDA for the year. The tabular array below provides the multiples estimated inwards September 2013 for Facebook in addition to Linkedin inwards the start 2 rows, every bit good every bit a broader sample of firms that loosely derive their revenues from online services (though some similar Netflix are subscription based in addition to some similar Pandora acquire a mix of advertising in addition to subscription based revenue):

All the normal caveats apply. The accounting numbers reverberate trailing 12 calendar month estimates, but inwards companies similar these, these numbers volition alter dramatically from catamenia to periods, every bit volition the number of users in addition to employees. The number of users disguises broad differences amid them, alongside heavy, mild in addition to completely idle users aggregated together in addition to sometimes double or triple counted. The value per users volition live skewed past times differences inwards concern models, alongside companies similar Netflix that withdraw maintain subscription based revenues registering much higher values.

Even alongside the really express world numbers that y'all withdraw maintain for  Twitter, y'all tin start estimating prices, using these multiples. For instance, if the tidings stories that peg Twitter's most recent twelve-month revenues at $583 1000000 are right, y'all could apply the revenue multiple of 17.45, that its 2 closest competitors ($FB & $LNKD) merchandise at, to acquire inwards at a value of $10.17 billion, fairly closed to the most recent transaction price. (Twitter's cash residuum would withdraw maintain to live added to this number to acquire to a marketplace capitalization.) 

Twitter's estimated enterprise value = $583 * 17.45 = $10.17 billion

Before y'all acquire also excited nearly this convergence, recognize that applying the median EV/Sales ratio of 8.67 for the social media medley to Twitter's revenues yields a value of $5.05 billion, making the $10 billion addition numbers existence bandied nearly expression awfully high. 

Twitter's estimated enterprise value = $583 * 8.67 = $5.05 billion

Just to circular out the estimates, y'all could ever apply the multiple of $130.32/user that investors are paying collectively for Linkedin in addition to Facebook to Twitter's 240 1000000 users (I withdraw maintain seen wildly varying estimates of this number alongside some estimates ranging upwards to 500 million) yields a cost of closed to $25 billion.  

Twitter's estimated marketplace capitalization = $130.32 * 240 = $24.4 billion
I withdraw maintain estimated a arrive at of prices for Twitter based upon the dissimilar combinations (multiple, selection of comparable firms, averaging approach):

Which 1 of these is the right price? That depends on what your priors are nearly Twitter in addition to maybe what y'all are trying to convince me to do. If y'all believe that it is a peachy fellowship that volition also live a peachy investment, y'all volition locomote alongside the combinations that yield the higher number. If y'all are convinced that this is the side past times side bubble that volition burst, y'all volition usage the lowest values to justify selling curt or alarm people away from the company. It is no wonder that equity salespeople latch on to this approach. All y'all withdraw maintain to do is uncovering the right mix of multiple in addition to comparable firms in addition to y'all tin dorsum upwards whatsoever sales pitch (that the fellowship is cheap, expensive or correctly priced) y'all desire to brand nearly whatsoever company. If y'all are on the other side of this sales pitch, it has live caveat emptor.

b. Current versus Forward Numbers: To the extent that your multiples are skewed or meaningless because electrical flow values for earnings, mass value in addition to uppercase expenditures are little in addition to meaningless (in terms of forecasting futurity values), y'all tin attempt to forecast the values for each of these items in addition to apply a multiple (based ordinarily on what other publicly traded companies are trading for today) to acquire the estimated value inwards the future. Getting from that futurity value to value today tin live dicey, every bit I illustrated in my lastly postal service on Tesla, every bit risk, fourth dimension value in addition to dilution all swallow into the terminal value. It is also worth noting that acre this may live tardily to do for a immature growth fellowship inwards a sector where most of the competitors are mature, it volition live hard to do alongside Twitter, where the atomic number 82 competitors, Facebook in addition to Linkedin, are also inwards high growth in addition to volition alter over time.

The Drivers of Price
Just every bit the tools in addition to drivers of pricing are dissimilar from those of value, the drivers of cost vary from the drivers of value. Thus, acre value is determined past times cash flow, growth potential in addition to risk, cost is determined past times a dissimilar ready of variables:

1. Momentum/Mood: Much every bit intrinsic value investors tend to disdain momentum, it remains truthful that momentum is 1 of the most powerful forces driving returns alongside stocks. Studies signal that over shorter fourth dimension periods, momentum based investing ofttimes delivers much ameliorate results than key based investing. For some stocks, peculiarly those inwards "hot' sectors, momentum is the key driver of prices, drowning out tidings nearly the fundamentals.
2. Incremental news: Once y'all convey the pricing suggestion that the marketplace cost is what it is, the key to winning at the pricing game becomes forecasting changes inwards cost rather than assessing whether the electrical flow cost is right. As a consequence, your focus on tidings stories volition acquire incremental in addition to each tidings storey volition live assessed inwards terms of how it volition alter the price, rather than how it volition touching overall value. 
3. Liquidity: If y'all invest based on long term value, y'all tin afford to pose liquidity on the dorsum burner for 2 reasons. First, the cost of illiquidity (higher transactions costs) tin live spread over your long belongings period, reducing its impact on your returns. Second, since y'all are non investing on momentum in addition to non every bit theme on timely trades for your profits, y'all tin afford to hold off to purchase or sell, rather than withdraw maintain to do so inwards the middle of marketplace chaos. If y'all are trying to make money on pricing, liquidity or the lack of it tin non entirely brand the departure betwixt making in addition to losing money, but inwards extreme cases, tin atomic number 82 to disaster (especially if y'all withdraw maintain a pricing strategy accompanied alongside high high leverage). 

The Dangers of Pricing
The pricing game tin generate large profits inwards curt periods but it comes alongside a alarm label. It is non for the faint hearted, since it is accompanied past times risk. The marketplace tin brand mistakes inwards the aggregate:

1. Markets tin live incorrect inwards the aggregate: I know that active investors catch those who believe that markets are efficient (I don’t…) every bit eggheads or worse. It is worth noting, though, that many of these same active investors are “pricers”, who pick stocks based upon multiples in addition to comparable firms. In effect, they are assuming that markets are right inwards the aggregate, but brand mistakes on private companies, which would brand them semi-believers inwards marketplace efficiency. If markets are incorrect inwards the aggregate, y'all tin live right inwards your relative assessment (that a stock looks inexpensive relative to its competitors) in addition to all the same lose large amounts (if they are all over priced).
2. Mood shifts (inflection points): To the extent that cost is driven past times momentum in addition to mood, shifts inwards that mood tin really speedily plow profits to losses. The key to winning at the game thus becomes detecting inflection points (where positive momentum turns to negative momentum) in addition to altering your investment strategy. This is the hope of charting in addition to technical analysis, where cost in addition to mass patterns yield clues nearly futurity momentum shifts. Even the best indicators, though, ofttimes neglect at this task. It is also worth noting that momentum is delicate in addition to based partly on illusions. If bankers exhibit contempt for the procedure in addition to its players (as I remember Facebook in addition to its bankers did at the fourth dimension of their IPO), the momentum may really good shift.
3. Taxes in addition to transactions costs: As a full general proposition, playing the pricing game requires y'all to withdraw maintain a shorter fourth dimension horizon in addition to to merchandise without regard to taxation consequences. Thus, if y'all purchase a momentum stock in addition to turn a profit over the 10 months that y'all concord it but y'all uncovering a shift inwards momentum, y'all volition sell the stock in addition to convey your profits, fifty-fifty though y'all human face upwards a much taxation nib every bit a U.S. investor (if y'all had held for a year, y'all could withdraw maintain qualified for uppercase gains). 
4. Implied assumptions: Many analysts in addition to investors who usage multiples justify that usage past times contention that intrinsic valuation require also many assumptions in addition to that pricing/relative valuation does not. I would combat that whatsoever multiple has embedded inwards the same assumptions but that they are to a greater extent than implicit than explicit. Take Twitter, where the key assumptions are nearly how much revenues volition withdraw maintain to grow in addition to what the target operating margins volition live on these revenues. In the tabular array below, I withdraw maintain estimated the multiple of revenues that y'all would live willing to pay for whatsoever company, given how your await revenues to alter over the side past times side 10 years in addition to the operating margin inwards yr 10. For simplicity, I withdraw maintain left the opportunity (cost of capital) in addition to character of growth (reinvestment) unchanged. (My hypothetical fellowship had a cost of uppercase of 12% to start, moving towards an 8% cost of uppercase inwards perpetuity in addition to a render on uppercase inwards 12% subsequently yr 10.)

This tabular array tin live used inwards 2 ways. If y'all believe, for instance, that Twitter's revenues volition growth ten-fold (from $538 1000000 to $5.38 billion) over the side past times side decade in addition to that its target margin volition approach 30%, y'all would live willing to pay 12.71 times Twitter's electrical flow revenues for the fellowship (12.71*583 = $7,409 million). Conversely, if y'all are remember to pay xx times electrical flow revenues (about $11.6 billion) for Twitter, y'all would demand revenues to growth fifteen-fold over the side past times side decade in addition to margins to converge to nearly 32% inwards yr 10. (I volition update this tabular array when Twitter's fiscal statements come upwards out.)

A Cynical View of the Twitter IPO Pricing Game

If y'all create upwards one's withdraw heed to play the pricing game, y'all volition withdraw maintain lots of company. In fact, I would combat that much of what passes for valuation inwards investing is pricing. In an IPO, inwards particular, how a fellowship is priced for a world offering in addition to what happens inwards the subsequently market, at to the lowest degree inwards the months next the offering has to a greater extent than to do alongside pricing than value.

So, hither is my convey on what volition happen. Goldman Sachs volition start alongside the latest transaction value for Twitter, closed to $10.5 billion, in addition to conform it upwards for the improvement inwards both the overall marketplace in addition to inwards social media companies (especially Facebook) since the start of the year. They volition in addition to so create a sales pitch for that value, using the pricing of other social media companies (Facebook in addition to Linkedin, inwards particular) to combat that Twitter is a cope at their estimated price. (My guess is that they volition focus on the number of users in addition to how Twitter looks similar a cope on that basis.) That sales pitch volition live tried out on institutional investors for effect, alongside the salespersons’ ears peculiarly attuned to either also much enthusiasm from these investors (a sign that the cost was ready also low) or to trivial (a signal that it is et also high). The institutional investors, non having a clue nearly the fair value of Twitter, volition verbalize to each other in addition to ratchet upwards or downwards their ain enthusiasm based upon what they feel inwards their compatriots. The investment bank, having tweaked the cost based on investor reactions volition in addition to so do a discounted cash flow valuation, opposite engineered to deliver that cost every bit the terminal value. (A goodness exam of their valuation skills volition live inwards how good they shroud this opposite applied scientific discipline to brand it expression similar the valuation led to the pricing rather than the other means around). Finally, having learned from the Facebook fiasco that it is ameliorate to nether cost rather than over, they volition knock off nearly 15% off their estimated price/value to ready the offering price. At the opportunity of existence hopelessly incorrect inwards hindsight, I would live really surprised if I saw Twitter priced lower than $10 billion or higher than $15 billion, unless in that location is a major marketplace disturbance. (As a dot estimate, I would guess that it volition live priced around $12 billion. In fact, let's start a shared Google spreadsheet of our cost guesses. They are based on nix to a greater extent than than rumor in addition to minimal information, but why permit that halt us?)

Am I existence cynical? Perhaps, but I remember nosotros would all live ameliorate served if the procedure was stripped off its veneer of value. If nosotros honestly faced upwards to the reality that this is an do inwards pricing in addition to non valuation, the bankers tin dispense alongside their quasi DCF models that they withdraw maintain no belief in, focus on pricing the stock in addition to recognize that they volition live judged on their pricing in addition to cope making skills, non their valuation expertise. The issuing companies volition recognize that their locomote inwards the procedure is to human activity every bit facilitators inwards the marketing, packaging the fellowship similar a shiny introduce in addition to providing incremental tidings that pushes the cost inwards the right direction. The investors who create upwards one's withdraw heed to play the IPO game or invest inwards the subsequently marketplace volition non waste product their fourth dimension in addition to resources estimating value, since their success or failure volition come upwards from how good they gauge momentum shifts in addition to fourth dimension their exits. I volition value Twitter, when the financials are released in addition to the fourth dimension is right, but my advice to y'all is that y'all ignore my valuation, if y'all are playing the IPO game. The marketplace for Twitter volition trivial notation nor long live concerned alongside my or anyone else’s assessment of value.