Corporate Finance

MORE on Your First Assignment Task of Developing a Defensible FUNDAMENTAL Valuation of Twitter as of its Imminent IPO Date

MSING027- Primary Lecture Slides Set- Week 4 24.10.13

WORKING DEFINITIONS OF SOME TERMS DISCUSSED IN PRECEDING WEEKS

REVIEW Are you fully up to speed with ALL of the following words / phrases / acronyms, BOTH in terms of what they mean AND in terms of relevance to a financial investigation of this type?

Price versus Value IPO Pop JOBS Act valuation versus valuation Metcalfes Law v Zipfs Law MICAP / ODCAP EER Gordon Formula (GF) g NOPAT CF FCF WACC

float Rule of Small Numbers pricing range revenue-per-share multiple shark jump Pre-IPO market makers Proceeds from IPO sale Market capitalisation (MC) Multiples v DCF Terminal value (TV) DCF2S Residual EPP others?

Presently, the more revenues that Twitter generates, the greater the losses While Wall Street and the City confidently contend that Twitter is the next must have channel for advertisers and that losses will reverse with more subscribers and cuts in R&D as the business model is stabilised, those are mere hopes While one of THIS Dot Com bubbles iconic companies, other previous name subscriber +advertising based Dot Coms have disappeared or are headed in that direction iSalon, Excite.com, MySpace, Zynga more

Twitter is correctly viewed as a small to mid-sized SN company, both in terms of subscriber base size & advertising growth potential. In part this is because of what makes Twitter distinctive, including its 140 character format, emphasis on streaming volume, extreme ease-of-use

* Including identification as iconic major SN in MTD Ch. 6, in same category as FIRST Dot Com eras majors

PREFACE
Dont be intimidated by this assignment. Company valuation (Whats the company worth?) and merger valuation (Is the company worth the extra amount necessary to effect a change in ownership?) have been around for a while and THOSE are the two dynamics residing at the centre of IPO valuation. So, at the end of the day, an IPO is just another company to be valued using the right technique(s), just with more volatile & less reliable background information. GIGO? The bases for FUNDAMENTAL company valuation are well established, with the well-known two-stage DCF method as described in that assigned part of the Literature Review of Company Valuation Methods (featuring Gordon Formula) extensively used, at least for

highly-traded public companies with reasonably predictable future CFs as characterised by:
!! !! !! !! stable, evolutionary-but-not-revolutionary business models sufficient & consistent subscriber base to support managements profitable growth objectives control of below-the-line costs to ensure consistent profitability uniqueness and barriers-against-entry to ensure survival

Challenges today of fundamental valuation of at least initially-unprotable new social networking companies such as Twitter include:
OOPS! 1 PRESENT BUSINESS MODEL ONLY VIABLE IF (a) SCALE-DEPENDENT and (b) SUFFICIENT SUBSCRIBER & REVENUE/SUBSCRIBER GROWTH. Q: Are radical RE-model New Twitter propositions anything more than long-odds casino bets? OOPS! 2 RULE OF SMALL NUMBERS, SHARK JUMP THREAT AS TWITTER EXPERIMENTS WITH UNFAMILIAR FORMATS, MORE CONVENTIONAL SNs, OTHERS SEEK TO ADD SHORT MESSAGE COMPLEMENTS. Q: Is commercial saturation point approaching?

Stable, evolutionary-but-not-revolutionary business models Sufficient & consistent subscriber base to support managements profitable growth objectives Control of below-the-line costs to ensure consistent profitability Uniqueness and barriers-against-entry to ensure survival
OOPS! 3 JUICING S-T REVENUE THROUGH RECURRING BTL MARKETING & PROMO COSTS A STANDARD SN IPO PRICE (as contrasted w/VALUE) STING: JUST PRETEND THOSE COSTS ARE ONE-OFF (non-recurring) LATER: Mason at Groupon, FB. Q: Will the Marginal BTL to Marginal Revenue ratio decline in future periods? If yes supported by what? OOPS! 4 WHILST TWITTER HAS ICONIC NAME RECOGNITION, THERE ARE NUMEROUS PRESENTFUTURE SHORT MESSAGING FORMAT COMPETITORS, MANY OF WHICH HAVE A HOOK (e.g., games, affinity group, theses, photos) WHICH TWITTER PRESENTLY LACKS 6

PREFACE (cont.)

SOME IMPLICATIONS FOR YOUR ASSIGNMENT 1 DATA-GATHERING / DIAGOSIS / CALCULATION This Assignment IS NOT AND NEVER HAS BEEN about finding a magic equation and then plugging in data from Internet searches
Certainly there are a number of canned ratios around FT Lex has one. Most are either simple DCF period analyses or slight adaptations of Gordon Formula (you have examples of each in last weeks lecture slides). While these simple equations might suffice as a means of approximating fundamental value for widely-traded companies with stable business models (e.g., Apple), it is foolish to think that neophyte firms which are (or recently have been unprofitable) and which are actively contemplating MAJOR CHANGES TO THEIR BASIC BUSINESS MODEL AND CUSTOMER PROPOSITION (e.g., Twitter) are far less worthy candidates for such a technique. Even when a formula approach MAY BE appropriate, primary reliance on such a simplistic technique alone can result with laughable numbers when crude extrapolations and similar nonFROM LAST WEEK & YOUR comparable multiples are misapplied Wk1 READING IN MTD Ch.6

PRICE v VALUE @ Facebook:

Even amongst upper-tier, already profitable SNs with massive subscriber bases and no direct commercial substitute (FB), Pre- and Post-IPO PRICE indications are so variable as to be non-credible, whereas defensible, fundamental VALUE is in a much narrower, much more consistent range. X Mid-late 2013 PRICE speculation

DEFENSIBLE ONGOING FUNDAMENTAL VALUATION?

X VALUE post following

partial resolution of mobile obstacle

X VALUE

while FB has mobile problems mindset persisted

BASIS: Estimated guesstimates of FB worth extrapolated from extrapolation of minority positions (sometimes as small as 1%) to total company worth (100%)

INSTEAD of the insane roller-coaster of PRICE speculation before and now after FBs IPO, the focus of effective valuators then and now with Twitter is to discover the underlying worth of the firm as indicated by its internal cash flow generated potential, discounted back to the present:

X VALUE post following

partial resolution of mobile obstacle

X VALUE

while FB has mobile problems mindset persisted

LESSONS FROM CLARK & MILLS MTD Ch. 6

pre PRICE

7-9 months post (but for SOME of you, pre) VALUE

! Price speculation dominated by early shareholders ! With absence of credible information on profit or CF running rates, analysts overrely on revenue x implied margin ! Carnival atmosphere of period running up to IPO date unbalanced: few counterweights to lemming-like buy mania except the occasional informed DONT BUY warning ! Active manipulation by float and effective parking or syndicate management

! Informed insight based on gradually improving understanding of (1) true strengths and weaknesses of base business model, (2) actual achievable forward CF implications of same ! Whisper numbers forgotten, sometimes parodied ! Everyman Buy-On-IPO day investors duped by slogans such as Dont you get it (Dot Com Bubble I) or Investing in the Future (Dot Com Bubble II) correctly viewed as fools. 10

ABSENT CREDIBLE DETAILED SUPPORT DATA IN THE TWO KEY, INTERRELATED AREAS (ADVERTISING RATES, SUBSCRIBER GROWTH & ACTIVITY), ANALYSTS MAY REVERT TO SUSPECT ANALYSES:
LEAST (1) COMPANY VALUE DERIVED FROM COMPARABLE e.g., Facebook
(Cyran, Seeking Alpha Amigobulls) NOT a cash-flow based (ODCAP) perspective, and thus less credible. And what FB? The 103+Bn peak or the low at about half that 7-months post-IPO? Also multiple comparability issues, including Rule of Small Numbers In this approach, the analyst disregards the first part of DCF2S (EPP- Lectures Wk 2, 3) and develops a running rate based on three variable Gordon Formula alone. SEE OVERLEAF- Slightly better than (2), as EPP (Stage I) separately calculated and separately analysed residual is used instead of dangers g (FCF growth) function. But as with (2), STILL low credibility because of practice of crunching a few numbers, sometimes based on guesswork.

(2) GF = SIMPLISTIC DCF to (3) SIMPLISTIC DCF2S

(4) VALUE DRIVER ELEMENTSDetailed Analysis MOST

This is (3) adapted for the value elements for subscriber-based social networking companies primarily reliant on advertising revenues (Week 3 whiteboard arrows- refer to your notes). The end result may be communicated in a simple manner comparable to overleaf, but backup increases credibility!

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AA IDEAL: Customary investing in losses strategy early on, but then the company rapidly secures a proprietary customer base. Becomes a Top Three competitor in category by the beginning of TVP 1
Present Component CF Period Calculation basis: Todays Value Single Event 1m (reflecting Initial assets liabilities) 0

2
Near Future EPP Value 1 yr. (assumed) Negative 20k CF, however marginal CF is thought to be positive by end of EPP, *.93= (18.6k)

3
Future TV 5 yrs., analysed

4
End of Life Residual Single Event 1.5m book value (assumed) * . 63= 945k End of 6

overleaf 232k

Elapsed Time (yrs.)

!Means that company starts to become cash-positive as of beginning of TVP Estimated valuation = 1m - 18.6k +232k + 945k= 2.158m
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COMPONENT DATA AVAILABILITY v DATA QUALITY, USEFULNESS

Water, water everywhere, and ner a drop to drink.

- RHYME OF THE ANCIENT MARINER

MEANING: Nearly every quality source has some type of paywall-- you get what you pay for, I guess. But many have free or low cost introductory offers, and once you have your STRONGLY RECOMMENDED FT / NYTimes / WS Journal access, the archives are sometimes useful. Forrester Research and Gartner sometimes have some free access.

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.ON WHAT BASIS ARE THE SCENARIO WEIGHTS ASSIGNED?

(also from last weeks three scenario DCF2S illustration set) Guess? Backwards estimation from similar company, circumstance? Conservative estimation of each scenario?

Cash Flow Break Even (B/E)

A
AB: Dark Model

AA: Ideal

~50%
B

~35%
AC: Black Hole

~15%

C
0

Elapsed TIME from origin

Year X

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EXPECTED ECONOMIC RETURN (EER) BASIS Outcomes from the three scenarios are multiplied against analysed weights in developing an EER composite (k)
Scenario Lifespan Value (K est.) Probability (Weight)

AA Ideal

2158

50%

1079

AB Dark Model AC Black Hole

(224)

35%

(78)

(115)

15%

(17)

984k
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. AND HOW ARE COMPETING SERVICES REFLECTED BOTH IN THE SEPARATE SCENARIO ANALYSES AND THE WEIGHTS?

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