December 5, 2013
This blog is an extension of our blog on #Twitter Truths: Road Less Travelled – Capitalization of Expenses (R & D Expenses & Operating Leases).
Discounted Cash Flow Valuation
Many a times, we have seen analysts, modelers and participants of the class choosing the horizon of projections in their financial model arbitrarily. Most of the times, many of them when asked why they have made projections for “n” numbers of years, will say that the horizon period has been chosen based on their experience in the modeling. We have so far not come across any solid back up behind answer to this question. We have a detailed blog Deciding the Horizon Period for Projections available on the link . This article explains what should be the guiding factors behind selection of a horizon of projections.
Once we have decided the horizon of projection the next decision point is which cash flow to discount. We have elaborated which cash flow should be discounted for the purpose of valuing the firm or equity in our earlier blog. Please access the full blog titled Which Cash Flow to Discount under DCF Approach?.
As the company has nearly no debts on its books and very small quantum of capital lease that gets nearly paid off within the horizon of projection, we think FCFE will be the right cash flow to discount for calculating the equity value of Twitter, Inc. (“Twitter” or the “Company”).
Once we have calculated the cash flows for the horizon of projection, the next question waiting for us is how to handle the cash flows beyond the horizon period. We come across a concept called “Terminal Value”. Do you find derivation of the formula behind Terminal Value and its calculation complex? Please read our detailed blog on the subject titled Demystify the Mathematical Complexity Involved in Deriving Terminal Value.
A snapshot the output of the valuation model is shown below. Please refer to our detailed model for assumptions and workings:
Post an absolute valuation using DCF, we have done relative valuation using:
1. Trading multiple of the peer set
2. Acquisition of MoPub using all stock deal as benchmark
DCF is an elaborate valuation methodology. At the end of the day, it has more assumptions than data. If you look at the assumption sheet of any decently designed financial model leading to valuation, its assumption sheet will have the highest number of rows populated. Further DCF valuation is a time-consuming exercise and at times, any effort put into this may be spread over weeks.In life, we all must have come across various situations where we did not have the luxury of time to build a DCF model every time we spotted an opportunity. Even if we have the required time, we may not have enough data/ guidance to design a detailed valuation model. At times, you might have been pressed by your clients, senior management, colleagues or others to give a quick view of the valuation of a company. There comes to our rescue another methodology of valuation called “Relative Valuation”. Relative valuation is quick and makes lesser assumptions. Selection of the peer set for relative valuation is of utmost importance. Please read our blog on this topic titled Identification of Relevant Peer set for Relative Valuation & Beta Calculation. A snapshot of the relative valuation has been presented below. Please refer to our detailed model for assumptions and workings.
The Company has identified multiple players as its competitor on page 116 of Amendment no. 2 to Form S – 1. We reproduce below the appropriate paragraph:
“…We compete against many companies to attract and engage users, some of which have greater financial resources and substantially larger user bases, such as Facebook (including Instagram), Google, LinkedIn, Microsoft and Yahoo!. We also compete against smaller companies such as SinaWeibo, LINE andKakao, each of which is based in Asia.
We believe that our ability to compete effectively for users depends upon many factors, including the usefulness, ease of use, performance and reliability of our products and services; the amount, quality and timeliness of content generated by our users; our ability to establish and maintain relationships with platform partners that integrate with our platform; and our reputation and the strength of our brand…”
We have chosen following players as its competitors:
The output of relative valuation is shown above.
We summarise below all the prices calculated by us using different methodologies. Except the valuation methods using MAU as base, all other methods yield a value in the range of $ 20 – 24 per share.
Besides Twitter itself has undertaken a third party valuation of itself from time to time. They have disclosed the methodology of valuation and valuation itself on page nos. 90 to 93 in Amendment no. 2 to Form S – 1. The share price as per them had moved as depicted below:
An ideal IPO should leave 5% – 10% of the price on the table for investors to get value accretion immediately on listing. We believe that an IPO price range of $ 18 – 20 would have adequately captured the valuation and left a scope for immediate value creation for the investors. Their own internal valuation has pegged the share price @ $ 20.62 as recently as Aug 2013. Fundamentals would not have changed significanlty since then till the date of IPO to warrant a price higher than this. An IPO price of $ 26 per share is approximately 30 – 45% in excess of what we think should have been an ideal IPO price range. We could not find any solid justification behind this other than the way too much hype created around this internet company.
Not only this, we have also attempted to figure out what might be Twitter’s ideal share price a year down the line. Please refer to the detailed workings and assumptions in our financial model. The summary is presented below.
We expect that the best case share price a year down the line will be $ 40. In most likely case, it should trade in the range of $ 35 – 40 a share.
We heard Twitter debuted with $ 45 on the day of listing. By no means, we are able to justify such a high valuation. We will like to conclude with the remark that Twitter’s share price currently is a “Balloon waiting to burst anytime”…literally anytime…sooner or later.
This is the last blog of this particular series on Twitter. Hope you have enjoyed it! Please free to drop in your comments or start a discussion below!