From revenues to earnings: Operating, financing and capital expenses....

A few days ago, Groupon filed an S-1 statement with the Securities Exchange Commission, officially signaling its intent to do an initial public offering.
http://blogs.wsj.com/deals/2011/06/02/groupon-ipo-its-here/
I do know that there are valuation questions that will come up with the IPO but talking about them will lead me to repeat earlier points that I made about the Linkedin and Skype valuations: the value will depend upon revenue growth and potential operating margins. Instead, I want to focus on a claim that Groupon has made, that has opened up the company for some ridicule in the financial press. In 2010, Groupon generated revenues of $713 million and reported an operating loss of $420 million (see the S-1 filing link below):
http://www.sec.gov/Archives/edgar/data/1490281/000104746911005613/a2203913zs-1.htm
Pretty bad, right? But here's where it gets interesting. In the same S-1, Groupon claims that it will make money in 2011 using a different measure of operating income (which is calls Adjusted CSOI: Consolidated Segment Operating Income). I am already suspicious, because the term carries two pieces that make me nervous - the word "adjusted" and a new acronym for earning. But what is Adjusted CSOI? According to Groupon, it is the income before expensing to acquire new subscribers is taken into account and since this expense amounted to about a third of overall operating expenses in 2010, removing it does wonders to profitability. It is this claim that has raised the ire of financial journalists and of some investors and their argument is encapsulated well in this blog post on Forbes:
http://blogs.forbes.com/ericsavitz/2011/06/02/deja-vu-groupons-bubble-1-0-approach-to-accounting
Is Groupon breaking new ground in measuring profitability or is this playing with the accounting rules?

To answer this question, we need to go back to accounting first principles (which are often ignored by accounting rule writers, but that is a different story). In an ideal accounting world, the expenses incurred by a firm would be broken down into three groups:
a. Operating expenses: These are expenses incurred to generate revenues only in the current period; there are no spillover benefits into future periods. Thus, the cost of labor and material incurred in making a widget will be part of operating expenses.
b. Financial expenses: These are expenses associated with the use of borrowed money in the business. Thus, interest expenses on bank loans would be included here as should lease expenses.
c. Capital expenses: These are expenses that generate benefits over multiple years. Classic examples would be the cost of building a factory or buying long-lived equipment.
Assuming that you can classify expenses cleanly into these groups, here is how they play out in the financial statements. Operating expenses get netted out of revenues to get to operating income, financial expenses get netted out of operating income to get to taxable income and taxes get netted out of taxable income to get to net income. Capital expenses do not affect income in the year in which they are made but have two effects: the first is that they show up as assets on the balance sheet at the end of the year that they are incurred and then get amortized or depreciated over their useful life. The amortization or depreciation is also shown as an expense to get to operating income:
Revenues
- Operating Expenses
- Depreciation/Amortization of Capital Expenses
= Operating Income
- Financial (interest) expenses
= Taxable Income
- Taxes
= Net Income

So, here is the best possible spin on what Groupon is doing. The cost of acquiring new customers presumably creates benefits over many years, since once a customer is acquired, he or she continues to use Groupon for years (I told you that I was taking the best possible spin here). Using this rationale, you could conceivably argue that acquisition costs are capital expenses and should not be netted out to get to the operating income. However, here is why I am skeptical about whether this is being done to get a better measure of income (which would be noble) or for window dressing (which is not):
a. Back up the claim that customers, once acquired, stay on for a while: If you are going to capitalize acquisition costs, the onus is on you to show proof that acquired customers stay as customers (and actually buy products for many years). With strong competition from other online coupon based companies (like LivingSocial), it is entirely possible that customers once acquired, are fickle and move on... If that is the case, the acquisition cost has a very short amortizable life and begins to look more like an operating expense.
b. If you are capitalizing acquisition costs, carry it through to its logical limit: This would require amortizing previous year's acquisition costs (which would in turn require an answer to (a), since the amortization will be over the customer life with the company). In other words, you cannot just remove acquisition costs (as Groupon has done) from your income statement, but you would have to replace that cost with an amortization cost.
c. Recognize that all of this reclassifying of expenses does not change your cash flow status: The bottom line is that Groupon has negative cash flows and those negative cash flows will get more negative over time, since the company will have to keep spending the money to acquire customers (to get the growth rate it would need to justify a $20 billion value...).

Note that none of this is breaking ground. I have been making this point about R&D expenses at technology firms and advertising expenses at brand name companies for years. In fact, I have a paper on how we need to take a fresh look at companies with intangible assets:
http://pages.stern.nyu.edu/~adamodar/pdfiles/papers/intangibles.pdf
This is also a chapter in my book, The Dark Side of Valuation (2nd edition, Wiley)
If you want to try your hand out at capitalizing acquisition (or brand name advertising or R&D) costs, try this spreadsheet.

The bottom line, though, is that from a valuation perspective, reclassifying acquisition costs is a mixed blessing. For growing companies like Groupon, it can make the earnings look more positive, but it will also increase the capital invested at these companies (because the acquisition costs will be capitalized). It can alter perspectives on whether the company is actually profitable and creating value: the key profitability number in the long term is not the operating margin but the return on invested capital and Groupon has just admitted that it invests a lot more capital than people realize in what it spends to acquire customers.

The other adjustments that Groupon makes to operating income that are more dubious. It is absurd to add back stock-based compensation (it is an operating expense...)  and we are taking the company at its word, when it breaks its marketing costs down into acquisition costs and regular marketing costs. What Groupon is doing is also part of a trend that I find disturbing, where analysts adopt half-baked approaches to dealing with costs like R&D and marketing by adding them back to EBITDA, leading to a proliferation of measures like EBITDAR (Earnings before interest, taxes, depreciation and R&D) and EBITDAM (Earnings before interest, taxes, depreciation and marketing). While this approach deals with a serious accounting problem (where capital expenses are being treated as operating expenses in some companies and thus skewing not just earnings but book values), it does so at a surface level. After all, if we are going to treat R&D and customer acquisition costs as capital expenditures, we should follow up by asking the key questions: How effective are they? Are they creating or destroying value?

Postscript: I forgot to mention that I hope that the tax authorities don't buy into Groupon's argument. If they did, acquisition costs would no longer be tax deductible; only the amortization would. As is often said, be careful what you wish for. You may get it.

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There is an app for that....

I have a healthy respect for technology. While I don't see it as the cure for any of our problems in valuation, it has made life a lot easier in terms of mechanics. I still remember trying to value companies in the mid-eighties, where data had to be collected by hand (in libraries) and computers were primitive (I started with Visicalc on a Kaypro and it was just a glorified hand calculator, with limited features). I have tried to stay on top of evolving trends, though I have never been cutting edge on any dimension.

As I watch my kids and colleagues increasingly abandon their computers for their smartphones and iPads, I have wondered whether I could make this transition. Thanks to Anant Sundaram, my good friend, who teaches valuation at Dartmouth College, the first step has been taken. Together, we developed a valuation app for the iPad that allows you to value a stock or a business. A confession is in order. Neither Anant nor I have the technological capability to write apps: it is a lot more complicated than it looks. We owe aa great deal to Xiandong Ren, a graduate of the Computer Science department at Dartmouth College, who schooled us on the basics and wrote the code for the app. Initially, we wanted to give the app the moniker of "iValue" but as is common in this space, some one else beat us to that name by a few weeks. So, we used our fall back name for the app: uValue and it is now available on the Apple iTunes store:
http://itunes.apple.com/us/app/uvalue/id440046276

uValue is a valuation app, with surprising versatility (or at least, we think so). There are three basic models - a conventional cost of capital DCF model, an Adjusted Present Value (APV) model and a dividend discount model. For the cost of capital and APV models, we have detailed versions, where you are given full control over all of the input levers, and simple versions, where we set many of the input levers to safe defaults. In the near future, we hope to add a relative valuation (multiples and comparables) module as well as a financial tools module. Embedded in the app is a short book on valuation (called the uValue Companion) that leads you through the basics of which model to use in a specific context and the fundamentals of that model as well as data sets on industry averages on key input variables (margins, returns, betas, cost of capital etc.).

While we cannot be objective about the app's capabilities, here is what we see as its pluses and minuses right now. On the minus side:
a. The app is available only for the iPad right now. The output is too intensive for a Smartphone screen and we just don't have the capacity or energy or time (right now) to write the code to allow it work on Android pads.
b. It is a young app. We have already been alerted to a couple of errors in the app (the simple APV has a glitch in the expected bankruptcy cost component, for instance) that we will fix in the next update (in the next couple of weeks). This website for the app will keep you updated on errors as you find them (and we fix them):
http://uvalueapp.com
c. It does incorporate our "points of view" on DCF valuation, which may not map on to your points of view on the same. Just to make you feel better, even Anant and I have differences on individual components (like what to use for the equity risk premium) and have been open in laying them out in the app.

On the plus slide, we have tried the app out on all kinds of companies: young, growth companies (like Linkedin), mature companies, money losing companies, commodity companies, financial service companies, and it seems to work for all of them. Best of all, check out the price for the app. You will see why we feel absolutely secure in our "money back" guarantee...   

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Thoughts on intrinsic value

I know this post will strike some of you as splitting hairs and an abstraction but it is a topic that fascinates me. A few weeks ago, I got an email asking a very simple question: How do you estimate the "intrinsic" value of gold? This, of course, raised two key questions:
a. What is intrinsic value?
b. Does every asset have an intrinsic value?

On the first question, here is my definition of intrinsic value. It is the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth and risk. The essence of intrinsic value is that you can estimate it in a vacuum for a specific asset, without any information on how the market is pricing other assets (though it does certainly help to have that information). At its core, if you stay true to principles, a discounted cash flow model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk. Even a book value approach is an intrinsic valuation approach, where you are assuming that the accountant's estimate of what fixed and current assets are worth is the true value of a business.

This definition then answers the second question. Only assets that are expected to generate cash flows can have intrinsic values. Thus, a bond (coupons), a stock (dividends), a business (operating cash flows) or commercial real estate (net rental income) all have intrinsic values, though computing those values can be easier for some assets than others. At the other extreme, fine art and baseball cards do not have intrinsic value, since they generate no cash flows (though they may generate a more amorphous utility for their owners) and value, in a sense, is in entirely in the eye of the beholder. Residential real estate is closer to the latter than the former and estimating the intrinsic value of your house is an exercise in futility.

So, how do people value assets where intrinsic value cannot be estimated? They look at what other people are paying for similar or comparable assets: i.e., they use relative valuation. Thus, an auction house sets a value for your Picasso, based on what other Picassos have sold for in the recent past, adjusted for differences (which is where the experts come in). The realtor sets the price for residential real estate, based on what other residences in the neighborhood have sold for, adjusted for differences again. In fact, let's face it: this is the way even assets that have intrinsic value are evaluated for the most part. Thus, the investment banker who takes Groupon public may go through the process of providing a discounted cash flow model to back up the valuation, but the pricing of the IPO will be determined largely by the euphoric reception that Linkedin got a few weeks ago.

I don't intend this to come across as snobbish, but I think we need to clarify terms. Most people who claim to be valuation specialists, experts or appraisers are really pricing specialists, experts and appraisers. In other words, what separates them in terms of skills is in how good they are in finding comparable assets and adjusting for differences across assets. In fact, I have a counter question, when I am asked the question of what the value of a business or stock is: Do you want a value for your business or a price for your business? The answers can be very different.

In closing, though, let me try to answer the question that triggered this post: what is the "intrinsic value" of gold? In my view, gold does not have an intrinsic value but it does have a relative value. For centuries, gold (because of its durability and relative scarcity) has been an alternative to financial assets (that are tied to paper currency). Unlike the gold standard days, where the linkage between paper currency and gold was explicit, the value of paper currency rests entirely on trust in central banks and governments. As a consequence, the price of gold has varied inversely with the degree of trust that we have in these authorities. Though not a perfect indicator, gold prices have surged when a subset of investors have lost that faith, i.e., they fear that the currency is being debased (inflation) or systematic government failures. What makes this monent in economic history disquieting is that we are getting discordant signals from the market: the low interest rates on treasuries (US, German and Japanese) suggests that investors think expected inflation will be low in the future whereas higher prices for precious metals (gold, silver) give support to the argument that investors (or at least a subset of them) believe the opposite. One of these two groups will be wrong and I would not want to be in that group, when there is a final reckoning.

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Dual share structure: The Google model spreads

Google rewrote the book for initial public offerings in two ways. One is that they bypassed the traditional investment banking syndicate for an auction (which is a good development) and the other is that they were unapologetic about the fact that they had two classes of shares and that the founders would hold on to the shares with the disproportionately large voting rights. While shares with different voting rights are par for the course in many parts of the world (Latin America, for instance), their use in the United States was limited to a few sectors; publishing and media companies such as the New York Times and the Washington Post have used the structure to allow the founding families to control these companies, with relatively small percentages of the overall equity.

Two factors played a role in containing dual class shares: the first was that, for decades, the New York Stock Exchange barred shares with different voting rights from getting listed on the exchange and the second was the fear of an adverse reaction from investors. Google was unfazed by either concern. It listed on the NASDAQ and institutional investors were so eager to hold the stock that they seemed to overlook the voting share structure (or at least not price it in).

So, what's the big deal with voting rights? Voting rights matter because they allow stockholders to have a say in who runs the company and how it is run. It is true that most stockholders don't use these rights and prefer to vote with their feet, but the voting power does come into use, especially at badly managed companies, where a challenge is mounted on management either from within (activist stockholders) or from without (hostile acquisitions). The argument I have heard from institutional investors for their benign neglect of different voting share classes at Google is that the company is well managed and that control is therefore worth little or nothing. There is a kernel of truth to their statement: the expected value of control (and voting rights) is greater in badly managed companies than in well managed ones. However, if you are an investor for the long term, you have to worry about whether managers who are perceived as good managers today could be perceived otherwise in a few years. (A decade ago, Cisco would have been ranked among the best managed companies in the world. Today, its management is under assault after ten years of bad acquisitions and under performance).

How does this play out in valuation? Once you have valued the aggregate equity in a company, you have to estimate the value of equity per share. When shares all have the same voting & dividend rights, you can divide by the total number of shares outstanding. When they don't, though, you may have to allocate the equity value differently to different share classes. Generally speaking, voting shares should trade at a premium over non-voting shares, but that premium should be larger in poorly managed firms than in well-managed firms. How much larger? I have a paper on the topic that does try to come up with a specific premium for voting shares.

The trigger for this post was the Linkedin valuation that I did yesterday. I valued the equity of the company at approximately $ 2 billion, but I was unforgivably sloppy about getting the per share value. I used the 43.31 million shares that Yahoo! Finance listed as shares outstanding and I should have known better. Checking the prospectus for Linkedin, here is what I see:
* 7.8 million class A shares (all of the shares offered in the IPO are class A shares)
* 86.7 million class B shares (which have ten times the voting rights of class A shares)
Dividing the value of equity by 94.5 million shares yields a value per share of $21.51/share, but even that may be an over estimate. If we assume that the voting shares trade at a premium of 5% over the non-voting shares (the 5% is the average premium for voting over non-voting shares in US companies), the value per share for the non-voting shares drops $ 20.57:
Value per non-voting share = $2,033 million (7.8 + 1.05*86.7) = $20.57
Reading the prospectus, though, things get worse. Linked in notes that it has options outstanding on roughly 17 million shares, with exercise prices ranging from $6 to $23. Needless to say, all those options are deep in-the-money now and while I don't have information on vesting, it behooves us to act as if these options will be exercised. Using an average exercise price of $15, the value per share drops further to about $20.

Bottom line: Getting from value of equity to value per share gets progressively more difficult as you add shares with different voting rights and outstanding options to the mix. 

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Valuing young growth companies: A postscript on Linkedin

So, that was quite an opening for Linkedin.. The stock opened in the mid-80s, almost double the offer price. I know that some of you have used the model that I attached to my last post to value Linkedin on your own and that was exactly my point. None of us has a crystal ball that shows us the future and your estimates are as good as mine.

However, since we are on the topic of young growth companies, here is what I see in the base year numbers for Linkedin, as contrasted with Skype:
a. Linkedin is at an earlier stage in the life cycle that Skype. It revenue growth is more explosive (100% growth last year: Revenues grew from $120 million in 2009 to $243 million in 2010) than Skype's revenue growth in 2010 (20%).
b. Linkedin is already profitable. It reported pre-tax operating income of about $20 million in 2010. In contrast, Skype is still losing money.

Now, here's where the subjective component comes into play in the forecasts:
a. Revenue growth: You may disagree with me on this one but I see a smaller potential market for Linkedin than I do for Skype. While at least in theory, Skype could compete for the much larger wireless telecom market, Linkedin has a narrower focus. To provide perspective, Yahoo's total revenues in 2010 were $ 6 billion and I have a tough time seeing Linkedin generate revenues as large, even ten years from now.
My projection: 50% compounded revenue growth for the next 5 years, scaling down to 3.5% in stable growth. Revenues in 2021 will be about $ 5 billion.

b. Operating margins: I see margins falling somewhere in the middle of the range for companies in this space: Google at the top end and Yahoo towards the bottom. Competition in this space is much fiercer and the barriers to entry seem small.
My projection: Pre-tax operating margin of 15% in 2021, rising from the current margin of 8.23%.

c. Survival: The company has little debt ($2 million), enough cash on the balance sheet ($92 million) with more coming in from the IPO.
My projection: I am going to assume that there is a 100% chance that the firm will survive, though I am not sure how successful it will be.

The valuation, with these inputs, yields a value per share of $47 and I think that that number is at the upper end of the spectrum. So, the original offer price of $43 does not sound unreasonable... As for the current price in the mid-80s, I am glad I don't have it in my portfolio. (Update: It gets worse. There are two classes of shares outstanding and if you incorporate both, the value per share that I estimate drops into the twenties.. I have updated the spreadsheet as well..)

As with the Skype valuation, here is my Linkedin spreadsheet. Make your own best estimates.... and good luck...

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Is Skype worth $8.5 billion? An exercise in valuing young, growth companies

Last week, Microsoft announced that it would buy Skype for $8.5 billion. The reaction was fast, furious and very predictable. First, there was the search for reasons for the deal and technology mavens listed a few. Second, there was the reaction from investors and analysts, which was generally not very positive. Third, it was noted that Bill Gates, the face of Microsoft for so long, was strongly in favor of the deal (thus providing cover for Steve Ballmer).

Ultimately, though, the discussion of the deal was lacking in one key respect: Is Skype worth $8.5 billion to Microsoft? A few of the analysts noted that the price paid was roughly ten times Skype's revenues in 2010, an undoubtedly rich price, but by itself proving nothing. After all, if you had been able to buy into Google at ten times revenues in 2003, you would be rich now. A great deal of attention was paid to whether Skype was the right company for Microsoft to buy and the strategic/synergistic fit of the two companies.  It has always been my contention with acquisitions that it is not the strategic fit or synergistic stories that make the difference between a good deal and a bad one, but whether you buy a company at the right price. Put in more direct terms, buying a company that is a poor strategic fit at a low price is vastly preferable to buying a company that fits like a glove at the wrong price.

So, let's get back to valuation basics. What is the value of Skype? The question is rendered more difficult to answer because Skype is a private business and we know little about the insides of the financial statements. It is widely reported, though, that Skype had operating losses of $7 million on revenues of $ 860 million in 2010. Taking those numbers as a base, I tried to value Skype, making what I thought were very optimistic assumptions:
- Continued revenue growth of 20% (which was what they had last year) for the next 5 years and a gradual tapering down of growth to 3% in ten years.
- A surge in pre-tax operating margins to 30% over the next ten years; this margin is at the very upper end of the technology spectrum (where companies like Google reside).
- A decline in the cost of capital from 12% now (reflecting the uncertainty associated with young, growth businesses) to a cost of capital of a mature company in ten years
With those assumptions, I estimated a value of $ 3.8 billion for Skype. It is entirely possible, however, that I am wrong on my key assumptions - revenue growth rates and target margins. In fact, changing those base inputs gives me the following table:

Is it possible that Skype is worth more than $8.5 billion? Sure, if you can deliver revenue growth higher than 35% and a pre-tax operating margin of 30%. Is it probable? I don't think so.

The value drivers for Skype - revenue growth, target pre-tax operating margin and survival - are generally the constants you worry about with young, growth companies. In the Little Book of Valuation, in the chapter on valuing young growth companies, I argue that these value drivers also should give you indicators of value plays in young, growth companies. Thus, when investing in a young, growth company (Tesla Motors, Linkedin, Facebook etc.), here are some of the indicators you would look at:
a. Size of potential market: Since high revenue growth is easier to pull off, when the market is large, you want to invest in companies that are entering large potential markets rather than narrower, specialized markets.
b. Competitive barriers: For margins to improve over time, you need space to grow and protection from intense competition. This can come from patents (for a young, biotechnology company), a technological advantage, a brand name or the sheer ineptitude of established competitors.
c. Survival skills: Survival boils down to two types of resources: financial and personnel. Young, growth companies with access to capital, little or no debt and large cash balances have a much better chance of surviving than companies without those characteristics. In addition, companies that are dependent on a key person or personnel with no back-up are much more at risk than companies that have a good bench.
So, take your favorite young, growth company for a qualitative spin around this track and see if it passes the tests.

You can download the spreadsheet that I used for the valuation of Skype and play with the revenue growth and operating margin numbers. You can also use the spreadsheet to value any other young, growth company. As you do these valuations, recognize that uncertainty is the name of the game and that you are making estimates for the future. You will be wrong, but so will everyone else, and at least you are trying.

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The Little Book of Valuation

I don't like to use this blog as a publicity front, but my newest book just hit the bookstores. It is part of Wiley's Little Book series and it is titled "The Little Book of Valuation". My motivation for writing the book was simple. While I have three books on valuation - Investment Valuation, Damodaran on Valuation and The Dark Side of Valuation", they are all written for valuation practitioners. They are dense, not easy to read and require work to put into practice. I have always wanted to write a book for investors, many of seem to believe that valuation is far too complex for them to handle. That view makes them easy prey for valuation experts and analysts, who use a mixture of bombast, buzz words and numbers to intimidate.

As I started to write the book, I set myself two objectives. The first was to not short change readers, by assuming that they were not skilled enough to do valuation. I think valuation is fundamentally simple but that we choose to layer complexities on it. So, I wanted to provide investors with the tools to do a full fledged valuation of any type of company - young or old, mature or growth, cyclical or commodity. The second was to cut through the details of valuation models and identify the value drivers for any company. Even in the most complex valuation models, the value of a stock is determined by one or two key inputs. Knowing what those inputs are and how to estimate them is 90% of valuation. More importantly, if you know the drivers of value, you can create investment strategies that are built around those drivers, even if you choose not to do a full-fledged valuation. If you get a chance to take a look at the book, you will notice that the chapters are structured around different types of companies and that each chapter is centered around identifying the "value drivers" for that type of company and the "value plays" that emerge from these drivers.

Since I did write the book, I cannot give you an unbiased assessment of how well I did in accomplishing my objectives. I hope you do get a chance to browse through the book and I really hope that you not only find it useful but an easy read. If you are interested in getting the book, here is the Amazon link:
http://www.amazon.com/Little-Book-Valuation-Company-Profit/dp/1118004779/ref=ntt_at_ep_dpt_1
To support the book, I have put together spreadsheets and other material in a website for the book. You can visit it by clicking here.

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