Valuations are Stupid in an Illiquid Market

mark mcgwireI have some baseball cards from the 80s. They used to give them out in our school lunches. According to Beckett’s Guide, my Fleer Mark McGwire card has a valuation of $120.

Because it’s the holidays, I will sell my card for the blowout price of $119. Send in your offers today!

Wait, what? There is no market for baseball cards because no one has given a shit about baseball since 1992?

The value of an asset is whatever the market is willing to pay for it. You might say that my Mark McGwire baseball card actually has a valuation of $0, no matter what Beckett has printed.

The determination of valuation is regarded as a dark art, but it’s pretty easy to check your work: Is anyone actually willing to pay that price?

Facebook (FB) trades at $79.88 with a market cap of $223B. The market cap is what we, the market, have collectively decided is Facebook’s current valuation.

How do people come to this number? Those who subscribe to Benjamin Graham’s school of value investing might assign a valuation based on the company’s intrinsic value:

Intrinsic value. EPS = Earnings Per Share (last 12 months) 8.5 = P/E base for a no-growth company g = expected 7 to 10 year growth rate
EPS = Earnings Per Share
8.5 = P/E base for no growth
g = expected 7-10 yr growth

Different beliefs about a company’s share price reflect different assumptions on the company’s growth prospects, which is why financial analysts issue many conflicting price targets on any given company.

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Yesterday, a little analyst at Citigroup named Mark May announced that Instagram was worth $35B.

Instagram was acquired by Facebook in 2012 for $1 billion. Whether Mark is correct is of no practical value: there is no market for Instagram. It’s like learning that your left nut is worth $35 billion. You might feel warm and fuzzy about it, but there is no actionable information*.

The announcement that Facebook’s left gonad is worth $35 billion was enough to send FB up nearly 2% yesterday. Not only is Facebook unlikely to toss Instagram onto the auction block, it is also unlikely to generate Instagram revenue any time soon. Instagram has an intrinsic value of $0.

Hypothetically, says Mark May, Instagram could generate $2.7 billion in revenue if it were monetized.

If we’re assigning valuations based on best-case hypotheticals, every startup could hypothetically become a billion-dollar company and Mark McGwire could hypothetically come blitzing out of retirement and hit a million home runs and hypothetically my baseball card could be worth more than a T206 Honus Wagner.

The reason why every startup is not assigned an immediate billion-dollar valuation is because best-case hypotheticals often fail to materialize. Also hypothetically, Instagram could become a writedown as fast as OMGPOP, Del.icio.us, Geocities, Myspace, and all those other high-flying baseball cards.

I’ve decided that the valuation of my Mark McGwire card is a billion dollars. Also, it is no longer for sale.

*Valuations on non-marketable assets could be useful for insurance purposes. Kim Kardashian has a $21M insurance policy on her butt. Her appraiser sure has a fun job.

See Also:
intelligent investor

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How RadioShack Became Too Big to Fail

Believe it or not, this was the inspiration behind the Apple store.
Believe it or not, this was the inspiration behind the Apple store.

If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem. –J. Paul Getty

I’ve always wondered how RadioShack (RSH) stays in business. Warren goes there once a year to buy a fuse for his ham radio or some crap, but that leaves the store with $840M in debt, $43M in cash, and very negative margins.

rsh cds

The good news is that there is a $25.7B market for RSH credit default swaps. Credit default swaps were originally created so that a company’s creditors could buy insurance in case the company couldn’t pay back its debt. But just like life insurance, anyone can buy a CDS on anybody (as long as there’s a seller).

Now some third parties stand to gain $25.7 billion if RadioShack decides to go under, which is kind of like 31 people holding life insurance policies on your mother, if your mother was RadioShack.

The contract sellers don’t want to pay out $25.7 billion, so they went ahead and loaned RadioShack more money to keep it on life support. At this point I suspect that Radio Shack would just like to be put out of its own misery, but the counterparties are hedge funds with lots of money.

I guess the moral of the story is, if you’re gonna take on debt, take on enough debt that someone out there can’t afford to see you fail.

See Also:
RadioShack Kept Alive by $25 Billion of Swaps Side Bets –Bloomberg

Who the hell keeps going to AOL.com?

See Also:
From Lycos to Ask Jeeves to Facebook: Tracking the 20 most popular web sites every year since 1996 –Washington Post

Robinhood (part 1): Feeling Like a Rock Star is not a Trading Strategy

robinhood

Software was eating the world, and a revolutionary stock brokerage wanted to provide services for younger, tech-savvy clientele. The target investor class was different from their parents. They would rather look at a screen than Talk to Chuck, and they didn’t trust existing financial institutions.

In a world that was accustomed to $20 trading commissions, this fantastic new company was offering trades for free. It was 1999, and the founders of Robinhood were still in diapers when Freetrade introduced zero-commission trading to a new generation of investors.

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Freetrade couldn’t have come at a better time. A dotcom bubble was brewing, and people were quitting their jobs to daytrade tech stocks.

The web brought streaming quotes to the browser, and discount brokers enabled real-time reactions. Back when a trade cost as much as the new Backstreet Boys CD, retail investors weighed their options carefully before placing an order. But when trades became free, people flipped stocks with abandon.

Freetrade shut down in 2005 due to an unsustainable business model.

A decade later, free trades are back, and this time it’s mobile-first.

Robinhood has a mission to democratize access to the financial markets. The app feels like a toy. Companies are distilled into a minimal set of “Stats”, so we can balance our portfolios much like we draft our fantasy football lineups.

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I suppose I could pull up my Bloomberg terminal if I wanted to do some research before making an investment decision, but I feel like that’s not in the spirit of this app. Howard Lindzon, founder of Stocktwits and one of Robinhood’s early investors, says that placing orders with a flick of a thumb makes him feel like a rock star.

I think it’s great that Robinhood is encouraging millenials to take an interest in their financial future. But maybe the financial markets shouldn’t be quite so democratized. Maybe if Scottrade’s $7 commission is enough to impact your return, you shouldn’t be buying stocks. Maybe if you’re not willing to expend more than three taps per trade, someone else should be responsible for your portfolio.

Complain all you want about how Charles Schwab is swindling commissions from your account — trading fees force you to exercise a little more patience and selectivity when making investment decisions. You might not feel like a rock star, but how often do you think Warren Buffett needs to feel like a rock star?

Epilogue
After Freetrade went out of business in 2005, a startup called Zecco Trading launched another zero-commission brokerage. 16 months later, Zecco stopped offering free trades and got acquired.

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Silicon Valley is a Meritocracy, According to Rich White Men

History is written by the winners. A long time ago, I had a best friend whose father was a Vietnam Vet. I asked him if he killed anyone. Only bad people, he said.

Nobody ever thinks of themselves as the bad person. The winners just live to tell about it.

Not only do people universally think of themselves as good, they also believe themselves to be smart. Cue Jack Dorsey, founder of Twitter and Square:

Success is never accidental. No accidents, just planning; no luck, only strategy; no randomness, just perfect logic. –@jack

Nevermind Jack’s privileged upbringing. Those in power call Silicon Valley a pure meritocracy because they want to believe they earned success through tenacity and wit and dashing good looks.

tony-perkins-tim-draper

So the losers should think, Gee, I guess I’m just not as smart as Jack Dorsey. I deserve to be slinging code as a low-level developer with a fraction of a percent of his net worth.

Somehow, the less-successful don’t go home and dismiss themselves as morons. They, too, believe in their own sheer brilliance. In fact, they’re so smart that they totally would have succeeded except The Man was holding them down. In a recent interview, Silicon Valley expat Shanley Kane calls the Valley: “a sexist and racist wealth distribution mechanism that relies on cronyism, corruption, and exclusion to function.”

Yeah yeah, the same can be said for Wall Street, politics, Hollywood, or any high-stakes industry. Or low-stakes industry: Academia is a politicized old-boys’ club and those souls are grappling to earn minimum wage.

Silicon Valley is totally sexist unless you Lean In like Sheryl Sandberg and Marissa Mayer. Silicon Valley is totally a meritocracy unless you’re a minority who isn’t getting funded.

Maybe Silicon Valley isn’t really binary. Maybe Silicon Valley is a little of everything, just like the rest of the world.

And maybe the world isn’t totally fair, but whining is unlikely to make it more fair. And until we come up with a way to make the world inherently fair, maybe the best we can do is try to make the most of our own merits.