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.

instagram-cover1

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

Also Worth Watching:

Don’t Rush the Cash Flow

TWTR crashed 20% last week after Twitter’s earnings report indicated a slowdown of user growth.

twitter-fail-whale.top

The income statement, at first glance, would appear to be a winner – TWTR beat analysts’ revenue expectations by 12%, with reported earnings of 2 cents per share as opposed to the 2 cent loss that was expected.

Silly Twitter. You’re an internet stock, which means shareholders care about user growth, not cash flow. Every last cent should go towards making the fire burn hotter.

Remember, Facebook was founded in 2004 and did not become cash-flow positive until the end of 2009. Google was founded in 1998 and turned profitable in 2001, with the invention of Adwords. LinkedIn was founded in 2003 and probably didn’t become profitable until 2010.

Check out these gross margins:

Quarterly Gross Profit Margins, Dec 2013. Source: ycharts.com
Quarterly Gross Profit Margins, Dec 2013. Source: ycharts.com

Twitter, you have lower profit margins than Facebook, Google, or LinkedIn. If you are coming back with positive net income, you’re doing something wrong. Your cash flow is too strong. Get back out there and lose more money for your shareholders!

But only in the name of user growth, of course.

See Also:
Which Internet Stock is the Most Overvalued? –New Yorker