Billion-dollar Tech Babies: A Blessing of Unicorns or a Parcel of Hogs?

A unicorn is a magical beast, a horse-like, horned creature that is so rare, that even in mythology, you almost never run into a blessing of unicorns (which, I have learned is what a group of unicorns is called). It was perhaps the rarity (and magic) of private businesses with billion-dollar valuations that led Aileen Lee, founder of Cowboy Ventures, to call them unicorns, in 2013, but as their numbers increase by the month, it may be time to rename them after a species that is more common and less magical.  While there are several provocative questions that surround the rise of unicorns, this post is dedicated to a very specific question of how the investor protections that are offered to venture capitalists at the time of their investments can not only affect the measurement of value and make non-unicorns look like unicorns but also skew the behavior of both investors and owners.

A Blessing of Unicorns

Cash, Debt and PE Ratios: Cash is an upper and debt is a downer!

In my last post, I looked at the leavening effect that large cash balances have on PE ratios, especially in a low-interest rate environment. In making that assessment, I used a company with no debt to isolate the effect of cash, but many of the comments on that post raised interesting points/questions about debt.

The Value and Pricing of Cash: Why low interest rates & large cash balances skew PE ratios

For an asset that should be easy to value and analyze, cash has been in the news a lot in the last few months, both when it has been returned (in buybacks especially) and also when it has been accumulated either domestically or offshore. Since companies have always returned cash and held cash balances, you may wonder why these stories are news worthy but I think that the cash is under the spotlight because of a convergence of factors, including the rise of technology companies in the market cap ranks, a tax law in the US that is increasingly a global outlier, and low interest rates.

Accounting for, Valuing, and Pricing Cash

I start my valuation class with a simple exercise. I hold up an envelope with a $20 bill in it (which everyone in the class has seen me put into the envelope) and ask people how much they would pay for the envelope.  While some find this exercise to be absurd, it does bring home a very simple rule, which is that valuing cash should not require complicated valuation models or the use of multiples. Unfortunately, I see this rule broken on a daily basis as investors mishandle cash in companies, both in intrinsic valuation and pricing models.

Is your CEO worth his (her) pay? The Pricing and Valuing of Top Managers!

It is the time of the year when stories about CEO compensation are the news of the day, and investors and onlookers alike get to ask whether a CEO can really be worth tens or even hundreds of millions of dollars, in annual compensation. Before I join the crowd, it behooves me to list my biases to start, because it will allow you to make a judgment on whether I am letting these biases color my conclusions.

Dealing with Low Interest rates: Investing and Corporate Finance Lessons

A few months ago, I tagged along with my wife and daughter as they went on a tour of the Federal Reserve Building in downtown New York. While the highlight of the tour is that you get to see large stacks of US dollars in the basement of the building, I considered making myself persona non grata with my immediate family by asking the guide (a very nice Fed employee) about the location of the interest rate room. That, of course, is the room where Janet Yellen comes in every morning and sets interest rates. I am sure that you can visualize her pulling the levers that sets T.Bond rates, mortgage rates and corporate rates and the power that comes with that act. If that sounds over the top, that is the impression you are left with, not only from reading news stories about central banks, but also from opinion pieces from some economists and investment advisors. I know that investors, analysts and CFOs are all rendered off balance by low interest rates, but I will argue that the techniques that they use to compensate are more likely to get them in trouble than solve their problems.

The GM Buyback: Beyond the Hysteria!

Here is a script for a movie about the evils of stock buybacks, with the following players. The victim is an well-managed company in a business with significant growth opportunities and profit potential. The company has delivered products that its customers love, while paying its workers top-notch wages & benefits and invested heavily and prudently in its future. The villain is an activist investor, and for added color, let's make him greedy, short term and a speculator. In the story, he forces the  company to redirect money it would have spent on more great investments to buy back stock.

The white knight can be a regulator, the government or a noble investor (make him/her successful, wealthy and socially conscious, i.e., Buffett-like) who rides in and saves the hapless company from the villain and stops the buyback. The story ends happily, with the defeat and humiliation of the activist investor, and the moral  is that stock buybacks are evil (and need to be stopped). As you read some of the over-the-top responses to GM's buyback, such as this one, you would not be alone in thinking that you were reading about the mythical company in the movie. But given GM's history and current standing, do you really want to make it the basis for your case against buybacks?

Illiquidity and Bubbles in Private Share Markets: Testing Mark Cuban's thesis!

It looks like Alibaba is investing $200 million in Snapchat, translating (at least according to deal watchers) into a value of $15 billion for Snapchat,  a mind-boggling number for a company that has been struggling to find ways to convert its popularity with some users (like my daughter) into revenues. While we can debate whether extrapolating from a small VC investment to a total value for a company make sense, there are two trends that are incontestable. The first is that estimated values have been climbing at exponential rates for companies like Uber, Airbnb and Snapchat. In venture capital lingo, the number of unicorns is climbing to the point where the name (which suggests unique or unusual) no longer fits. The second is that these companies seem to be in no hurry to go public, leaving the trading in the private sharemarket space. These rising valuations in private markets led Mark Cuban to declare last week that this "tech bubble" was worse (and will end much more badly) than the last one (with dot-com stocks).

In the article, Cuban makes four assertions: (1) There is a tech bubble; (2) A large portion of the tech bubble is in the private share market which is less liquid than the public markets; (3) The bubble will be larger and burst more violently because of the absence of liquidity; and (4) This bubble is worse than the dot-com bubble, though it not clear on what dimension and from whose perspective. In his trademark fashion, Cuban ends his article with a provocative questions,  "If stock in a company is worth what somebody will pay for it, what is the stock of a company worth when there is no place to sell it ?" I like Mark Cuban but I think that he is wrong on all four counts.

The Aging of the Tech Sector: The Pricing Divergence of Young and Old Tech Companies

As the NASDAQ approaches historic highs, Apple’s market cap exceeds that of the Bovespa (the Brazilian equity index) and young social media companies like Snapchat have nosebleed valuations, there is talk of a tech bubble again. It is human nature to group or classify individuals or entities and assign common characteristics to the group and we tend to do the same, when investing. Specifically, we categorize stocks into sectors or groups and assume that many or most stocks in each group share commonalities. Thus, we assume that utility stocks have little growth and pay large dividends and commodity and cyclical stocks have volatile earnings largely because of macroeconomic factors. With “tech” stocks, the common characteristics that come to mind for many investors are high growth, high risk and low cash payout. While that would have been true for the typical tech stock in the 1980s, is it still true? More specifically, what does the typical tech company look like, how is it priced and is its pricing put it in a bubble? As I hope to argue in the section below, the answers depend upon which segment of the tech sector you look at.

DCF Myth 1: If you have a D(discount rate) and a CF (cash flow), you have a DCF!

Earlier this year, I started my series on discounted cash flow valuations (DCF) with a post that listed ten common myths in DCF and promised to do a post on each one over the course of the year. This is the first of that series and I will use it to challenge the widely held misconception that all you need to arrive at a DCF value is a D(iscount rate) and expected C(ash)F(lows). In this post, I will take a tour of what I would term twisted DCFs, where you have the appearance of a discounted cash flow valuation, without any of the consistency or philosophy.

The Consistency Tests for DCF



In my initial post on discounted cash flow valuation, I set up the single equation that underlies all of discounted cash flow valuation:

How low can you go? Doing the Petrobras Limbo!

A few months ago, I suggested that investors venture where it is darkest, the nether regions of the corporate world where country risk, commodity risk and company risk all collide to create investing quicksand. I still own the two companies that I highlighted in that post, Vale and Lukoil, and have no regrets, even though I have lost money on both. At the time of the post, I was asked why I had not picked Brazil's other commodity colossus, Petrobras, as my company to value (and invest in) and I dodged the question. The news from the last few days provides a partial answer, but I think that the Petrobras experience, painful though it might have been for some investors, provides an illustration of the costs and benefits of political patronage.

Petrobras: A Short History

Petrobras was founded in 1953 as the Brazilian government oil company, and for the first few decades of its life, it was run as a government-owned company from its headquarters in Rio De Janeiro. Until 1997, it had a legal monopoly on oil production and distribution in Brazil, when the domestic market was opened up to foreign oil producers. Petrobras was listed as a public company in 1997 on the Sao Paulo exchange and as a depository receipt on the New York Stock Exchange soon after. The arc of fortunes for the company can be traced in the changes in its market capitalization over time, reported in US dollars in the figure below:

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