As Alibaba's IPO approaches and the road show kicks into high gear, questions about its accounting, value and corporate governance that came up at the time of the filing of its initial prospectus on May 6, 2014, are resurfacing. Alibaba's banking team announced on Friday that their initial pricing for the stock would between $60 and $66 a share, giving the company an estimated anof about $155 billion at the pricing midpoint. That would make it the most valuable IPO in history, much higher than the $80 billion at which Facebook's equity was priced at the time of its IPO in 2011 or the $25 billion at which Google priced itself in 2004.
In keeping with my posts on narrative and numbers, the key question is whether there is anything that has happened in the last few months that has changed my narrative of Alibaba as a dominant, profitable Chinese online merchandiser and the answer is 'not yet'. The reason that it is not an emphatic no is that some of the actions taken by Alibaba in the last few months, including a rumored investment in Snapchat, suggest that it has ambitions to become a global retail giant, , Google and even Facebook. In the quarters to come, if these actions become more concrete and costly, I will revisit this valuation to see the effects, positive and negative, of this narrative shift.
When asked to attach a number to an asset, I believe that you have to start with a fundamental question: Is your mission to attach a value to the asset or is to price the asset? If your job is to facilitate a transaction or get a deal done, as is the case with bankers in an IPO, you have a pricing mission and we would all save ourselves significant disappointment and disillusionment, if we remembered that. In effect, Alibaba's bankers have to price the stock for the IPO, not value it. To get to the right price for a company in an IPO, there are five key steps involved, though one of them is purely for external consumption.
- Use pricing metrics and comparable firms to arrive at an estimate of what investors will pay for the shares: Those pricing metrics take the form of multiples of earnings, book value and revenues and the comparable firms are other publicly traded companies that you believe investors will compare your firm to. The process clearly has subjective judgments in it, in your choice of multiple, in what firms you include in your comparable list and how you control for differences. The table below provides the range of estimates of equity value that I obtain for Alibaba, depending on which multiple I use (PE, Price to Book Equity, download a spreadsheet that lets you alter the choices and one that contains the raw data on individual companies.
Alibaba equity value: Based on Trailing 12-month numbers. With EV multiples, I add cash and subtract out debt to get to equity value/ , EV/Sales or EV/Invested Capital), what I choose as my comparable firms (Just Baidu, Online Advertising, Online Retail, Online Services or all Online companies) and how I compute my sector average (Simple average, Median, Aggregate values). I can get values ranging from $11.9 billion (using the EV/Sales of online advertising companies) to $944 billion (using the simple average PE ratio of Online service companies), and while this may strike you as absurd, it also points to why how easily relative valuations can be used to justify almost any point of view or sales pitch. With Alibaba, at least, it seems clear to me that if multiples are used in the road show, they will almost always be earnings-based (since you get much higher values with those than with revenues or book value) and that the comparable firms will be pruned to create a sample that makes Alibaba look cheap. You can
- Gauge demand: If pricing yields such a wide range of numbers for Alibaba, how do you arrive at a price for the initial offering? The answer is surprisingly simple. The bankers setting the price start by getting a measure of how much potential investors (especially larger ones) are willing to pay for the stock and gauging demand. If investors seem too enthusiastic at a specified price, they will move the price up, whereas a muted response will lead to a lowering of the price.
- Build in the "pop": For better or worse, bankers are not feted for getting the price right but for getting it wrong, albeit in one direction and not by too much. A well-priced IPO is one where the stock jumps on the offering date by about 10-15%, relieving bankers of their underwriting responsibility, rewarding key clients (who were able to subscribe at the offering price) with a quick profit and providing press buzz and price momentum for the issuer to make subsequent offerings. I may be reading more than I should into Alibaba's initial pricing numbers, but the fact that the offering price is set at $63 ($155 billion) suggests to me that the bankers believe that a fair price for the stock is about $180-$200 billion.
- Reverse engineer a "valuation" to back up your price: For some reason, bankers seem to believe that they have to cloak their pricing in a value framework, i.e., make it look like the price that they have arrived at is really the result of an intrinsic valuation. Thus, a valuation is created, inputs are tweaked and first principles are often mangled to arrive at the desired number (from the first three steps). To be fair to bankers, this step in the process may be designed to prevent legal jeopardy, since courts seem to also think that due diligence in this process requires a DCF valuation.
- Reassess demand: While we think of roadshows as designed to help the issuing company and its bankers make their sales pitch to investors, the information flows both ways, as investors' views and reactions can help bankers reassess their offering price range. The final offering price does not have to be set until the day before the offering date, leaving plenty of time for adjustments and readjustments.
After all of this effort on pricing, you would think that the bankers/issuing company would get it right, but as Facebook and Twitter illustrated in divergent ways, it is easy to get it wrong, with the offering price set too high for Facebook and too low for Twitter. As to how Alibaba will fare on opening day, your guess is as good as mine, but if the stock does jump about 15% on the opening day, the company and its bankers will celebrate a Goldilocks pricing moment.
Should you trade Alibaba? That will depend on whether you are good at playing the pricing game and I drew the distinction in this earlier post. Since I am not particularly good at this game, my advice on this count is worthless, but if you do play the pricing game, recognize that your capacity to make money will come from assessing investor mood and stock price momentum.