Monday, February 11, 2013
Most large public companies trade at a value far higher than a reasonable estimate of their stock's inherent value to minority shareholders. Any institutional fund or analyst that recommends or invests client funds at inflated market prices has a conflict of interest of participating in a pyramid scheme even if they have a genuine speculative belief that for the next few months collective market exhuberance/hysteria/mispricing will maintains a stock's price.
A valuable company with a worthless stock
A company that cannot be taken over either because it is too big, or because it is controlled by insiders who can block any takeover attempt, necessarily has a stock that is relatively worthless (to outside minority shareholders) compared to the value of the company. For such a stock to have value as a piece of paper, it must be paid dividends or have the reasonable prospect of high future dividends. (Proof of this statement) For a stock to be worth what it was bought for the company must either be bought out at a higher price or the sum of all dividends to be paid must be high enough.
A reasonable hoped minimum stock return of 7.2%
The concept of a reasonable hoped return is relevant as a threshold for establishing liability when influencing other people's money. A 7.2% return per year on a company that cannot be bought out, and doesn't pay a dividend, means an expectation that its price will double in 10 years, or quadruple in 20 years. After those 10 or 20 years, there should be an expectation of a continued healthy company, and an expectation of say a 3.6% dividend yield instituted in that future, and expected dividend growth that accompanies the company's continued health and prosperity.
The key part in the above analysis is the continued healthy future prospects. If you believe the company's health will be deteriorated in 20 or 50 years, then its stock must pay significant dividends prior to its deterioration in order to compensate for its purchase price. While I've said that all companies pay too little in dividends today, the big dividing line between reasonable disagreement on dividend policy is the division between sustainably hopefully permanent companies and those destined to eventual deterioration. It is excusable to tolerate low dividend payout ratios from companies with sustainable growth, because there is a theoretical possibility of proper shareholder compensation in the future.
My previous article delves into the math behind this in more detail
The problem with social media companies
The core problem with investing in social media stocks is that the companies have no unique technology. Its unlikely that the generation 10 or 20 years from now will want to use the same social networks as their parents, teachers and grandparents. Its hard to maintain a sustainable value of 10s of billions, when competition can be created easily/cheaply, and necessarily provide better value to members by monetizing them less.
The core misunderstanding of social media company valuation is that their member/subscribers are equivalent to 1990s cable company subscribers with the assumption that they can be infinitely milked as a captive audience. Social media members are in fact more sensitive to excessive monetization efforts, and likely to move to a new platform that buys growth.
The problem with high sales growth and no profit
Any company should be able to increase sales by $100M by increasing sales expenses by the same amount. Marketing rebates, bribes or "hookers and blow" can create the sales increase. Financial reporting and auditing is not designed to inform investors whether the spending is legitimate or not, but even if legitimate, it is never an effective marketing program if its costs match the increased sales revenues. There's no reason for investors to be impressed by unprofitable high sales growth, because it never includes evidence of sustainability.
The majority of Facebook's shares are owned by its main founder. Because facebook has a dual class share system, its founder can compensate himself by awarding and selling non voting shares without the possibility of diluting his ownership. For that reason, and because of current dividend tax treatment rules, there is no possibility that FB will ever declare a dividend until the founder retires. Because FB is currently worth $60B it is too large to be bought out. It is also impossible for it to be bought out because the owner/founder doesn't want it to be. The owner enjoys the surplus privilege to his shares of being able to control the FB empire. Only significant deterioration in the company could change the outlook on a takeover.
So, even if FB as a company can be optimistically valued at $60B or even $100B, hoping that it has sustainable longevity, its shares cannot be worth more than $10B because minority shareholders rely on deterioration in the company to ever see compensation on those shares.
Linkedin shares FB's dual class share structure. That means that its difficult for outsiders to buy out the company, and insiders that control the company strongly prefer issuing themselves additional shares over the prospect of ever paying out a dividend. The other issue that makes a takeover impossible is that LNKD shares are grossly overvalued, and not something that informed investors using their own money would buy hoping to replicate current management's performance. Its more sensible to launch a new job recruitment platform instead.
Linkedin's main problem as a company is that it pays its management and employees too well, has no real profitability this past year, forecasts no growth in the next quarter, and forecasts no real profitability for all of 2013 either. The addressable market for its core recruitment services is saturating, as it has approximately the same recruitment revenue as Monster worldwide, and it has spent so much to gain that revenue. I don't believe that users will ever value the social aspects of Linkedin, and may be turned off by constant sales communications. For all of its sales growth, it has stagnated in page views even though it is buying high profile blog content, and investing heavily in redesigns.
With a current value over $16B, and the criteria outlined before, we could ask if it is reasonable that LNKD could be worth $32B in 10 years. However, because LNKD pays its management and employess with a large amount of stock compensation, its shares oustanding grow about 5% per year. We should be evaluating, as a criteria to justify a $16B valuation today, whether LNKD will be worth $50B+ in 10 years, if we take into account expected future issued shares. I don't think it is possible or reasonable to expect LNKD to make more than $1B or so in annual profit in 10 or 20 years, and so would not understand a company future value of beyond $10B (and so max $5B in today's value).
There is substantial competitive risk to the company, because while it does the heavy lifting to penetrate international markets, it is simple to duplicate the useful aspects of the platform, and offer it with a cheaper self-serve model for recruitment. It would seem impossible for LNKD to maintain a sustainable $10B+ value as a company, if easily formed competition is content with sustainable valuation under $1B.
Bigger issues than the value of LNKD as a company, is the value to external shareholders. Will LNKD ever repay shareholders $50B before it deteriorates? Will it ever even repay $16B or $5B?
Liability of ratings firms
When analysts announce a target value of $175/share ($19B) for LNKD, I have to wonder about their crack addiction based on Linkedin's own projections of sales and profitability growth. It becomes blatantly irresponsible when you factor in the company's limited addressable market, dual class share structure, and its impossibility of being bought out or offering dividends, as well as its nearly assured eventual deterioration.
If it is indeed irresponsible for analysts to confirm a stock's current high valuation, or for institutions to invest client/member money in such stocks, then there is liability for investor losses both for short sellers that might suffer from a short term price hike, and buyers/members who suffer eventual losses from long term deterioration of that stock price.
The defense that investors have a short term horizon, and hope to flip out of the stock prior to any collapse, is invalid. If it is irresponsible to view the piece of paper that is a stock as having any real long term value (possibility of receiving sufficient compensation through buyouts or dividends), then it is irresponsible to participate in the short term hype and greed manipulation surrounding that stock.