Finding Twitter's Fair Value

| About: Twitter, Inc. (TWTR)

Since blasting off on its IPO, shares of Twitter (NYSE:TWTR) have drifted mildly lower by about 7% to $42. During this time, we have seen wildly differing takes on what Twitter is actually worth. In this article, I am presenting my model on what I believe Twitter's intrinsic value to be.

Unlike some who doubt the viability of Twitter looking out several years, I am tremendously optimistic about Twitter's future as a company (which is different than liking the stock). Twitter is the most compelling and powerful product that I have ever used because it is both highly addictive and useful thanks to its customizability. While Facebook allows you to connect with friends, Twitter makes it easy to connect with decision makers in addition to friends.

I, along with millions of other users, use Twitter like it is a constantly refreshing newspaper, following news organizations, journalists, politicians, sport teams, and fellow investors to stay constantly up to date. With Twitter, you can learn the news before you see it on TV as breaking stories like the horrific Boston bombing showed. However, unlike old media, you can also interact with stories by discussing them in real time with friends and like-minded individuals who follow the same trends and users as you do. I believe Twitter's product is innately successful because it meets the basic human instinct to stay informed and offer knee-jerk opinions on both important and trivial subjects.

Because of the beauty and simplicity of its product, I believe that Twitter can continue to grow its user base in the 6-10% range for a decade with terminal potential in the 700 million-1 billion user range. Its product is also built for advertising with companies able to advertise tweets to users who don't follow it, an ability to promote trends, and plenty of unused space alongside the news feed to include advertisements. In the next 18 months, I also expect Twitter to allow users to promote multimedia tweets, which would generate significantly more revenue per click. Twitter could also eventually become a hub of e-commerce where companies can easily offer deals to its followers.

These initiatives should enable Twitter to drive increasingly more revenue per user. With growing users and growing revenue per user, revenue growth will be above 20% for at least five years. Next year, Twitter will generate about $5 per user while Facebook (NASDAQ:FB) will generate $13. I believe Twitter will be as efficient as Facebook is today within three years. However, Facebook is certainly not hitting a ceiling at $13 as advertisement dollars continue to roll into social networks instead of old media avenues. I expect ad dollars allocated to social networks growing by over 10% a year over the next five years, and as Twitter continues to improve its ad offerings, it will be able to better leverage its user base going forward.

During this time, Twitter will also be able to roll back the amount of money it is investing in its business as a proportion of revenue, which will be significantly beneficial for margins. Facebook is now starting to deliver profit margins in excess of 20%, and I think Facebook has the potential for margins towards 25% as its business matures. I expect Twitter to be where Facebook is now by 2020 with margins around 20%.

Given all of these factors, here are my expectations for Twitter's financial performance through the end of the decade. For a fair present value of the business, I discounted TWTR's 2020 value by 10% annually. While a long run discount rate of 8% is more typical for equities, I recognize Twitter is a more speculative investment than the market as a whole, which means investors should demand a higher rate of return. 10% is a relatively fair approximation.

I believe Twitter is a fantastic company, but the stock is pricing in too much of its potential growth right now. Given my optimistic thesis, Twitter's fair value is around $33. At $42, investors can expect 6-6.5% appreciation over 7 years, which is a below market return for a company with more cash flow uncertainty than the average company. While Twitter's stock price is certainly no bubble where investors are likely to lose money for a long time, it is too high to generate a fair return. I think Twitter is one of the more amazing companies on the planet, but investors should wait for an inevitable pullback and use that as an opportunity to buy shares.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.