- Twitter's current market capitalization of $25 billion is quite ridiculous.
- We're expecting significant downside.
- Worst case scenario, we don't think the world is large enough for the number of social media platforms out there.
As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Twitter's (NYSE:TWTR) case, we think the firm is irrationally overpriced. Let's walk through our valuation process on the company and arrive at a fair value estimate for shares.
But first, a little background to help with the understanding of the terminology behind this article. We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. Said differently, our process runs the gamut of investment considerations from value through momentum (hence, our name).
The process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). We think the more investment methodologies that like a stock, the more buying potential, and the increased likelihood of price-to-fair value convergence.
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At the core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Twitter posts a Valuentum Buying Index score of 4, reflecting our "overvalued" DCF assessment of the firm, its unattractive relative valuation versus peers and bullish technicals. Perhaps worth noting that since this update, Twitter's technicals have turned decidedly sour, and investors should expect a lower VBI score on the next update, all else equal. For relative valuation purposes, we compare Twitter to peers Facebook (NASDAQ:FB), Yahoo (YHOO) and Google (GOOG, GOOGL).
Our Report on Twitter
• Twitter is a global platform for public self-expression and conversation in real time. The firm's platform is unique in its simplicity: Tweets are limited to 140 characters of text. Users can quickly create and distribute content that is consistent across its platform and optimized for mobile devices.
• Twitter's financials aren't pretty. Although the company's revenue growth has been impressive in recent years, net losses continue to pile up. It wasn't until 2012 that the firm finally posted positive adjusted EBITDA ($21.2 million).
• Twitter and its social networking brethren LinkedIn and Facebook will continue to dominate the news spotlight in coming years. Shares of Twitter will trade on assumptions of its business 5 to 10 years from now, which command a wide range of fair-value outcomes.
• Mobile has become the primary driver of Twitter's business. The firm's mobile products are critical to the value it creates for users, and they enable its users to create, distribute and discover content in the moment and on-the-go. We're expecting explosive growth in this area.
• Twitter's price will be extremely volatile. Our valuation is based on future potential, but it will be years before Twitter's current fundamentals catch up to its optimistic equity pricing. Worst case scenario, we don't think the world is large enough for the number of social media platforms out there.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. We assign Twitter a ValueCreation™ rating of VERY POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid gray line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Twitter's free cash flow margin has been terrible during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Twitter, cash flow from operations moved into positive territory from levels two years ago, but capital expenditures expanded significantly during this time period as well.
Our discounted cash flow model indicates that Twitter's shares are worth between $16.00 - $48.00 each. The margin of safety around our fair value estimate is driven by the firm's VERY HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. Shares could reach the low end of our range, and we wouldn't think anything of it. Our model reflects a compound annual revenue growth rate of 55.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 186.7% - mostly due to the law of large numbers. Our model reflects a five-year projected average operating margin of 7.7%, which is above Twitter's trailing three-year average. For Twitter, we use a 11.7% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $32 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Twitter. We think the firm is attractive below $16 per share (the green line), but quite expensive above $48 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Twitter's fair value at this point in time to be about $32 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Twitter's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $45 per share in Year 3 represents our existing fair value per share of $32 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
We see absolutely no reason to own shares of Twitter. Frankly, we're surprised that the firm has had such a "nice" reception following its initial public offering, and we would not be surprised at all to see the firm trade to the low end of our fair value range in the years ahead. There are no investors in Twitter's shares - there are only speculators, and the crystal ball indicates that Twitter won't be the last company to use a shortened character limit to drive a unique network. Competition will eat away at any excess returns Twitter hopes to earn.
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score, as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Additional disclosure: GOOG is included in the Best Ideas portfolio.