The stock market is as opaque as it is petulant. In the long run it depends on the premise that the wisdom of its participants will guide a stock's market price to the expected value of its future earnings. But in the short run, observers see an incredible level of volatility as the market grapples with this convergence. During this process, new information continuously modulates the point to which the market is attempting to converge. It is in this short-run stage that the market is inefficient. And it is in this stage that the possibility of an outsized return based on asymmetric knowledge exists.
In this light, I wrote an article that attempted to quantify Vringo's (VRNG) chance of victory in its patent litigation trial with Google (GOOG) entitled "Vringo Vs. Google: Why the Underdog Will Come Out on Top." Given empirical data on patent litigation in the Eastern Virginia Federal Court and a qualitative assessment of the case, I estimated the probability of a Vringo victory to be around 70%. However, simply calculating Vringo's probability of winning is not enough to justify a position in the company.
What follows is a discussion of some of the missing pieces: a look at the impact of time decay on the equity value of Vringo, the chances of settlement, and the value of a jury verdict.
Valuing Vringo as a Call Option
Equity of companies is predominantly valued through the application of comparable metrics of similar companies (forward P/E, PEG, EBITDA multiples, etc.) and the Discounted Free Cash Flow model. These approaches revolve around pro forma forecasts of a company's future earnings discounted by a rate that approximates a company's risk profile and the time value of money. In the case of Vringo, these approaches are a fool's errand because Vringo's equity value is almost entirely contingent on the outcome of its lawsuit against Google.
As such, Vringo bears a striking resemblance to a small-cap biotechnology stock in the time preceding an FDA decision (this binary nature amplifies the effect of mistakes in an investor's assumptions). Vringo's equity value represents a call option with a premium based on the binary outcome of its patent lawsuit. This risk-reward profile includes the expected values of settlement, an acquisition by Google, and a trial verdict. Some authors have applied a multiple to this expected value, which seems unwarranted given the uncertainty of Vringo's prospects in a tumultuous future environment.
To calculate the market value of this option, we can take Vringo's stock price and subtract the components that are not tied to the trial. These include its mobile entertainment/marketing operations and future revenue from the patent portfolio it acquired from Nokia. Analyst J.P. Moreno approximates the value of these components to be between $1.10-$1.60 per share in the case that Vringo loses the trial. This estimate seems accurate, given that Vringo's share price before its merger with Innovate/Protect stood around the $1 mark without the patent assets it acquired from Nokia. Vringo's ability to monetize those newly acquired patents is significantly correlated to the outcome of its case against Google, the general intellectual property environment, and the legal system's acceptance of lawsuits by non-practicing entities.
Taking the middle of Moreno's range, and a VRNG share price at closing on October 22nd of $3.60, the market values the embedded option at $2.25. On October 8th, when VRNG closed at its highest level of $5.43, the market valued the option on Vringo's patent litigation at $4.08. Between that time, the valuation of the company's other assets (mobile business and Nokia patents) did not change in any materially significant way. The decrease in price must be solely attributed to a decreasing call option premium.
Vringo's Embedded Call Premium Is Declining
The value of the embedded call in Vringo's share price depends on two drivers: the expected value of a trial verdict, and the expected value of a settlement/acquisition of Vringo. In a recent interview, Dan Ravicher, a patent expert from the Cardoza School of Law, observes that speculating on the outcome of the case is fruitless because of the randomness of a jury verdict and the sealing of pivotal information during the trial. Ravicher is right that trying to predict the trial as it unfolds is akin to chewing the fat. However, this does not mean that an investor or the market cannot price an expected value of an outcome into the stock.
In fact, this is exactly what happens every day as buyers and sellers square off. And if the market is efficient in the long-run, its short run valuation should converge to the true value. The imminently logical conclusion of Ravicher's analysis is that the expected value of a jury verdict in the eyes of the market cannot have materially changed since Google's request for summary judgment was denied, the last truly significant piece of information in the process.
However, the second driver of the option premium, the expected value of a settlement or acquisition, has changed. Market participants expected some probability of settlement. As each day passes and the trial is brought closer to a verdict, the probability of a settlement decreases. And as it does, the component of the call option that is made up of the expected value of the settlement decreases in value. In the coming days, absent settlement or acquisition, this decreasing value will continue to drag Vringo's share price lower. Since, the summary judgment on October 3rd VRNG has fallen by an average of -0.84% every trading day. Absent a materially significant event, this decay will continue. Given the trial's expected duration of 8-10 days, this means that VRNG could continue sink to the low $3s where the stock established a baseline prior to the summary judgment outcome.
The market and I differ on the probability of a settlement. Whereas the market priced a significant possibility into Vringo's stock, Google has seemed adamant about taking a stance on the issue of patent litigation. Under the notion of game theory, this intuitively makes sense as a way to protect itself from future litigation. Two occurrences have potentially changed this calculus:
- Google's earnings release on Thursday disappointed severely, and the accidental early release fiasco didn't help. The resulting rout of the company's share price may put pressure on decision-makers to act in the Vringo trial under a more risk-averse framework.
- The danger of an F.T.C. antitrust lawsuit increased recently. The broad case the F.T.C. may bring to trial against Google by the end of the year is fundamentally different from the Vringo lawsuit and is only tangentially related, but it may have a spillover effect in the Vringo trial. No one in Google wants to be on the hook for two enormous losses. This alters the risk preferences of Google's decision-makers in the current lawsuit.
These factors may lead Google to be less staunch in its settlement negotiations with Vringo.
VRNG's Simplest Valuation is its Most Certain
There is no doubt that ascertaining the value of Vringo is a muddled affair. The market has allowed itself to devolve into a Kentucky Derby that comes with all of the accompanying horse-blinders and flying mud. Given the cloud of uncertainty that surrounds VRNG's valuation, utilizing the idea of Occam's Razor may provide the most accurate investment framework. The theory states that among competing methods that are equal in their predictive power, the simplest framework should be preferred above the others. Pivotally, such a valuation framework would be unencumbered by the perils of broad estimates and faulty assumptions. In the sea of speculation that has enveloped Vringo, I believe in the simplest of valuations - an estimate of the probability of a Vringo victory multiplied by the expected value of the jury award.
Using a conservative empirical probability of 60% for a verdict in favor of Vringo and a middle of the road jury award of $500 million (past earnings, future royalties, interest, and fees), the valuation of the outcome stands at around $300 million. Combined with a current market's approximation of the rest of Vringo at roughly $50 million, and about 75 million outstanding shares, the expected value of a share of Vringo is $4.67. The gap between Vringo's current market valuation and its true valuation stems from the market's short-run volatility, the impact of rumors and unfulfilled expectations, and the risk-averse nature of stockholders.
The above valuation is in no way meant to be a concrete forecast of Vringo's share price in the future, which some have predicted to range from one dollar and all the way to thirty. It is a conservative point in an overwhelmingly broad range. And it addresses a binary situation with an equally binary framework. In a discussion that has become more and more convoluted, the certainty found in simplicity cuts through the mind-splitting din of the market and leaves a clear picture.