Shares of Snap Inc. surged immediately upward on March 2, 2017, its first day of trading on the New York Stock Exchange. When the bell rang in the afternoon, signaling the end of trading, the parent company of the vanishing messaging app, Snapchat, had a market value of $34 billion. The 26‐year‐old founder and CEO of the company, Evan Spiegel, was suddenly a paper billionaire, and early investors in the social media company had reaped a tidy return. But questions hung in the air about the future financial performance of Snap and what that would mean for its market value down the road.
Would it be like Facebook, which had a market value of $390 billion on the day that Snap began trading, or more like Twitter, worth only $11 billion? Facebook and Twitter had followed very different paths over the past several years. When Facebook’s stock debuted on the NASDAQ in 2012, shares initially soared from $38 to $45 a share, but then dropped back down to $38 at the close of trading. Over the next year, the price of Facebook stock dropped as low as $18 a share, before beginning a steady climb in late 2013. On the week that Snap went public, Facebook traded at $137 a share. The price of shares in Twitter, on the other hand, had more than doubled on its first day of trading in November 2013 to $45, giving the company a market value of $25 billion. But its price per share peaked at $69 in early 2014, and had fallen steadily since to approximately $16 a share in early 2017.
What determines the price of a share of stock, and ultimately, the market value of a publicly traded company? What is a fair price to pay for a company that is for sale? How do investors and industry analysts place a value on a company that is unprofitable? In this chapter, we’ll explore the following questions:
All companies, whether publicly traded or privately held, have a financial value. The worth, or market valuation, of a media company is based on its past performance and the credibility investors and shareholders place in the current management to deliver future earnings. If projections of future earnings decline, then the valuation placed on a media company also declines. For example, in the 1990s, before the widespread adoption of mobile devices, newspapers in small and mid‐sized markets in the United States typically sold for 13–15 times earnings because they were considered de facto local monopolies with little competition for either readers or advertisers. Today they sell for 3–5 times earnings. This drop in value reflects the sharp decline in both advertising revenue and readership that newspapers have experienced in recent years. Newspapers are no longer de facto local monopolies since they now compete with digital giants, such as Facebook and Google, for both readers and local advertisers.
When referring to publicly traded companies, such as Snap or Facebook, the terms market value and market capitalization are often used interchangeably. Market capitalization, or market cap, is calculated by multiplying the price of a share of stock times the number of outstanding shares (i.e., the number of all the shares that have been issued, including those that are restricted or held by the company’s owners or officers). Some companies issue many shares of stock, while others don’t. In March 2017, when Snap went public, the Walt Disney Co. had almost 1.6 billion shares in circulation while Twitter had approximately 730 million. The price of the stock in a company depends on demand for the shares that are available to trade on a public exchange. The world’s largest is the New York Stock Exchange, where Alibaba chose to list its shares in 2014. The second largest, the NASDAQ, founded in 1971, is where many technology companies, including Facebook, Apple, and Google, are listed.
Market capitalization takes into account both demand for shares and the number of shares available. It, therefore, becomes a proxy on investor sentiment in a company at a given point in time. If market capitalization is rising, investors are optimistic about earnings growth. In early 2017, as Snap prepared to go public, the three largest companies, measured by their market capitalization, were Apple, valued at $733 billion, Google at $587 billion, and Microsoft at $496 billion. Amazon at $405 billion was fifth largest, and Facebook at $396 billion was sixth. In other words, investors were bullish on technology stocks.
Market value or market capitalization is determined by both external and internal factors. As much as 90% of a company’s valuation can be accounted for by external factors—such as the growth prospects for the industry segment in which a company operates. Therefore, legacy media companies, such as CBS Corporation, tend to have a lower market valuation than digital enterprises that are perceived as having better prospects for earnings growth. At the close of the first day that Snap began trading, CBS had a market valuation of $31 billon, less than half the market cap of Netflix, even though CBS’s net income of $1.3 billion in 2016 was nearly ten times as much as Netflix’s. In the eyes of investors, Netflix had greater potential to grow its customer base—and its future earnings—than CBS.
Nevertheless, how the management of a company capitalizes on opportunities or responds to competitive threats can significantly alter the valuation of both start‐ups and legacy companies. When it became apparent in late 2013 that Facebook had successfully adapted its platform for ease of use on mobile phones, which were rapidly replacing desktop computers as the primary way to access the Internet, the price of the stock began climbing. Between July of 2013 and 2014, the price of Facebook stock almost tripled, from $26 to $70. Investors reasoned that the company was positioned for significant growth of both advertisers and users in the years ahead.
Here is how external and internal factors affect the value of a media company.
All media companies—and many technology companies—are cyclical, meaning that revenues from advertisers and consumers (and ultimately profits) tend to move in sequence with economic cycles, trending down during recessions and upward during recoveries. During the 2008 recession, the stock price of all media companies fell. CBS stock, which traded for $23 a share at the beginning of the year, traded for $8 in December. Its share price did not rise to $23 again until late 2011. Even Google stock, which had risen steadily since it began trading at $50 a share in 2004, fell from a high of $357 in December 2007 to $165 in November 2008.
As a successful company moves from start‐up to maturity, growth rates decline from high double‐digits to single ones. In time, growth may actually begin to decline, as customers adopt new technologies. Industry segments follow a similar pattern of growth and eventual contraction. Therefore, companies in mature industry segments with steady but slowing growth rates—such as cable or broadcasting companies like CBS—tend to carry lower valuations than those in high‐growth areas, such as streaming enterprises, like Netflix. Industry segments that have declining growth rates and are very competitive have even lower valuations. For example, Gannett Company, one of the largest US newspaper companies in terms of both circulation and number of papers owned, had a market valuation of only $1 billion in early 2017.
Even in the best of times and in high‐growth industry segments, many companies fail to meet investor expectations about growth in earnings and users. While Facebook’s stock soared from 2013 onward, Twitter struggled. Twitter stock peaked at $69 a share in 2014 and then seesawed back and forth between $30 a share and $50 over the next year and a half. After a series of management stumbles and shake‐ups at Twitter in 2015 and 2016, its stock began steadily declining and was trading at $16 a share in early 2017. When Snap went public, Facebook’s valuation of $396 billion was 36 times that of Twitter.
Similarly, the strategy that an established company pursues can set it apart from its competitors in the same segment. In 2006, Disney stock was roughly comparable in price to that of CBS. Both traded for around $25 a share. In early 2017, Disney stock sold for $110 a share, and CBS for $69. With many more shares outstanding, Disney had a market cap of $177 billion, almost six times that of CBS’s market valuation of $31 billion. The difference in market cap also reflected the difference in earnings between the two companies and the diversity of its assets. Disney’s operating income of $14.2 billion in 2016 was almost six times that of CBS, which primarily relies on revenue and profit from its television‐related properties—broadcast and cable networks, locally owned stations, and studios that produce shows for other networks. Disney operates in four different industry segments—film studios, theme parks, consumer products, and television networks. Each of the four segments can operate independently of one another, so that a strong performance in one segment can compensate for weak growth in another. However, each of the segments can also contribute to growth in another division. A blockbuster film—such as Pirates of the Caribbean—can lead to many profitable box‐office sequels, new rides in its theme parks, and increased sales of movie‐related merchandise in retail stores. Large diversified market‐cap companies, such as Disney, with multiple streams of revenue and sizeable profits in each division, can absorb a flop or bad bet more easily than a smaller, less diversified company can.
Most companies—other than those run as hobbies by their founders, such as blogs—have assets with some value to other people:
Therefore, establishing a credible valuation is important. The value placed on a company is a best guess about future earnings potential, based on available information, much of it found in a firm’s financial statements. A valuation is a forward‐looking assessment. Financial statements are backward‐looking and quantify a company’s performance over the past several years. Nevertheless, analysts, investors, underwriters, and lenders pore over several important line items on a financial statement: (1) looking for clues as to how a company will perform in the future; and (2) placing a value on the tangible assets (such as real estate and equipment) and intangible ones (i.e., copyrights and customer relationships). This process is called due diligence.
Media companies compete for share of wallet—the amount of money a customer spends on a product or service—as well as share of mind—the amount of time customers spend on a product or service. Especially for companies that depend on advertising revenue—including technology giants such as Google or Facebook—the size of the audience and its demographics ultimately drive revenues and earnings. Those with the largest audiences (i.e., scale) and those that can also target specific customer segments (i.e., depth) are most likely to attract advertising dollars in the digital space. Therefore, investors track both the number and type of users, as well usage—engagement with the site or application—since this will drive revenue and profits in both the short and long term.
Here are some of the financial trends investors focus on when trying to assess a company’s current management and strategy and the impact these will have on future earnings:
After analyzing a company’s financial statements to answer these questions, investors, lenders, and underwriters then use one of several methods to establish the market value of both private and publicly traded companies.
Here are the pros and cons of each method (Box 3.1).
EBITDA and revenue are the two most frequently used methods for evaluating media and technology companies. Large, established media enterprises are valued on average at 11.2 times EBITDA and at 2.4 times revenue. Technology companies, such as Google or Facebook, carry much higher EBITDA and revenue multiples.
Both EBITDA and revenue are calculated on a weighted, trailing average. Earnings and revenue for the last three to five years are often used, with the most recent earnings given a higher value (or weight) than earnings in the more distant past. For example, if you are calculating a weighted average based on the past three years of earnings, the most recent earnings would be multiplied by a factor of three, the next by a factor of two and the farthest by a factor of one.
As you will recall from Chapter 2, News Corp provides EBITDA calculations for all its divisions—newspapers, book publishing, digital real estate services, and cable network programming—as well as for the corporation. In its annual report, the company says that it uses EBITDA when assessing the performance of each division within the company. It also uses EBITDA when deciding whether to buy or sell a property. Let’s look at how News Corp would be valued based on an EBITDA Multiple (Table 3.1, page 53).
Table 3.1 Placing a value on News Corp based on EBITDA multiple, March 2017 (in million $).
Source: News Corp Annual Report 2014/2015/2016.
| 2016 | 2015 | 2014 | ||
| EBITDA multiple (in $ millions) | 684 | 945 | 963 | |
| Weighted multiplier | ×3 | ×2 | ×1 | |
| Sum of weighted EBITDA | 2,052 | 1,890 | 963 | 4,905 |
| EBITDA weighted average (divide $4,905 by sum of multipliers: 3 + 2 + 1 = 6) |
817.5 | |||
| Market cap of News Corp, March 2017 | 7,690 | |||
The market capitalization of News Corp—$7.69 billion—is 9.4 times the EBITDA average of $817.5 million. Therefore, in March 2017, News Corp was being valued by its shareholders at a multiple of 9.4 times EBITDA. This is slightly below the industry average of 11.4, and it suggests that one or more divisions within News Corp may be pulling down the average. Most likely, it is the newspaper division, which has recorded declining revenue and earnings in recent years. As newspaper companies have struggled to transition from print to digital, their earnings multiples have dropped significantly. However, book publishers have fared much better. As we discussed in Chapter 2, the EBITDA for HarperCollins is comparable to that of its competitors. In its 2015 annual financial statements, News Corp indicated that it paid between 11 and 12 times EBITDA for Harlequin Books, which it purchased in 2014. Therefore, if you were to put a market valuation on HarperCollins, you would use an EBITDA multiple of 11 to 12. The average weighted EBITDA for HarperCollins from 2014 to 2016 was $165.6 million. This would place the market value of HarperCollins in March 2017 at an estimated $2 billion. Therefore, if News Corp decided to sell HarperCollins, it could expect to receive at least $2 billion.
The process for valuing a company, based on revenue, is very similar to that of the EBITDA exercise above. However, a much lower multiple is employed in the calculation. Revenue growth—along with costs—are projected forward and used as a proxy to estimate future EBITDA potential. This method is most often used to value a new company that has not yet turned a profit. Therefore, assumptions about both user growth and the revenue associated with users are critical to establishing a fair market value for a company that is about to go public, like Snap, or about to be acquired by another company. Both Google and Facebook, which have been very active in purchasing other smaller private tech companies, often use the revenue multiple method to establish a price for those enterprises.
Let’s do another valuation of News Corp, based on its revenue over the past three years (Table 3.2). In contrast to early‐stage companies, such as Snap, which have high‐growth rates, revenue for News Corp has been relatively stable, and actually declined in 2016. Therefore, you would expect the revenue valuation for News Corp to be lower than its EBITDA valuation.
Table 3.2 Placing a value on News Corp based on revenue multiple, March 2017 (in million $).
Source: News Corp Annual Report 2014/2015/2016.
| Revenue multiple (in million $) | 2016 | 2015 | 2014 | |
| Revenue | 8,292 | 8,524 | 8,486 | |
| Weighted multiplier | ×3 | ×2 | ×1 | |
| Sum of weighted revenue | 24,876 | 17,048 | 8,486 | 50,410 |
| Revenue weighted average (divided by 6) | 8,401 | |||
If you divide the weighted average revenue of $8.4 billion by the market cap of $7.69 billion, you determine News Corp is trading at 1.1 times revenue. This is half of the industry average of 2.4 times. The newspaper division accounted for two‐thirds of the company’s revenue in 2016, and has declined significantly over the past three years. To offset the decline in revenue in this division, News Corp has made significant cost reductions, which is why its EBITDA margins have not decreased by a similar amount. However, a revenue valuation does not take into account those cost reductions. As a result, with the revenue method, News Corp has a much lower valuation than with the EBITDA method.
As these two valuation exercises on News Corp illustrate, putting a price tag on a company involves both quantitative analysis, as well as qualitative judgment. All methods for evaluating a company rely on the numbers that are in a company’s annual statements. But, in the end, assumptions about growth in revenue, costs, and liabilities determine projected earnings and cash flow. Past performance is not necessarily indicative of future performance. The strategy that management pursues can make a substantial difference in the long‐term viability of a company—whether it is a start‐up, such as Snap, or a legacy company, such as News Corp. That’s why placing a value on a company is about predicting the range of possibilities that could impact a company, both positively and negatively.
Anyone can purchase a share of stock in a media company that is traded on an exchange, such as the New York Stock Exchange or the London Stock Exchange. Increasingly, however, the shares of most companies are owned not by individuals, who buy shares through a broker, but by institutional investors, who invest money for other people. Institutional investors include banks, pension funds, endowments, mutual funds, and, in recent years, hedge funds and private equity funds. They basically pool money from many investors and then funnel this money into purchasing shares of specific companies. On a typical day, institutional investors account for more than half of the volume of shares traded. As a result, they can exert significant influence on both the overall movement of the stock market, as well as the price of shares and the market valuation of companies. One study found that, by 2007, institutional investors held almost 60% of the stock in publicly traded media companies. Table 3.3 provides a sampling of media and technology companies and the percentage of shares owned by institutional investors in March 2017.
Table 3.3 Today’s media investors: percentage of shares owned by institutional investors.
Source: Information on historical stock prices and investor information can be accessed for each company at https://www.google.com/finance?q=NYSE%3ASNAP&ei=JsGMWfmZFJO1mAGy_Z7QCw and http://www.marketwatch.com/investing/stock/.
| Company | Percentage of shares owned by institutional investors |
| CBS | 79 |
| Comcast | 85 |
| Disney | 62 |
| 72 | |
| Google/Alphabet | 70 |
| News Corp | 96 |
| New York Times | 66 |
| 45 |
Over the past two decades, three types of investors have played a very important role in shaping the market value of media companies: venture capitalists, hedge‐fund operators, and private equity fund managers. In general parlance, these investors are referred to as “the smart money” since it is assumed they are better informed about the risks than individual investors, and also better able to spot deals. However, there is little empirical evidence that, over the long haul, their investment portfolio performs better than the stock market average.
What exactly do each of these three different investors do and how does their presence shape the economics and finances of today’s media enterprises? What sort of return on investment (ROI) are they seeking? And what is the time frame for achieving that return?
These investors provide seed money to fund early‐stage companies in exchange for partial ownership in the company. Founders of start‐up media enterprises typically seek initial financial support first from a group known as “angel investors.” These are typically individuals—friends or family members, as well as wealthy individuals, who supply money to support salaries for a small management team, proof of concept and prototype development and testing. Valuations of the company during the angel round are usually driven by subjective appraisals of the management team, the value proposition, estimates of the time‐to‐market, path to profitability, and estimated capital expenditures. The primary goal in this stage is to hire a talented initial team and develop a proof of concept that will attract investors for the next, more formal round of investment.
Venture capitalists typically enter in the next round of funding, often called the mezzanine level or Series A. In return for as much as a 50% ownership in the firm, a venture capital firm will expect the management team to continue developing and testing the product, hire additional talent needed to bring the product to market, and begin business development efforts. Recent research by Harvard University professor Ramana Nanda found that more start‐ups are getting a first round of financing, however, fewer are getting funding for next round. As a result, more than one in five start‐ups fail before receiving a second cash infusion. By the Series B—or the balcony level—the goal is building scale and revenue traction. In this stage, typically one or more firms will furnish financing, which will be larger than in the previous round. There may also be a Series C round, with another cash infusion in return for ownership. This round is focused on strengthening the balance sheet, including operating capital to achieve profitability, acquire another company, or develop new products. The last round signifies the start of an exit strategy for most venture capitalist investors.
More than half of all start‐ups never make it to the five‐year mark, and only a third make it to the ten‐year mark. In general, value capitalists tend to invest with an expectation of selling their shares in a start‐up within three to five years. At that point, venture capitalists typically place a valuation on the surviving start‐ups, based on revenue and projected EBITDA. Additional funding may be sought to shore up the balance sheet and profitability as the venture fund determines the best exit strategy: Should the company issue an IPO or be purchased by another, larger company? As we discussed in Chapter 1, Facebook received three different major rounds of funding—including an initial $500,000 from the founder of PayPal, $12.7 million from the venture capital firm Accel Partners, and an additional $16 million from Microsoft that valued the firm at $15 billion. Because the valuation of a company at this final stage of funding is based on sales and a best guess on future EBITDA, it may or may not relate to the actual IPO price of the shares or to the eventual selling price. For example, at the close of the first day of trading in 2012, Facebook had a market valuation of $100 billion.
Like Microsoft, many media companies have their own venture capital fund. This includes Comcast, Verizon, Reed Elsevier, Time Warner, and Hearst. Corporate venture funds participated in almost one‐fifth of the more than 3,600 venture capital deals in 2014. In some cases, these corporate venture funds will continue to “hold” instead of “exiting.” In 2005, Jerry Yang, the founder of Yahoo!, invested $1 billion for 40% ownership of a start‐up e‐commerce site in China that was “killing” Yahoo’s own site in China. The start‐up was headed by Jack Ma, a former government translator who had been assigned to give Yang a tour of the Great Wall in 1997. Both parties benefitted, according to Ma and Yang, who were on stage together at Stanford in 2015, reminiscing about the deal. Ma says he received management and strategy advice from Yahoo that he would not have received from a “non‐corporate” venture capital fund. As for Yahoo, that initial $1 billion investment was worth $20 billion when Alibaba listed its shares in an IPO offering in 2014.
Once a company has done an IPO and is publicly traded, it will likely attract a second type of investor, the hedge fund operator. By 2015, three years after the IPO, more than 133 hedge funds had purchased sizeable stakes (of 1% or more) of Facebook stock. Hedge funds proliferated in the 1990s and first decade of 2000 as an investment alternative to mutual funds. Like mutual funds, hedge funds are classified as “institutional investors” since they pool money from other individuals and institutions (such as universities or pension funds) and invest in stocks, bonds, and other types of equity. However, they typically invest in a broader range of instruments (including derivatives or shorting stock), seeking a higher rate of return, regardless of whether the market rises or falls. Since risk is correlated with return, they are often restricted to high net worth individuals and institutions, with at least $1 million net worth. A hedge fund is a limited partnership with a fund manager, who, unlike a mutual fund manager, receives a percentage of the investment returns. One of the criticisms of the hedge funds is that this system of compensation can encourage the fund manager to seek out riskier investments and employ leverage (i.e., use debt) in order to get a higher return on investment.
Hedge fund operators often employ a dual strategy of “buy and hold” and “buy and sell.” The long‐term strategy (called “going long”) usually involves buying stock in companies judged to have the potential for a higher than average ROI when compared to the stock market or their industry peers. The short‐term strategy involves purchasing stock with leverage, selling it, and then buying it back when the price falls. (This is called “shorting” the stock.) Hedge fund manager John Paulson, for example, became famous for correctly betting against the mortgage industry in 2008.
Because of this dual “long‐short” strategy employed by hedge funds, the fund managers tend to be “activist” shareholders of stock that they hold—especially if they calculate it is falling short of projected returns. They acquire a sizeable percentage of the shares and then use their financial stake to seek seats on the board of directors, and then lobby for appointment of a new management team and/or a strategy to “unlock the value” of an underperforming company. Often that strategy involves selling the company or parts of the company. In 2005, the manager of a Legg Mason hedge fund, Private Capital Management, acquired 19% of the outstanding shares in Knight Ridder, the second largest newspaper company in the United States in terms of circulation. He then joined with two other hedge firms that together held an additional 20% stake and “put the company in play,” forcing it to sell off its assets. In 2006, McClatchy Newspapers, a much smaller company with only one‐third as many newspapers as Knight Ridder, bought the company, paying $67 a share—considerably less than the hedge funds had calculated. Still, it represented a 26% premium over the $53 price a year before. The hedge funds “exited” the market and Knight Ridder ceased to exist.
In 2008, Legg Mason’s Capital Management, which had acquired a 4.4% stake in Yahoo, took the opposite stance, opposing the sale of the company and the ousting of CEO Jerry Yang, which was advocated by another hedge fund manager, Carl Icahn, who had a 5% stake. Yang resigned later that year, and Icahn quietly left the board the following year when the new CEO failed to take his advice. In recent years, Icahn has acquired significant stakes in a number of media and technology companies––including Time Warner, eBay, Apple, and Netflix—and has a mixed track record of success. In 2006, for example, he unsuccessfully pushed to break up the AOL Time Warner conglomerate into four separate companies—publishing, cable services, Internet, and film/television. Two years later, after Icahn had sold his stake in the company, a new CEO began implementing the break‐up strategy advocated by Icahn, spinning off AOL, Time Warner Cable, and Time Inc. as separate companies.
Most CEOs and CFOs spend a considerable amount of time managing the expectations of institutional investors—especially activist hedge fund managers who buy up significant shares of a particular company. Often, as was the case at Yahoo, they take diametrically opposing views. Other times, as was the case with Knight Ridder, they band together to force change. Critics say that these activist hedge funds force managers of media companies to make decisions that may boost short‐term gains for their own funds, but hamper long‐term sustainability of the company. Regardless, since they now own a significant portion of stock in media companies, managers of publicly traded companies have to reckon with them and try to chart a financial course that delivers an acceptable ROI and a strategic course that allows the company to grow in the years ahead.
Once a company is “put into play,” as Knight Ridder was in 2006, private equity funds will most likely take a look at the company’s prospectus and decide whether to make a bid on the company. In contrast to venture capitalists, which invest in start‐ups, private equity firms tend to buy existing companies. These can be private companies, as well as publicly traded ones, such as Knight Ridder. As with hedge funds, private equity managers pool the funds from other high net worth individuals and institutions, to make large investments in private companies or to “buy out” all the stock in publicly held companies and make them private. Private equity is exactly as it sounds: equity (part ownership) of an investment fund that cannot be purchased or traded on an exchange.
Private equity funds often focus on buying distressed properties and reviving them through a combination of cost‐cutting and “better management” before selling them either to another firm—or taking them public again, issuing another IPO. These funds typically require their investors to commit to a long holding period (of five to seven years) before they can withdraw their money. However, private equity companies are often criticized for both their use of leverage and a short‐term focus on ROI. Many of the companies acquired by private equity firms are saddled with a significant amount of debt, with the assets of the company used as collateral. This is called a leveraged buyout. As a result, private equity funds can make a large number of acquisitions without having to commit a lot of money to any individual company they purchase. Without significant funds invested, private equity managers can simply shed underperforming properties in their portfolio and move on to the next acquisition. This strategy is summarized as a “buy ‘em, hold ‘em and flip ‘em” strategy. After the sale of Knight Ridder in 2006 and the subsequent recession in 2008, private equity companies have aggressively purchased newspapers in small and mid‐sized markets across the United States, and implemented significant cost reductions. Newsroom employment, for example, had declined by more than one‐third by 2015, lower than at any time since the numbers were first tracked in 1970. Investment entities—most of which are private equity companies—now own all or portions of 2,000 of the nation’s 7,500 papers. Many papers have been sold two or more times since.
Regardless of the pros and cons, these three types of investors are a fact of life, with a significant stake in media companies. The average share of stock is held for only nine months today, compared with nine years in the 1970s. The unrelenting focus by institutional investors on ROI means that managers and owners of both public and private companies have a new imperative to grow and grow quickly—revenue, profit, and cash flow—all of which is assumed to ultimately drive shareholder return of both public and private companies.
How much would you pay to own a company founded in 2011 by Stanford classmates who designed a disappearing photo app as a class design project? One of the earliest and largest investors in Snap was the venture capital firm, Benchmark, which, beginning in 2013, invested a total of $24 million in return for a 12% stake. Later investors paid more and received less of a stake, but were still eager to get on board. In 2016, in its last round of financing before it went public, Snap raised $1.8 billion, including $169 million from four mutual funds run by Fidelity Investments. Shut out of the last round, NBC Universal, instead, made a deal to buy $500 million of stock in Snap in the March 2017 IPO.
At the close of the opening day of trading, early stage and late stage funders appeared to have made very profitable decisions. Benchmark’s profit alone was estimated to be $3–4 billion. But, how about the individual investors, who scrambled to own a piece of Snap at $24 a share on opening day? Would this prove to be a wise investment or had they entered the game too late? Over time, how would both the big and small shareholders in Snap calculate a return on their investment?
The large brokerage and securities firms employ research analysts to develop earnings estimates for publicly traded corporations and make recommendations on whether to buy stock in a specific company. Typically, analysts specialize in covering an industry sector, so the same analysts that cover CBS will likely cover Disney. Likewise, the same who cover Facebook will also cover other social media companies, such as Twitter. This allows them to compare the financial performance of peers and competitors quarter to quarter, year to year. These analysts develop their earnings estimate with quantitative models that take into account a company’s past financial performance, trends within the industry sector (i.e., is demand for a product or service increasing?) and the macro‐economic environment.
Once they have worked through several scenarios, they then set a target price for the stock, based on whether they conclude earnings will rise or fall. They make one of five recommendations:
Table 3.4 shows how analysts assessed four stocks in March 2017, as Snap issued its IPO.
Table 3.4 Four stock analyses as Snap issued its IPO, March 2017.
Source: http://www.marketwatch.com, accessed March 6, 2017
| Company | # of analysts | Average rating | Current price ($) | Average target price ($) |
| 46 | Buy | 137.00 | 158.00 | |
| 34 | Buy | 827.00 | 986.00 | |
| News Corp | 12 | Overweight | 12.95 | 14.87 |
| 39 | Hold | 15.56 | 14.64 |
In reality, the majority of stocks in established companies, even those that are underperforming compared to their industry competitors, have a recommendation of “hold” or higher. Note the recommendation on Twitter in Table 3.4. Even though Twitter had an average target price lower than its current price of $15.56—indicating that most analysts felt the stock was overvalued—22 out of 39 research analysts still had a “hold” recommendation on the stock. Only 13 analysts had issued an “underweight” or “sell” recommendation.
Since grade inflation affects stock ratings, investors often employ other metrics to determine whether to buy or sell stock. Two of the most commonly used calculations are earnings per share (EPS) and the price/earnings (P/E) ratio. Both give some insight into a firm’s current profitability.
Both metrics are simple to calculate and allow investors to compare the performance of companies across industries, regardless of size. But they have their significant drawbacks. First, the earnings figure used to calculate both EPS and P/E is net income, which includes taxes, interest, and noncash items such as depreciation, which can vary widely from year to year. Second, both EPS and P/E can vary depending on the number of shares a company has issued. (Management can increase earnings per share by buying back shares.) Finally, both are snapshots of current profitability and may not represent future prospects.
This is why most investors use a combination of metrics to evaluate established businesses that also includes trailing, weighted EBITDA, as well as revenue growth over time, and projections of trends in the industry. Additionally, managers of a portfolio of stocks may also take into account the “beta” of a security. Beta measures the tendency of a stock to respond to swings in the market as a whole. A beta of “1” means the stock tends to move in tandem with the market. Facebook had a beta of .67 in March 2017, indicating its stock price had not reacted to recent dips or peaks in the market. Disney had a beta of 1.20, which, theoretically, indicated that its stock had been 20% more volatile than the market.
Established companies, as well as start‐ups, issue stock because they want to raise money to invest in new products and services, and grow revenue and profitability over time. Shareholders buy stock in a company because they hope to share in the company’s profitability. Underwriters handling the IPO for a new company that is unprofitable, such as Snap, set the target price for a share of stock by using the revenue multiple method discussed previously, along with complex modeling formulas that project user growth and potential earnings. The trick is to price the shares so there is sustainable demand for the stock on opening day, but not so much investor enthusiasm that the price rises to unrealistic multiples of revenue growth in the days after the IPO, as Twitter’s stock did.
The lead underwriters of the Snap IPO—Morgan Stanley and Goldman Sachs—initially indicated that, based on investor demand, the shares for the IPO would be priced between $14 and $16. On the day of the IPO, March 1, 2017, the target price was raised to $17 a share, which gave the company a market value of $24 billion. On March 2, the first day of trading on the NYSE, the stock opened at $24 a share, and rose to $29 a share the next day before falling back down to just under $24 a week later.
Early investors in the firm, venture capitalists like Benchmark, were clear winners in the early days of trading. Benchmark’s investment of $24 million in Snap was worth $3.2 billion at the close of trading on the first day. Later investors, like Fidelity and NBCU, had also reaped significant gains on their shares, acquired for $17 or less. But what about the investors who bought at $24 dollars or higher? Would this be a profitable investment for the small investor?
Let’s consider the trajectory of two other stocks: Facebook and Twitter. Suppose you had purchased one share of stock each in Facebook and Twitter on their first day of trading and sold the two shares on March 2, 2017, the day that Snap went public. How would you calculate a return on your investment in these two start‐ups?
In the weeks leading up to Facebook’s IPO in 2012, several analysts argued that a $38‐per‐share price was too high, given the company’s recent metrics (including revenue and user growth rates). On the first day of trading, Facebook stock closed just barely above its opening price, and it fell as low as $18 a share over the next year before beginning to rebound. However, if you had purchased a share of Facebook stock for $38 and held onto it until Snap went public in 2017, a share purchased for $38 on opening day was worth $137. You had a gain of $99.
Hoping to avoid a repeat of Facebook’s first weeks, underwriters priced Twitter’s IPO shares at $26. As soon as Twitter began trading on the New York Stock Exchange on 2013, the share price shot up to $45, before closing at $40. Six weeks later the price had climbed to $69 a share. It then began a relentless downward tumble in early 2014. A share of Twitter stock purchased at $40 a share on opening day in 2013 would have been worth $16 in 2017. You had a loss of $24.
You calculate a return on your investment (ROI) on the two stocks by subtracting the cost of the shares of stock from the proceeds on the investment, and then dividing that answer by the cost of the investment (Box 3.2). Because the answer is expressed as a percentage, you can easily compare a return on various investments.
On the surface, return on investment (ROI) is a fairly simple calculation. However, the above ROI calculations do not take into account two important economic and financial variables: opportunity costs and the time value of money.
Let’s consider the opportunity costs of buying Twitter stock, instead of investing the money in another stock. What if, instead of purchasing one share of Twitter stock at $40 a share on Nov. 8, 2013 (the day that company went public), you purchased another share of Facebook stock, which was then trading at $48. In that case, you would have a very positive ROI on your purchase of two shares of Facebook stock compared to the negative ROI when you bought both Facebook and Twitter (Box 3.3, page 62).
In this case, you not only lost $24 on the Twitter stock, but also missed out on a gain of $89 on a Facebook share purchased for slightly more ($48) at the same time. So, the opportunity costs of choosing to invest in Twitter stock are even greater than the accounting loss ($24).
Calculating the time value of money diminishes your ROI even further. Simply stated, given inflation and other risks, the value of a dollar today is greater than a dollar four or five years hence. Inflation from 2012 to 2017 was low compared to rates in the previous two decades. Nevertheless, the annual average rate for those five years was between 1 and 2%. So, even if you had chosen to invest in Facebook, instead of Twitter in 2013, dollars you received in 2017 would have been worth less than the dollars you invested in Facebook stock in 2013, as well as the dollars you invested in 2012. You still have a positive ROI, but it is discounted for the time value of money (Box 3.4).
In a similar fashion, a manager of any firm is constantly evaluating and analyzing options for using the earnings at his or her disposal, and then choosing which option is more likely to yield a better profit over the next several years.
In calculating an ROI on major investments—such as taking a major stake in Snap—all of the following three methods are used since they take into account both opportunity costs and the time value of money: net present value, internal rate of return, and profitability index.
Suppose you invested $1 million in a start‐up company and received a 50% share of ownership. This enterprise is sold five years later for $2.5 million, yielding a profit of $250,000 (or a 25% gain). Let’s consider how to calculate ROI on this investment using net present value (NPV) (Box 3.5). This method takes into account the time value of money by discounting future cash flows to what they are worth in today’s dollars. Five years have elapsed since your investment in the start‐up. The ROI has to be adjusted for an average inflation of 2% in the intervening years, which brings down the $250,000 gain to $226,432.70.
This method builds on the net present value (NPV) calculation. It not only takes into account the time value of money, but also establishes a targeted rate of return, also called a hurdle rate. Let’s assume your company is evaluating a five‐year project that requires a one million dollar investment. It has the following expected cash flows: Negative cash flows of $30,000 in year one and $30,900 in year two, followed by positive cash flows of $31,827 in year three, $32,782 in year four, and $1,250,000 in year five. Let’s also assume the hurdle rate in this case is 5%. We can calculate the internal rate of return (IRR) by finding the rate at which the NPV of the project is equal to zero (Box 3.6). The IRR must be equal to or greater than the hurdle rate of 5% in order for a project to get the go‐ahead. The IRR is 4.5%, which is lower than the hurdle rate. Therefore, you should not proceed with the project.
This method builds on the IRR method and allows an investor to compare many different projects, projecting an IRR for each one and then choosing whichever has the highest rate of return. Let’s suppose you want to compare the ROI of two projects, assuming an inflation rate of 2% (Box 3.7, page 64). You can buy a 50% stake in a start‐up that you anticipate will be sold in five years for $2.5 million. Or, you can invest $1 million in the development of a new product with projected cash flows of $25,000, $400,000 and $600,000 in years three through five. Which is the better option?
As these examples illustrate, every decision that a manager—or an individual shareholder—makes has an associated opportunity cost, which is the profit or value of the option that was given up in order to invest in the other one. Opportunity cost and the time value of money are economic concepts that are not recognized in a company’s financial statements. However, it is front of mind for analysts and investors who pore over a company’s annual statements, evaluating not just the recent performance of an enterprise, but also the decision‐making acumen of the managers.
Those who bought Facebook stock on opening day and held onto their stock for at least two years had a nice return on their investment. But, it took almost a year a half for the Facebook stock to rebound to its opening price. The rise in share price was ultimately propelled by the company’s shift in strategy, away from desktop to mobile platforms, which placed Facebook on a new growth trajectory of both revenues and profits. In 2016, four years after its IPO, Facebook had revenues of $26.6 billion and net income of $10.2 billion. Those who bought Twitter were not as lucky. As user and revenue growth slowed and then plateaued, Twitter’s management seemed to flounder. In 2016, three years after its IPO, Twitter posted revenues of $2.5 billion and a net loss of $456 million.
How long should Snap investors hold on to their shares before selling? Metrics such as EPS and P/E ratios, as well as recommendations from Wall Street analysts, offer some guidance about the direction of the company and its prospects for future growth. Ultimately, the ROI for any investor—whether venture capitalist or individual stockholder—will depend on a variety of factors. When did they invest? How much did they invest? How long did they leave their money in this investment? Were there other options that might have yielded greater returns?
The market valuation of any media company is determined by both external and internal factors. External factors—such as the economic environment and industry sector in which a company operates—have historically exerted an outsized impact, determining as much as 90% of a company’s market valuation. That is because most media companies are cyclical, with revenues and profits mirroring the ups and downs of the economy. Also, companies in rapidly expanding and innovative industry sectors tend to grow more rapidly than those in mature and stable industries. However, decisions made by managers of a firm can make a big difference in the financial performance and valuation of both a start‐up or legacy company, such as a book publisher.
The fate of media companies lies increasingly in the hands of institutional investors. This includes venture capitalists, hedge fund operators, and private equity fund managers. Venture capitalists typically fund start‐ups, while hedge fund and private equity fund managers tend to focus on established companies. These three types of investors typically have an expectation for a quick return on their investments. This often prompts media companies to focus on near‐term growth.
There are a number of financial tools used to place a valuation on both private and publicly traded companies. Analysts, investors, and lenders pore over the annual financial statements looking for trends in revenue, costs, profits, and cash flow. They determine the value of a company, using one or more of these methods: EBITDA multiple, revenue multiple, discretionary cash flow, or book value. Established media companies are typically valued based on the EBITDA method. Most start‐up valuations are based on some combination of a revenue multiple and projected EBITDA.
Whether you are a shareholder in a publicly traded company or an investor in an early‐stage company, you will calculate return on investment (ROI) using the same financial tools. ROI is a very simple calculation but it must be adjusted and discounted to account for opportunity costs and the time value of money. More complicated tools—such as net present value, internal rate of return, and the profitability index—allow investors to discount future cash flows because of inflation, and to consider what other options might have yielded a better return.
Most start‐ups and “unicorns” fail to pass the test of time, despite the phenomenal success of Facebook and Google in recent years. What made them different? Why were they able to reach scale and profitability when others weren’t? Will their sky‐high market valuations continue? What are the lessons for other start‐up and legacy media enterprises? These are all questions we will consider in Chapter 4.