Snapchat most recently raised money at a rumored $10bn valuation. All good MBAs know that the current value of a company is the value of all of its future cashflows, discounted back to the present. So all good MBAs consider these VCs completely insane. Or they would, except that implicitly people use two valuation frameworks: either they think of an investment in terms of discounted cash flows, or they think of it as a “strategic” investment. “Strategic,” in practice, means “clearly not the result of anyone’s realistic estimate of Snapchat Inc.’s free cash flow generation circa 2029, but not strictly crazy, either.”
But there is a fairly trivial way to square that circle. A company’s current value is the net present value of all future cash flows it can generate, or the amount of cash flow it can cause a single prospective purchaser to lose, discounted to the present.
Can Snapchat return ten billion 2014 dollars to investors over its lifetime? Never say never, but probably not.
Can Snapchat cost Facebook, Google, or mobile phone companies ten billion dollars in unwanted capex and forgone income? Much more likely!
I am by nature a value investor. I read Lowenstein’s Buffett Hagiography,The Intelligent Investor, and Security Analysis from about mid-2000 to mid-2001. This is sort of like cracking a Bible for the first time right after personally witnessing all of the world’s sinners descend straight into hell. Value investors have this mentality that they are an obscure and virtuous niche, making their way in a financial industry strewn with degenerate gamblers.
So it was a big surprise to find out that everyone in finance reads Graham and Dodd and thinks they knew what they were talking about. There are still degenerate gamblers, but they are degenerately gambling on the output of fairly traditional value formulas. (The reason trading is so frenetic is that, if everyone is a value investor, being a pure value investor is a mug’s game—your goal is not just to find what’s undervalued, but to figure out what is undervalued and what’s going to change that. Which also lets you buy something you think is 10% too cheap but is going to hit the right price in a month, instead of buying something at fifty cents on the dollar but living with the risk that it’ll be fifty cents on the dollar in ten years, too.)
Many investors are not just value investors, but are averse to straying too far from value investing. While people will speculate on whether or not a company could get taken out, or what the valuation would be if they were, that’s often viewed as a pretty qualitative question. If it’s quantified, it’s often in terms of whether or not the most likely acquirer has enough dry powder to finance a deal.
And that approach generally makes sense. It’s hard enough to model the behavior of the average investor whose actions determine a stock price day to day. Now you have to model the behavior of acquirers, too?
But it’s necessary. Graham and Dodd wrote for a general audience. They were popularizing techniques, not writing a textbook for full-timers. So they made lots of simplifying, almost Newtonian assumptions, many of which held for a long time. One of which was, implicitly, that competitive dynamics are pretty stable. Yes, there are cyclical companies that are expensive at five times earnings and cheap at fifty. Yes, there are some companies that raise their prices every year. But that rarely changes.
The economy is actually made up of numerous tiny, blurry monopolies, all of which allow owners to extract profits above the cost of capital but under complicated constraints. Sometimes those are easy to intuit (eg patents and trademarks, or owning hard-to-duplicate capex like a railroad). Sometimes they’re fairly counterintuitive (Google’s search engine is sustainably better not because they hired the best engineers, but because their market share is so high that their sample size for testing new improvements is huge).
Across older supply chains, competitive dynamics shift in a fairly understandable range. Slightly more expensive oil can lead to radically more expensive tanker rates and equipment leases, and that doesn’t change. But in newer supply chains, like “attention paid to a mobile device -> information about an individual’s behavior and purchasing habits -> well-targeted ads -> purchases,” supply chains shift qualitatively, too. And the big drivers of qualitative change are product changes and acquisitions.
Graham and Dodd rounded competition down to the point that game theory wasn’t a factor. In many of the industries they looked at, it wasn’t. But in the high market-cap, high-volatility Internet sector, it turns out that game theory is critically important. For the median small tech company, the biggest market-cap impact they can have is negative, for their competitors.
This sounds like a reversal of standard value investing thought. Value investors are supposed to stand away from the crowd and buy unpopular stuff knowing what it’s really worth. Buying something for more than the value of its future cash flows, but selling to somebody who will overpay more, sounds like pure speculation.
But ultimately, the vast majority of investments are going to be sold some day, and if there’s a reason to think the price a) won’t be a DCF, but b) can be analyzed reasonably, it’s totally reasonable and consistent to invest on that basis. Warren Buffett says he buys stocks with a preferred holding period of “forever,” and it’s true that his time horizon is unusually long. But that line itself is a little game theory, too: Buffett buys large stakes in companies that grow free cash flow with little incremental capex, so he can afford to be patient. And by saying he buys now and holds forever, he becomes the buyer of first resort for a huge class of sellers. This is probably not a cynical ploy, but it’s also what a cynical person might do.
For those of us who aren’t trying to acquire family-owned companies at fairly low multiples, a holding period of forever is not so ideal. Outside of big, brand-name consumer products, competitive advantages don’t last forever. (And even when they do, by now everybody knows it, so eventually every single share of Coca-Cola will be owned by Buffett acolytes.)
So we can modify value investing from “buy a stream of cash flows for less than its net present value,” to “buy a stream of cash flows for less than its future value to whichever acquirer is most likely to buy it.” And who is more likely to buy a startup that competes with a big online incumbent? Either that incumbent, to cauterize the damage—or their competitors, to keep it out of the incumbent’s hands. Either way, the exit price of the investment is driven by how much damage it can do to other business models.
The most significant claim this makes is that speculative startups and value investors are on a continuum, not engaged in separate activities. The value end of the spectrum assumes that all possible future buyers of a given company are homogeneous. The speculative side assumes that buyers are heterogeneous, but that their behavior is still reasonable. (ie when Instagram sold to Facebook, it was selling to a “value investor” who was paying $1bn to avoid far more than $1bn in forgone free cash flow.)
A useful check on this is to see if more monopolistic industries have more high-valuation acquisitions. And it seems so: Facebook and Google (who have near-monopolies on online identity and online demand-harvesting) tend to make splashy and confusing purchases. In more fragmented markets like online travel agencies and general e-commerce, there are fewer such deals. Online real estate: two of the three American pure plays in that market have accepted offers this year, both at surprising premiums.
If investors are behaving this way, what are the broader implications? First, monopolies are not as bad as they look in a naive model, because monopolies are more or less required to be the high bidder for direct and indirect competitors. If Facebook really owned personal identity and messaging, that could be problematic. But if owning that means having to periodically write $10bn+ checks for companies like WhatsApp, the net present value of their monopoly is much lower.
And, conversely, the net present value of starting a company purely to be a thorn in the side of monopolists is much higher.
Whether that’s a good thing or not depends on how much you value ridiculously expensive moonshots that can only exist when a giant pile of money is under the control of a single determined owner. Breaking monopolies is great for consumers on the margin, but Facebook and Google, at least, are spinning their monopoly profits into free wifi, subsidized data in the third world, immortality research—all very interesting stuff that they couldn’t pursue if more of their excess profits were diluted.
But this does present a positive vision. An entrepreneur can escape that weird rat race by building something so truly weird that nobody can even describe it well enough to build adjacent competitors. One way to do this is to invent a completely new business, but most completely new businesses are new because they are a bad idea to start. Better to build a search engine when all the other search engines are turning into portals, or a social network when MySpace is a cesspool with a huge head start.
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