Taking Stock of Twitter

When Twitter eventually goes through an IPO (initial public offering), its investment bankers will be faced with the challenge of establishing a price per share for the company’s stock. To the uninitiated, this might seem like a simple task.

The fact is there are several valuation scenarios that can be used to price a stock. I’ll describe two of these, and then I think you’ll be surprised with my guess about an alternative valuation the bankers might ultimately use.

The Revenue Stream Approach

This approach tries to predict how a stream of revenue that a company generates can be translated into its present value. There are several variations to this type of income analysis. The most common one is called the “price/earnings” ratio or P/E ratio. Most of us are quite familiar with this approach to valuing a stock.

This rather simplistic analysis takes the trading price of a stock and divides it by the company’s annual earnings per share. For example, if a company’s stock is traded at US$20 and it is earning $1 per share, its P/E ratio is 20. Theoretically, this means that it will take 20 years of the company’s earnings to get your investment back.

Curiously, the fact is that many companies trade well above a P/E ratio of 20. Why is this? It generally means that the company is in a “sexy” industry. Sexy meaning a relatively new industry that has tremendous upside potential. Thus, for such an industry, investors might be more than willing to disregard the earnings of a company and put a high valuation on its stock because they feel that its earnings will substantially improve over the coming years. They are betting on what they believe will happen to the company and the industry.

Net Asset Value Approach

This is a rather conservative approach in that it takes the value of a company’s net assets (assets less liabilities) as depicted on its financial statements and divides that amount by its outstanding shares. So if a company’s net assets are $1,000,000 and it has 500,000 shares outstanding, its net asset value, NAV, is $2 per share.

An investor willing to pay $2 per share for such a company is disregarding the income flow of the business and is solely looking to its net asset value per share to value the business-usually a very conservative approach.

Certain businesses do, however, lend themselves to this type of evaluation. For example, I own a portfolio of mutual funds. These funds hold shares in many different companies and industries. At the end of each day, each of the companies in which the mutual funds have invested will have a closing stock price for its company’s stock. So if the stock of a company in which the mutual fund has invested closes at $5 per share, that amount becomes part of the cumulative NAV of the mutual fund. The mutual fund merely has to add up all of the closing prices of its various investments then multiply that amount by the number of shares it holds in each investment to come up with the total NAV of the mutual fund.

In this situation, NAV makes sense for the mutual fund. This is so because a mutual fund is simply an accumulation of investments in various companies. The stock prices of those companies become available at the end of each day. It is then a simple task for the mutual fund to add up these closing prices, times the number of shares owned and come up with a NAV for the mutual fund itself.

All of this being said about NAV, it is not at all likely that a company like Twitter will be initially traded for anything near its NAV. The stock will most likely trade at a value far above its NAV.

Perceived Value as a Pricing Technique?

The investment bankers handling the Twitter IPO will more than realize that they have a very attractive candidate on their hands. Twitter is a leading social media company, and I firmly believe that it will continue to be one of the most dominant players in this field, not unlike Facebook.

With this said, I think that investment bankers will price Twitter based on its perceived future value. They will realize that such an IPO will generate tremendous interest among investors, and investors will be anxious to gobble it up. In fact, many of us rue the day that we didn’t buy Google stock when it went public. Therefore, we simply don’t want to miss a similar opportunity.

This is why I think that the investment bankers will evaluate Twitter based upon its perceived value. And let’s keep in mind that perception is in the eye of the beholder. Social media is perceived and will continue to be perceived as a hot area, an area that has a tremendous future with wonderful potential.

One note of caution: Investment bankers will invariably offer tranches of stock to their major customers and to their friends before these shares are then traded with the general public. These customers and friends will likely make tremendous profits on their presumably short-term holdings of the stock. Other people who get in on the first day of trading will find their shares initially drop. This occurs because the original holders are “dumping” their shares at a substantial profit. Once the dust has settled, my guess is that Twitter will be a handsome addition to a diversified portfolio.

Finally, I must mention that I’ll never forget the powerful force of Twitter and social media during the Arab Spring. Tweeting became the collective sigh of humankind, expressing its hopes for freedom. History was changed forever!

Good luck!