Social Media

Going Cheep?

The shares of microblogging firm Twitter may not be the bargain investors are hoping for.
Economist StaffOctober 31, 2013

Twitter is already a social-media star. Now it hopes to become the toast of the stock market too. The firm has gradually been unveiling more information about its business. But as it gets ready for its first day of trading as a public company on the New York Stock Exchange, which looks likely to be on November 7, opinions about a fair price for the shares vary considerably.

The firm has announced a provisional range of between $17 and $20 for its stock, which would value it at up to $11.1 billion. Speculation is rife that Twitter and its bankers could set an even loftier price before trading starts, though as we went to press no change had been announced. If they do push the price higher, long-term investors could get their fingers burned.

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Twitbulls point out that Twitter is going public at a time when social-media stocks are all the rage. On October 30,  Facebook’s share price, which had already risen by 84 percent this year, soared in after-hours trading following news that its latest quarterly revenue had hit $2 billion. LinkedIn has seen its stellar revenue growth slow a bit recently, but its shares are still up 95 percent this year.

Twitter’s boosters also claim that the company deliberately set a conservative initial price range to fuel investor interest in its stock, noting that an internal valuation conducted by the firm in August reckoned its shares were worth $20.62 each at the time. The company has continued to increase its audience, and now boasts 232 million users that visit it at least once a month.

twitter PSR chart

Small wonder, then, that some financial folk are predicting Twitter’s stock will fly even if the IPO price is a bit higher than the existing range. Brian Wieser of Pivotal Research Group reckons its shares will be changing hands at $29 by the end of the year. Others are even more optimistic. Doug Kass of Seabreeze Partners Management, a hedge fund, has said he thinks the share price of Twitter could double within its first month of trading and that he would be willing to pay up to $32.50 for its shares. Twitbulls like to point out that Twitter is currently generating about $2.30 of revenue per user. That is much less than Facebook makes from its audience, implying Twitter has plenty of room to boost sales.

But they gloss over an important fact. Unlike Facebook and LinkedIn, which were making healthy profits before they went public, Twitter is still losing money — $134 million in the first nine months of this year compared with $71 million in the same period of 2012. These losses make it impossible to compare Twitter’s IPO with others using the traditional yardstick of a price-earnings ratio.

Instead, analysts often look at another measure: the ratio of a firm’s proposed market capitalization at IPO to the past 12 months’ sales. Jay Ritter, a professor at the University of Florida, has calculated this ratio for Twitter using a share price of $18.50, which is the midpoint of its proposed range. Counting in restricted shares and those associated with outstanding stock options, this produces a market cap of $12.9 billion and a price-to-sales ratio (PSR) of 24.1 based on Twitter’s revenues over the past 12 months. That is the third-highest PSR of any IPO in America since 1980 involving firms with significant revenues (see chart).

Shares in the two companies ahead of Twitter in the chart — Facebook and Palm, a now-defunct maker of hand-held devices — fell sharply in the months following their IPOs; and Ritter notes that the top 15 companies in his PSR ranking saw their share prices drop by an average of 5 percent in the six months after their first day of trading. “A valuation at a high price-to-sales ratio removes a lot of the upside potential for investors in the public market,” he says.

The challenge faced by companies with high ratios is to generate revenue fast enough to meet investors’ expectations. So far, Twitter has only a microscopic share of the $118 billion-a-year global market for online advertising. Yet the fact that many people tweet on their smartphones means it is well-positioned to take advantage of growth in mobile advertising. On the other hand the compact nature of its tweets, limited to 140 characters, means that Twitter will find it harder than Facebook to generate ad formats that mint money. And it now faces much stiffer competition from the social network and other companies such as Google in the mobile-ad arena.

Trick or tweet?
So what is a fair value for Twitter’s shares? Aswath Damodaran, a professor at New York University, has built a valuation model that assumes Twitter will scoop up around 5.5 percent of the online ad market by 2023, giving it revenues of $11.2 billion. His model also posits an operating margin of 25 percent for the company, which seems plausible given that of other internet firms that have grown fast. Based on his analysis, he reckons Twitter’s shares are worth $17.84 each, which is towards the lower end of Twitter’s current price range. Given the many uncertainties that still dog the company’s business model, a price of around $18 a share seems reasonable.

But investors who like volatility may still want to take a flutter on Twitter’s stock even if the price is somewhat higher. Given all of the hype around the company, Twitter’s shares could spike upwards immediately after its IPO, allowing investors to mint money by buying and selling quickly. So Twitter’s flotation could be a great short-term trading opportunity. But at anything above $18 each, its shares will be a poor long-term investment.

© The Economist Newspaper Limited, London (November 2, 2013)