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Monthly Archives: February 2012

CAPM:

Ke = Rf + B x MRP
where:
Ke = Cost of equity
Rf = Risk-free rate (Basically, a treasury bond [long term])
B = Beta
MRP = Market Risk Premium

An except from Warren Buffet’s annual letter to shareholders:

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.

I’ve talked to a number of people about how stocks are priced and how they’re priced wrong according to the Capital Asset Pricing Model (CAPM). This is because CAPM assumes that stocks are perfectly priced which is based on the efficient market theory. A quick note on efficient market theory, it basically says that all equities are perfectly priced all the time. Meaning, a stock will be perfectly priced compared to everything in the market.

I feel like when you learn about pricing things in finance, that the efficient market theory is like a fairy tale. You want to believe all of that is true. In reality, it’s just used as a process used to make you feel warm and bubbly until you get hit with the harshness of reality. The reality is that markets will always be inefficient (at least in my opinion).

This is not to say markets become more efficient, if that makes any sense. As more and more people enter the market, instruments should be priced better. This is not to say that because the NYSE has the largest amount of volume that it is the most perfectly priced market. But ideally it should be. People’s sentiments go into pricing stocks. People are not always rational.

This brings us back to this concept of CAPM and beta. I read an article in the Financial Times also articulating the same point Mr. Buffet brought up in his annual letter to shareholders. What both are saying is that beta doesn’t accurately represent risk, it just represents how much a stock moves in according to a major market index. In the US, most people think of this as the S&P 500 index.

Therefore, in the US, let’s say there’s a stock ABC. If it’s beta is 1, that means when the S&P goes up one point, ABC will go up one point (on average). If it’s beta is 2, ABC goes up two points (again on average) when the S&P goes up one point. In the same scenario that the S&P goes up a point and ABC’s beta is -1 (which can happen but rare), ABC goes down one point (on average).

Now, let’s say a ticker, we’ll use BSC as an example, has a beta of .7. This doesn’t reflect the fact that they own a bunch of worthless bonds and that they are highly dependent on that portfolio for liquidity and/or solvency.

Most people will know that BSC was the symbol for the now defunct Bear Stearns. I really don’t know what their beta was in 2007 before it tanked. But I know it didn’t reflect the price of the stock properly. And that’s because most reports base their prices on CAPM.

(This may have a continuation)

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I meant to post something Sunday night or Monday morning on CAPM and Warren Buffet’s letter to shareholders, but I’ll get to that soon.

Right now, the most prominent news is that S&P has official rated Greek debt to be in selective default. In my previous post, I had mentioned how Greece was having problems collecting taxes. Also I mentioned this was beginning to spread into other countries, specifically the UK.

While taxes may not be the only source of revenue, it goes to show that some countries need to be more aware of their financial situations. I brought up the UK as an example because I saw an article on it. Last August, S&P had downgraded US debt, not because of our ability to pay but more on where the funds were coming from.

Now I’m not saying the US is having the same problems as Greece. In Greece, people are protesting out on the streets about wage reductions while the politicians are freaking out trying to figure out what to do. In the US, we have people complaining about a 99% and the politicians are going through the same motions. Not freaking out, but certainly much closer to a solution than in Greece, as long as people can get their egos checked.

That being said, I have a much more positive outlook here as long as people are willing to collaborate and compromise.

I had a finance professor, Yiorgos,  who after confusing everyone with crazy valuation methods, he would say “It’s all Greek to me!” and laugh. The funny part about it was, he was Greek. So to him it made sense. He was a smart guy.

I would also say he’s smart because he decided to leave Greece to teach at the University of Virginia, given the mess going on there today. And there’s been recent news about the bailout going on this week. Originally this post was going to be about that until two of my friends shared links that really caught my attention.

It’s on how tax revenues in the UK fell. 

Now from what I’ve read on Greece in the news and from Michael Lewis’s Vanity Fair article which you can read here, a major problem was people who have their own businesses not reporting income tax. This is a common thing in many emerging markets, but to see it happening in the EU is kind of scary. I’d be more worried if it were Germany but at least the situation is contained to one of the weaker countries in the EU.

But now, we have that problem happening in the United Kingdom? I find this to be very scary.  Why the country isn’t checking up on people paying taxes is beyond me. Look, we all hate tax collectors. It’s an international thing. But you can’t argue that we don’t need them because when you look around the world that don’t have enforcement on paying taxes, it just doesn’t get done. Once that starts happening is when you see emerging markets become more stable. But now, in some of the more powerful countries this is happening?

It’s all Greek to me.

A lot of the reports I see going out in the market give Facebook a value of somewhere in between $75 and $100 billion. I realize that Facebook is unique in the marketplace but I think people are forgetting about some of the comparables in the past. Does anyone remember Friendster or Myspace?

Friendster has not had a valuation since 2009 and in 2011 went through some major changes in its services. Originally, the site was known as a social networking site, one of the first I remember ever using but never being that excited about it. The site, at its peak, was valued at $53 million and at one point turning down a $30 million bid from Google. The most recent data I found on the valuation of Friendster has a transaction value of $26.4 million. Since then, the company has turned into more of a social gaming site and focused its attention in Asia. I just find it funny that no one mentions this when valuing Facebook.

Myspace is a different story and one that I feel is much more important to mention. First of all, at one point someone posted that Myspace at one point had a valuation of $65 billion! That sounds scarily close to Facebok’s valuation. While the posting itself admits this was based on a per user basis coming of Facebook’s valuation and suggests that $5 billion is more acceptable, it did invite that idea. If you want to look at a history of Myspace’s valuation, look here: http://www.theatlantic.com/technology/archive/2011/06/as-myspace-sells-for-35-million-a-history-of-the-networks-valuation/241224/. The most important thing to note is that in June 2011, Newscorp sold 90-95% of its stake in Myspace for $35 million, six percent of what it purchased it at. This gives me a company valuation of around $40 million. The other comparison I want to allude to Myspace has to do with Facebook’s new Timeline. Critics of the new Timeline have said it looks way to much like Myspace. Given these criticisms, shouldn’t the market be wary of these concerns?

While I make a lot of criticisms, it is not to say I do not like Facebook. I think it’s a great social networking platform. They have brought people together in a way that hasn’t been done by anyone else in the social networking space. I wouldn’t be communicating with soccer fans talking trash about Real Madrid (as I’m a Barcelona fan) every time El Clásico comes up. I would not be able to share information with people I know that are completely on the other side of the world in a quick and easy manner. I just think that the market isn’t taking into account the failed social networks in the past.

So basically, I have come up with a ‘back of the envelope valuation’ of Facebook. I have not done a discounted cash flow valuation but rather, I just wanted to take the enterprise values of the street, a well-known NYU professor, Aswath Damodoran, and the two companies mentioned previously. I basically weighted the outcomes of Facebook going the way of Myspace and Friendster each at 10%. I believe that given what has happened in the past, this is not entirely inappropriate and in reality, I think putting it higher would be more correct but since this method of valuation is not the most proper, I think 10% is ok to use. For the other 80%, I have split it evenly between Professor Damodoran’s valuation (see here: http://aswathdamodaran.blogspot.com/2012/02/ipo-of-decade-my-valuation-of-facebook.html) of $70.9 billion and the street’s valuation of $87.5 billion (87.5 being the midpoint between 75 and 100). When I calculate the value using these weighted averages, I get a value closer to $63.4 billion. Following Damodoran’s process, I subtracted debt from the Enterprise Value and added cash to come up with an equity value. After that, I subtracted the option value and came up with a net equity value of about $60 billion. Dividing this by the number of shares mentioned in their filing, this comes up with a value of about $25.69. Again, I want to stress that this isn’t a properly done valuation. But if Facebook is going to be priced at around $30.66 or $41.37 (based on a $75 billion and $100 billion valuation, respectively), the price is just too high. I am not saying the company won’t succeed, but from a value standpoint, it just may be too pricey.

I’m not after Zuckerberg or anything. I just think that instead of his potential $28.4 billion stake in Facebook, it should be more around $20 billion. For a link to my quick math, look here https://docs.google.com/spreadsheet/ccc?key=0Av2Mf-4zrZ4CdHNEWTVYODU3cVh1cGp3emVmVGU4c0E

For about a year now I had been planning to start a blog. I got tripped up on a couple things, such as what it was going to be about and what the name of it was going to be.

My name is Gabriel Gonzalez and I have my MBA from the University of Virginia. Currently I’m studying for the CFA and I’m registered to take it June. The purpose of this blog is to call attention to news I believe that is interesting mainly in the financial world, but may spread to other topics.

As for the name of the blog, I decided to make it “The Muse on the Street”. The Muse part came from collaborating with people and I wanted that word in the name. After struggling with it, I woke up and finally thought of “The Word on the Street” but then switched out word with muse. Simple as that.

I think the first post is going to be one of my longer ones, I definitely wasn’t planning on writing 750 words per post (with a spreadsheet attached). I would like to do one like that once a week though and maybe as I become more comfortable to start doing longer posts more often. But as for the first post, it’s a back of the envolope calculation I did on Facebook last week. It should be up shortly.