LinkedIn – A good company with a horrible value

I mentioned I’d talk about another social media stock NOT to buy. Very simple, it’s Linked In.

Before people start going off on me, let me get something straight. I love LinkedIn’s business model. It provides a great service, possibly more useful than Facebook. Also unlike Facebook, they have premium accounts which people in business will pay for (I’m thinking recruiters and people in HR). While it is not as social or developed as Facebook, it does provide some services and fills a gap that FB lacks.

On the flip side, it is trading at 600x earnings. Yeah. I know with regards to technology companies a lot of people say you have to through out the P/E ratio but when something is trading that high compared to earnings, you have to wonder whether its worth it. While FB is somewhere around 65-70x earnings, LI is 9 to 10 times that. Yikes.

I have this shirt given to me from Pink Sheets from when I was a market maker and used their product. On the back of it in big letters it says “CAVEAT EMPTOR.” So just a quick Latin lesson, it means “Buyer beware.” Here’s a fun cartoon about it found:

Now LinkedIn is a great company, just not at the prices its trading at. When the Price Earnings, Price Book, Price to sales, and Price to Cash Flow ratios are all out of this solar system, I stay away until it comes back to Earth. Still, it’s a company to watch.

I promise to write some things that are uplifting, particularly about something to actually BUY.

Image comes from:
The Bunny System

Facebook: Vindication.

OK, so it has been awhile. I apologize, as I was gearing up for Level I of the CFA exam. Afterwards I was in New York visiting people and just got time to write a quick post… to say..

I WAS RIGHT

Back in February, I had estimated Facebook’s value to be about $25 a share. And I thought that was being generous. At the close on 14 June, the shares were at 28.29. I noticed a big drop occurred on the day that the options on Facebook started trading. While options prices derive from the price of the stock, I believe it also works the other way around.

If people start driving up the price of puts (the right to sell a stock at a certain price, think of it like an insurance premium you pay to get some value if your car gets in an accident or a tree lands on your house), then the value of the stock will go down. Likewise, if people crush the price of calls (the right to buy a stock at a certain price, or think of it like reverse insurance, like paying something so you can own a house at a reduced price if the cost soars for whatever reason), then the price of the stock will also go down.

There’s a reason why Warren Buffet doesn’t invest in technology stocks. And while Google and Apple may have crazy valuations. And while Google and Apple may seem sky high, at least they have some steady revenues and aren’t trading at 90x earnings.

Anyway, I mean to write some more posts, including one social media stock that I think is in more danger than Facebook and some global macro opinions. I also am thinking about writing a small opinion (treading carefully) on my CFA experience. I may write about my exam day experience and what I think about the level I material.

How Crackberry lost its name

Remember when you responded to 100 emails a day using this?

Remember when it seemed every banker, business person, politician, and anyone else that needed email on their cell phone all seemed to be on Blackberries? Those days are starting to go away. Research in Motion, the producers of said “Crackberries” posted earnings yesterday and they were dismal. So how did the great Crackberry go down?

First, RIM can blame Steve Jobs. Apple came out of nowhere and started the iPhone. A smartphone that was almost as good as Blackberry for the technical side but winning on the social side. I mean, the best Blackberry had for social was being able to connect for chatting and not to mention the Blackberry Messenger. BBM remains important, but it’s lost out to Apple’s iMessage in a way… though I think it would be better if iMessage was more separate than text messaging.

Second, and maybe part of number one, RIM can blame Google’s Android. Android came out as a respond to the iPhone, but with a lot more open programming. The tech geeks (whom I know plenty of) love Android because of the open source attitude they have. Don’t forget about the tech geeks. Maybe it’s the business users that drive the market in the short run, but its the geeks that drive innovation in the short and long run.

Third, they jumped into changing their game too late. Only now they are starting to dramatically change things. They acquired a company with a new OS, QMX, that has been going on since 2010. But Apple released the iPhone in 2007. That’s way too late, especially when things change all the time, especially in social media.

In the end, what does this mean? Right now, RIM’s book value is 19.00 per share or so and it’s trading at about 13. This is not a good thing. I’d be short RIM long term, which is sad in my opinion. I love the fact that their OS is very technical. The problem is there’s no market for it. MS-DOS got beat out by Windows. Windows is close to being beaten out by MacOS. It’s the circle of life. While I love the technical side of RIM and Blackberry OS, it just won’t stand. Phones are meant to be social and for business. Apple and Google got it. RIM only focused on the business, and that’s they’re downfall. While I still think they can compete, I mean I’d rather have a Blackberry for work than an iPhone (if only for the keyboard), Apple will win out. Or Google will, seeing as they have phones with keyboards.

If this were a chess game, I’d say, RIM, check (and your options are limited).

Fun links:
iPhone vs. Burrito – and the Burrito wins!

How to clear some of the smoke on the Volcker Rule

The Volcker Rule is a bit hazy...

Over the past couple years there has been a lot of talk about the Volcker Rule. Basically this rule prohibits banks from taking safe assets and putting them up against liabilities as a result of proprietary trading. Essentially, the idea is that if you deposit money in the bank, you shouldn’t have to worry about the FDIC backing your deposits as a result of your bank engaging in trading that may tumble. The problem with this is defining what’s market making and what’s proprietary trading.

When it comes to equities, most equities at least, is that there is generally a good market for them. And for the ones that are illiquid, it doesn’t require much capital to hold to them. But with bonds and and other instruments, it requires a large amount of capital to hold on to these positions. By limiting the amount of money banks have to hold these positions, you will be holding back the amount of money they can spend on certain instruments, most notably municipal bonds and non-US sovereign bonds.

The latter is a significant problem because holding back on holding back certain instruments may upset some countries. How would large growing economies respond if the US started to suddenly sell their bonds? Given that it will actually increase their interest rates but decrease exchange rates. This helps because it makes their exports cheaper but also increases their borrowing costs. For smaller emerging economies, the effect on their interest rate will be less, essentially making it a good thing because they are more able to compete with the US while not raising their borrowing rates dramatically.

This isn’t calling the Volcker a complete disaster. There are solutions. Instead of making banks sell these positions, why not require them to hedge against them? Make them buy credit default swaps on some of the riskier debt. Now the problem with this being that to purchase credit default swaps, which is essentially a put option on interest rates, is that someone has to take the other side. Plenty of mutual funds now will also have a problem with the Volcker Rule. But they could also engage in the CDS market to take the other side of trades. Which saves AIG from drowning again.

Maybe it’s not a perfect solution, but it’s a start.

Links:
http://www.cfainstitute.org/newsletter/advocacy/volcker_rule.html
http://www.cfainstitute.org/Comment%20Letters/20120215.pdf

Don’t be scared of BATS!

If you haven’t heard of BATS, you may be very well to question what it is. BATS has become the third largest exchange for equities in the United States, behind NASDAQ and the NYSE. While both of these exchanges as primary exchanges, BATS operates more of a back up exchange, as a place to provide additional liquidity.

In past years, a lot of these type of Electronic Communications Networks (ECNs) have been gobbled up by some the larger trading systems such as NYSE and NASDAQ. NYSE itself bought Archipelago Exchange in the mid 2000s. NASDAQ on the other hand purchased Brut and Instinet, two previous ECNs.

On Friday, there was a big fuss because BATS launched its own IPO primarily traded on its own proper exchange in order to try to bring itself business. This brought about a rare circumstance where a company’s IPO begins trading on its own exchange. Additionally, ECNs have come under criticism as a result of 2010 flash crash, which many people blame on Arca. But going back to last week, when BATS started trading, the company caused two big errors in trading.

First, Apple somehow got to be mispriced by $9.00 below its trading value. This caused a half across all exchanges in order to figure out what was going on with the stock. While this is a little crazy, it’s not uncommon for this to happen with some stocks. I have seen thinly traded stocks crash below the level of support for some exchange listed stocks to the point that it crashes below support (the price where anyone left is willing to buy the stock).

Second, BATS own stock got to be mispriced. This is a bigger deal, because there hadn’t been a stock listed primarily on the BATS exchange previously. I find this to be a problem because it questions the reputation of the BATS exchange, especially because they’re dealing with their own exchange. After the mishap, they elected to remove the IPO of BATS from the entire market, something that should have people concerned, at least in the short term.

While I think BATS will get their operations in order, it is going to serve as a black mark. Still, I don’t think that the sky is falling. As a society, a big part of our attention is going to be in finance and the continued advancement of technology in this sector. While this is a bad day for BATS, make no mistake, it shouldn’t hurt the company’s long term prospects. They’ve messed up and if history goes to show, people learn from their mistakes.

Building an order book in a stock that’s just opening is much different than doing it for stocks that have been trading already. First of all, people need to establish support and resistance (a large collection of offers [prices] where people are ready to sell stock). This is not easy because while analysts may have opinions on stocks, they have no precedent. Each one wants to see what the other will do first. One small mistake can send a stock tumbling down, and that’s what happened with BATS on Friday.

Wells and America (WFC and BAC)

In the prior week, banks fortunes have changed plenty. Consider Bank of America. A stock once considered to be cheap ran up to $10 and then back down as a result of the news resulting in their stress tests.

While I know plenty of people who liked B of A at lower prices, at 10 is when people start to get nervous. I’m certainly not going to say it’s overvalued at 10 but it’s not a place I’d like to know it. Not while there are plenty of other worthwhile banks out there. At 10 it’s trading half it’s book value, which might be a good thing to some. But considering it’s trading at ridiculous price earnings ratios and it has enough risky debt to question its balance sheet, you might think of other reasons why its valued as such.

On the contrary, look at Wells Fargo. A company that during the 2008 financial crisis definitely took its lumps. Afterwards it acquired Wachovia, a company with a good amount of bad debt in its books and in serious need of cash.

Wells on the other hand trades at about one and a half times its book value currently. Many people question the Wachovia purchase, but in reality, Wells didn’t have that many bad assets during the 2008 crisis. Instead, it was guilty of being in a bad neighborhood. While every bank was either selling (Bear, LEH R.I.P.), or tanking because of what it had on its books, Wells went down just for being a bank.

They saw an opportunity to buy Wachovia because they could and why not to expand operations? If anything, downturns in the economy shouldn’t make us feel like the sky is falling, it should make us look for opportunities, just like Bank of America did with its Merrill purchase, JP Morgan did with its Bear purchase, and Barclay’s did with its Lehman purchase.

While maybe I should like BAC a little bit more given that it looked for opportunities, that bank makes me nervous and I think its relying on its brand name. I definitely like Wells Fargo more because its a more true retail bank trying to expand, where as Bank of America was primarily a retail bank, expanded into something else, and is now paying for the consequences. You could argue that Wells may go the way of B of A, but I think it will manage its safe business with its more lucrative ventures in the future.

AIG is doomed

I remember watching plenty of soccer (football/futbol) matches. More specifically the 2009 Champions League Final between Barcelona and Manchester United. At the time, Manchester United was sponsored by AIG, which had received a $85 billion (which got up to $182 billion) credit facility from the US government. I just loved the irony that the American public was sponsoring a football club in the UK. Honestly, I laughed then and the joke still isn’t old. I honestly thought they should replace the AIG logo with a picture of Uncle Sam or the American flag.

This week, AIG announced they would be looking to raise $6 billion in order to help pay back the credit facility. In order to do this, they plan on selling AIA Group, an Asia based insurance holding company. While AIG certainly is in desperate need of some cash to pay back the US Treasury, I worry about the long term prospects of AIG.

As a result of taking the bullish side of the first credit default swaps, AIG really hurt itself as a firm*. In order to meet short term liquidity issues, it had to complicate its long term solvency. Meaning, it had to forego its long term credit for short term credit. Now, the bills are coming due and AIG has to trim the fat. The main issue I have with them selling off assets is that it will reduce the diversification of the firm.

Not only that, I believe that AIG’s sell of AIA is just the beginning. I’m pretty sure more will be coming. After this, AIG will have raised $6 billion of the money they need to pay back. Afterwards, they will owe about $42 billion back.

* Credit default swaps – A credit default swap is best thought of as insurance on a bond. You can buy a credit default swap on Greek debt. If Greek fails to live up to its debt obligations and defaults, you get paid. Think like a put option. You pay a premium for downside risk. You don’t have to own the underlying asset.

CAPM is hurting

CAPM:

K_e = R_f + B x MRP
where:
K_e = Cost of equity
R_f = 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)

Why Facebook is over-valued

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