I’m reading the book Sapiens: A Brief History of Humankind by Yuval Noah Harari. In a section on the Agricultural revolution, Harari reminds us that while farming allowed human populations to grow, the quality of life for the average farmer was worse than the average hunter-gatherer. Farmers worked longer hours, with worse health, and generally lived more repetitive (and possibly more boring) lives than their hunter-gatherer counterparts.
Still, living in cities with farms to work on meant more babies, which meant more people with more reason to cooperate, leading over the years to the complicated network of nations and societies we live in today. Similarly, are modern day humans are working harder than our ancestors worked. Are we living longer, but less fulfilling lives?
It’s unclear to me whether tools like Twitter, which are taking up more and more of our precious time, are making our lives better or worse. It does seem to me however, that Twitter and the Internet in general are bringing people together cognitively in the same way that farms brought people together physically. While sporting events, movie launches, wars and riots happen in different places all over the globe, everyone can share in these experiences in the same virtual space in real time scrolling through Twitter feeds 140 characters at a time.
What does this have to do with Twitter as a company and stock? I’m not sure, but hopefully we can come together here to figure out if Twitter is a good investment at $22.45 per share.
Twitter (TWTR) stock is trading at around $22.45 a share right now, putting it at a market cap of $15.7 Billion. They have about $4B in cash, revenues of $2-$B, and trailing 12 month earnings per share of -$0.86 (negative 86 cents). Twitter IPO’d around $45 per share, hit an all time high around $75 per share earlier this year, and has since tumbled to the current price.
Is Twitter stock cheap yet?
The answer to this depends on what metrics you are using for valuation. Technology companies like Twitter, which have ubiquitous use but indirect methods of making money, are especially hard to value. I’ll try my best.
For mature companies there are two benchmarks that I like to use when valuing a company. (1) A price to earnings ration (PE) of 15. (2) A market cap that is 2x revenue.
Why these numbers? I think that’s a good topic for another post or ten, but in short a PE of 15 is roughly the long term average PE for the entire stock market. Similarly 2x revenue is fairly average for companies across industries and maps pretty well to the 15 PE if you consider an operating margin around 10-20%.
These numbers are most definitely rules of thumb and shouldn’t be held sacred, however they are a good starting point for analyzing a stock. If a stock doesn’t trade at a 15 PE or 2x revenue, that is normal and expected, but you can learn a lot by asking WHY the stock is trading at a different PE or revenue number. Is there something structural about the company that makes it more or less profitable than others? Or, as we’ll find is the case with Twitter, do we need to wait around for revenue growth to justify the market cap.
Where does Twitter stand from a revenue and PE perspective? As of writing…
Stock Price: $22.45
Market Cap: $15.7B
PE: N/A (negative 86 cents per share earnings)
Revenue: 7x Revenue (estimated $2.2B in 2015)
Not looking good, but let’s ask why the PE is negative and why the revenue multiple is so high.
Why is the Twitter PE negative?
Twitter is spending more money than it makes. Obviously this can’t be sustained, but it makes sense for young companies that are transitioning from a user growth phase into a revenue growth phase.
Twitter earnings are also hard to figure out due to the large amount of stock options they use to compensate their employees which makes for a large difference between their GAAP (generally accepted accounting principles) and non-GAAP (shit we just made up) earnings numbers. This post is from 2014, but explains the difference in Twitter’s case pretty well.
As an aside, non-GAAP numbers are fine in principle and often help investors to understand special cases with regards to how a company is making money. More and more companies though are paying their employees in stock options, effectively moving that expense off the books by using non-GAAP numbers or diluting outstanding shares. It makes our job as investors harder.
The bottom line for Twitter’s PE is that negative earnings are obviously bad and if you invest in Twitter, you have to have some expectation that earnings will turn around at some point in the future. Hopefully sometimes soon before cash reserves run out. The good news is that Twitter’s earnings are trending up and future estimates are positive.
Specifically, to justify a $15B market cap at a 15 PE, Twitter would need to generate earnings of $1B per year. As we’ll see below, getting to the revenue and operating margin to bring in $1B in earnings should be very doable for Twitter a few years out.
Why is Twitter’s revenue multiple so high?
Twitter is currently trading at 7x revenue, which is above our 2x revenue benchmark. Why?
Again, Twitter is growing and investors know this. The 2x benchmark is for a mature company, i.e. one that is not growing or growing slowly. Twitter revenues are growing somewhere north of 50% quarter over quarter and year over year. At these rates, $2B in revenue in 2015 becomes $3B in revenue in 2016, $4.5B in 2017, etc.
The obvious next questions are if current growth rates can last (hint: they never do), how they will trend in the future, and if the company will be able to make a profit on those future revenues.
How big can Twitter revenue grow?
I’ll use a really simple method to calculate further revenues, which I’ll call “Twitter will make as much money as Facebook does”. More specifically, I suspect that Twitter will be able to make as much per user as Facebook is.
Anecdotally, Twitter’s new “put a sponsored tweet where you expect to see replies or click to reply” tactic is super annoying and probably making bank for them. I expect their revenue to beat in their next earnings report.
Facebook has about 4x the number of monthly active users (1.2B vs 300mm) but is making 8x the revenue ($17.4B vs $2.B). I believe that Twitter can close the gap and should be able to make at least $4.4B from their 300mm users. This would put their revenue multiple at a respectable 3x. If we expect their user numbers to grow as well, they can very reasonably reach a 2x revenue multiple in 2-4 years.
A 20-25% profit margin (reasonable for an Internet services company) on $4.4B in revenues leads to ~$1B in earnings or that 15 PE we’re looking for as well.
We’re just doing math here, so it’s important for everyone to do their own homework to see if they think that these numbers we end up with make sense. The particulars of each company, what I would call “Main Street Analysis”, will tell you in the numbers make sense. In practice that might look like a lot of reading of earnings reports, other analysis, or general knowledge of how the business works. In our case, we’re being lazy and just saying that Twitter will have a similar trajectory that Facebook has had since IPO.
So is Twitter cheap?
Based on this analysis and the expectation that Twitter can get to $4.5B in revenue and grow respectively from there, Twitter is about fairly valued and just starting to get cheap. So I personally am considering starting a position with the expectation to add more as the price drops. I’ll probably purchase shares in my children’s brokerage accounts. (Christmas money for the win.)
If you expect Twitter to grow into more than just a platform to show ads occasionally to 300m people, you can basically get all of that extra stuff for free. The current price is inline with the straight forward, low risk, advertising business Twitter has now. So any extra revenue from Periscope, premium services, digital ID fees, or spoils collected from the governments it overthrows is gravy.
In my opinion, Twitter is very much an integral part of our society. When news happens, it happens on Twitter first. Facebook is starting to work like Twitter in this way, but I don’t see it overtaking Twitter without losing all of the other stuff we like about Facebook. The hole quick, 140 character, nonchalant nature of Twitter is actually exactly what makes it work so well. And considering they are ingrained in every news organization, business, and with every celebrity, I don’t see another service overtaking them without warning.
Assuming the general market doesn’t suffer a pull back, Twitter should be free of any new “bad news” that could move the stock lower. Weak investors should be shaken out soon, and if Twitter continues to grow as I expect it to, I suspect a slow rise with each new earnings report. Look for the stock to trade a bit lower, but turn around soon, and then rise up steadily from there.