Going Cheep?

The shares of microblogging firm Twitter may not be the bargain investors are hoping for.

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)

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