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#buyerbeware - How excited should investors really be about the upcoming Twitter IPO?

15/10/2013

Jamie Lowry

Jamie Lowry

Fund Manager, Equity Value

With Twitter preparing to float on the stockmarket next month, plenty of investors have been growing very excited indeed. But should they be? Here on The Value Perspective we thought it would be helpful to see what sort of numbers we would have to believe to make the current valuation of Twitter work. Let’s do the maths.

From the outset, we should stress this article will involve a fair number of assumptions – some of them by necessity pretty optimistic – but bear with us. So, at the time of writing, no price had yet been set for Twitter but, given the number of shares in issue and the fact they have been trading on the secondary ‘grey’ market at around $20 (£12.50) each, we can realistically reach a round number of $13bn.

So what must Twitter do to be worth $13bn? To put that number into context, the company made just over $300m of revenue last year but was loss-making. Indeed, in the paperwork it has filed with the US Securities and Exchange Commission, the company says:” Since our inception, we have incurred significant operating losses and, as at the half-year, we have accumulated a deficit of $419m.”

Time for some more assumptions, the first of which is a small one – that, as it is in line to do, Twitter doubles its revenues to $650m this year. The other assumption is much, much larger – that the business also turns profitable in line with its closest peer. Facebook made 29% margins in the first half of 2013 so, improbable as it may seem, for this exercise we will assume the same for Twitter.

We now have our revenue figure and our profit figure and, as we did with a different mathematical exercise in Sweetening the deal, let’s aim for a 10% return on our investment. Putting all that together, the maths says Twitter – if it makes a profit straightaway – will have to grow revenues for the first 10 years at about 25% a year and at about 6% a year thereafter to reach our $13bn valuation.

Now some people might argue those figures do not seem that unattainable – that they are hardly 1,000% a year or anything – but that would be to misunderstand the effects of compound interest. The maths is going to have to work very hard to get to $13bn – and we will illustrate just how hard in two different ways.

Our assumptions so far mean Twitter moves from $300m of revenue in 2012 to $6bn of revenue in 2023. At present, the business derives some 85% of its revenue from advertisers and, if we first assume the revenue the company receives per user from advertisers only grows at the rate of inflation, the only way Twitter would be able to increase its revenues is to attract more users on the site. A lot of users.

Squaring this maths to reach $6bn of revenue by 2023 would require Twitter to have 1.9 billion users at that point – or roughly 25% of the world’s population – which to put it mildly looks a challenge. More problematic still is that, if we continue our analysis further into the future, our revenue target would need Twitter to have 100% of the population on its books by 2085 and, er, 150% by 2100.

The point being that, while our revenue forecasts of 25% a year for 10 years and then 6% a year after that may not sound too much of stretch, there will simply not be enough people living on this planet to make them work. Still, there is another way to square the maths and that is by deciding how much of the world’s population needs to be on Twitter by a certain date and how much to charge advertisers.

So let’s say – picking a number at random – that we want half the world to be on Twitter by 2050. To make the maths work this time, then not only would we need to hit that hugely optimistic penetration number of 50%, we also need Twitter’s average revenue per user to grow by about 4% a year between now and 2050.

That does not sound very much, you might say. But, then again, you might know better now because once more there is a snag, a clue to which may be found in the title of an article in the Financial Times – “Advertisers remain wary to branch out on Twitter”. Yes, advertisers have yet to make up their minds as to whether they can actually make money through the business.

The article quotes executives from a number of the world’s largest advertising groups as they explain that any money currently allocated to Twitter only comes from “experimental” budgets. In other words, they are saying that, unlike with Facebook and Google, for example, they have yet to see how they will make a return on their investment and Twitter’s business model is essentially unproven.

One final issue that emerges from the FT piece is that, far from Twitter’s revenues growing at a steady 4% to complement our optimistic 50% penetration rate by 2050, the business is actually seeing advertising prices falling dramatically. The most recent figures show the price per unit of advertising actually fell 46% over the second quarter of this year.

To be fair, even if a business sees its price per unit of advertising falling, it can raise its advertisements per user to compensate – although, if your price per advertisement is falling by 50%, by definition you then need twice the amount of advertisements per user than you did before. However you look at it, the maths is suggesting it will be tough to make a decent return from the Twitter IPO.

Author

Jamie Lowry

Jamie Lowry

Fund Manager, Equity Value

I joined Schroders in 2004 as an equity analyst in the European Equity Team initially specializing in the Industrial sectors before moving on to Consumer-based companies and finally Insurance. In 2007, I became a co-manager on a fund investing in undervalued European companies and took on sole responsibility for the fund in May 2010. Prior to joining Schroders, I worked at Hedley & Co Stockbrokers and Deutsche Asset Management as a trainee analyst.

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