Imagine you had a small business that sold $100,000 worth of goods in January 2013. Then in January of this year, you sold $219,000 worth of goods. That would be just incredible, amazing growth—you’d feel like you hit the lottery, that you were headed for the big time, and your business was really just a factory to print money. Right?
So when that happened to Twitter (TWTR), why did the stock fall by over 10%?
This is the question that many retail investors are probably asking themselves after TWTR’s disastrous earnings release last night. (By the way, institutional investors beyond TWTR’s underwriters aren’t really asking this question—most hedge funds and mutual funds have stayed far away from the stock for a long time.) The answer really cuts to the heart of how differentiated valuation is essential to creating alpha for a portfolio.
Differentiated valuation is a simple concept, despite the cumbersome phrase: it just means estimating the value of a company in a way that is different from how everyone else is doing it. The market’s valuation of the company is simple: it’s the market capitalization (now $21.75 billion for TWTR, a couple billion less than yesterday).
But every analyst on Wall Street has a different and very complicated method of valuing the company—and each analyst guards his or her method with extreme care. After all, that differentiated valuation is what makes the analyst unique and valuable to the market. So all analysts need to think of their own way to value this and all other publicly traded companies.
So how to do it? Firstly, we need to ask ourselves three questions:
- What are TWTR’s expenses?
- Who are TWTR’s paying customers and what do they buy?
- How is TWTR’s products going to change in value in the future?
For our current purposes, we will ignore the first question. The second question is simple: Twitter’s users are free, but its advertisers pay — and they pay for ads.
Our answer to the third question is much more complicated, and the source of TWTR’s doldrums today. Twitter sells ads, so the growing value and inventory of its ads is what analysts look at when projecting how much TWTR’s total sales are likely to grow in the future.
Last evening on the company’s earnings report, the numbers that relate to that figure were very bad, despite the impressive 119% total revenue growth that the company saw in the last quarter.
TWTR’s ad inventory depends on two things: how many people are on the platform and how often those people use the platform. Because the stock is new, the company is relatively young, and the user base is very small relative to what investors are used to with Google (GOOG) and Facebook (FB), growth of both numbers is crucial.
And we did see growth of a sorts. TWTR announced that monthly active users (MAUs) rose 25% year-over-year to 255 million people. This growth was expected.
At the same time, timeline views rose 15% year-over-year to 157 billion. While that is growth, the amount of timelines per active user declined, because the total number of MAUs rose faster than the total number of timeline views.
This can be interpreted in many ways. The bear case is obvious: people are less engaged. A lot of those new TWTR accounts are spam bots and people who don’t like the platform, so TWTR’s long-term growth is unsustainable and the stock is overpriced.
The bull case is more subtle, and is best understood by looking at what TWTR’s CFO Mike Gupta said on the earnings call:
“If you look at what we just disclosed around timeline views, primarily you see that at a constant quarter-over-quarter. And I think that’s indicative more broadly — outside some of the product changes that we’re going through year-over-year and that eventually will anniversary. I think it’s indicative more broadly that when we look at cohorts, old cohorts versus new, there’s different use cases within those. And so what we would say is on average, these new cohorts are just as engaged. And obviously, there are specific use cases that differ within them. But we generally view them as consistent in — over time.”
In other words, Twitter’s changes to how timeline views work and how users interact with people on Twitter caused a tremendous decline in overall timeline views because the platform got more efficient—you didn’t have to click to a different timeline to have a conversation with someone. This created the illusion of declining timeline views, but when you actually look at the new users and how they use Twitter, you see that they are just as engaged as older users—so the new users aren’t spam bots, they aren’t less engaged, and they aren’t quitting the site after trying it out. In other words, it’s just as engaging and its overall number of users and views per user should increase over time.
Another important issue here is how many of those timeline views are monetized currently and how many can be monetized in the future. This is something that is discussed in detail on the earnings call, and is worth studying in detail for someone trying to establish a bull or bear case for the stock.
Now, the bear case is simple—the company is overpriced and set to see flat or declining growth. The bull case is more complicated; if you believe that engagement is strong and there is more opportunity to monetize the platform, you need to do some calculations to answer these questions:
- What is the current ratio of monetized to unmonetized timeline views?
- How many will there be in the future?
- How much revenue per timeline view does the company currently get?
- How much can it get in the future, and what will drive that change?
The answers to these questions are numbers that will imply the company’s future revenue and, in turn, its earnings and growth figures.
These are the questions all potential investors in this stock should try to answer by creating a model of the company’s business. And every investor should guard that model with their lives—it is, after all, what makes you as an investor and an analyst unique and valuable in the market.