Reading - Analyst Reports

Thinking Away from the Herd: A
couple of real-world examples
Abdullah Karatash
Head of Investments at a major Gulf
financial institution
Yale SOM Class of 2005
Securities Valuation
• Finance 101 teaches us that when a credit rating
is downgraded, especially for a sovereign credit,
the credit (bond) should sell off. Historically this
has always held true, with one notable exception.
• What actually happened to the price of U.S.
Treasury bonds when the U.S. sovereign credit
rating was downgraded from AAA to AA+ on
August 5, 2011 by rating agency Standard &
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10 year US Treasury yield
S&P downgrades U.S. credit rating
from AAA to AA+ (8/5/11)
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The Herd
• The lesson to take away from this real-world
example (which is a lesson that was reinforced
right here in this very class by Professors Sunder
and Spiegel) is that things do not always play out
the way everybody (the herd) expects things to
play out.
• In the real world, sometimes (more often than
not), it pays to think away from the herd.
Securities Valuation
The Herd
• That is easier said than done.
• Behavioral psychology teaches us that people find
comfort in crowd-thinking and often, real-world
incentives reinforce this kind of behavior.
• For example, in the money-management sphere, the
whole concept of the "benchmark" and "beating a
benchmark" even as one delivers absolute negative
returns is a classic case in point.
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Fundamental Analysis
• So how does one muster the confidence to
stand away from the herd at the risk of their
professional standing?
• The answer is simple: through rigorous
fundamental analysis.
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Fundamental Analysis
• This class will train you to ask some very simple
and obvious questions about investment theses.
• Questioning some very basic assumptions
sometimes exposes some very obvious flaws in
investment theses (that are easily overlooked by
the herd).
• Training yourself to ask the right questions is one
major step in the right direction.
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Fundamental Analysis
• At a micro / idiosyncratic level, a great recent
example of an investment thesis that caught most
(but not all) off guard is the case of Facebook.
• While the business media salivated and fawned
over Facebook (most business reporters have
never taken Security Analysis), savvy investors
took a step back and challenged some very basic
assumptions about the company.
Securities Valuation
First the Pros
• Facebook is attractive by virtue of its 900 million user
base; the company had almost 60% of all Internet users
in the developed world.
• But it's what Facebook could potentially do with those
users that seemed so incredible.
• Facebook knows more about more people than any
company in history. And to date, it's done very little to
"monetize" what it knows.
Securities Valuation
• The average cost per thousand impressions on
the Web is about $2. Facebook sells for a mere 20
• With a better sales force the thinking went that
Facebook could leverage its massive database to
target its ads more effectively.
• Not to mention the untapped market of China (a
billion plus extra users?).
Securities Valuation
• So why would anyone be skeptical about Facebook before the company
went public in May?
• At the most basic level, Facebook's greatest strength (its extensive user
base) is also its greatest weakness.
• The minute the company tries to monetize that user pool and treasure
trove of information, it risks shrinking and alienating its user base.
• Additionally, based on anecdotal conversations, it became apparent that
many long-time users log in far less frequently (maybe once a month?)
than compared to when they first joined the site (several hours per day?).
• So it's difficult (and inaccurate) to extrapolate user habits in a linear
Securities Valuation
• From a valuation perspective, if the company
priced at a hypothetical price of $40 per share on
2.3 billion shares, it would give the company a
valuation of $92 billion.
• That monster valuation would be 93x earnings
and 25x revenue.
• (The company ultimately priced at $38 per share).
Securities Valuation
Facebook Valuation
• How does that valuation for Facebook compare with
growth stocks like Google or Apple?
• Back in May, Google and Apple both traded for roughly
16x earnings.
• Why would an investor pay 6x more for Facebook
considering that Google or Apple both had way more
cash on hand than Facebook would raise from its IPO?
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Facebook Valuation
• Facebook projected 2012 earnings of 50 cents per share on
revenues of $5 billion.
• If the IPO came out at $35, the high end of the predicted
$28 to $35 range, that would be 70x 2012 earnings and 18x
• It goes without saying that those multiples are absurd (at
the time, Google traded for 15x profit and 6x revenue).
• And then Facebook actually boosted (that's correct,
increased) its IPO price by almost 10% to $38.
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Facebook Stock Price Since IPO
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A Closer Examination of the Price
• We have not even factored in the "technical"
pressures that would exert downward
pressure on the stock price: nearly 2 billion
shares were held by insiders and as their
lockups expire they would sell at any
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• In conclusion the post IPO stock performance of
Facebook vindicated all skeptics (including this
• Facebook was obviously ridiculously overvalued if
anyone actually took the time to look at the
company from a fundamental perspective and
question some very basic assumptions.
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• Thanks for your time and good luck in your
• If you would like to stay in touch, I can always
be reached at:
[email protected]
Securities Valuation

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