Snap, Inc., the parent company of the Snapchat app, successfully came to market with an IPO at $17 per share. Snapchat stock began trading on Thursday morning at $24 and closed the week up 59% from the IPO price. Based on the current share price the company has a market cap of $31.35 billion which means the market values this stock more than 328 companies in the S&P 500. Are we to believe the present value of the future earnings of SNAP are more valuable than other companies with a track record of profitability such as Valero Energy, Sherwin-Williams, Aflac, and Sysco?
The friendly ghost in the Snapchat logo is meant to represent the key feature that differentiates Snapchat over its competitors. Snapchat allows users to send “snaps” (a photo or video message) privately or publicly that is visible for a specified amount of time by the sender. The messages disappear so there is no history of them, although I’m sure Snapchat keeps a record.
This Business Insider article contains interviews from several millennials who are regular users of Snapchat. Interestingly, one of the answers helps reinforce why I will never use this app.
Do you see a use for Snapchat for adults?
“No. Anyone over the age of 35 registered on Snapchat is probably also registered on Family WatchDog.”
I’m a few years shy of 35 but it looks like I would be labeled an old creep if I become a Snapchat user at this point. The theme of the answers from that small sample of users is this is an app intended for and used by a much younger audience. My impression was this app would be very popular for “sexting” due to the nature of the disappearing “snaps”. Not so based on this study that found just 1.6% of respondents’ primarily use of Snapchat was for sexting purposes. Most users find the app useful for just random things that happen during their day that is not worth saving on Facebook or Instagram.
Valuation of Snapchat Stock
As I mentioned before, the company’s market cap is around $31 billion. Valuation of a business is supposed to be based on the present value of future earnings. For a company such as Snapchat with very little available historical financial data, can we really make a reasonable valuation? We could determine how many average daily users they have now, how many we expect them to have over the next few years, and estimate how much revenue they can generate per user and what their profit margins will be.
So what data do we have?
Income statement data from the last 2 years shows the explosion in revenue growth and analysts currently expect strong growth to continue into 2017 and 2018. Unfortunately for shareholders, there is no expectation for profitability over this time frame.
SNAP Inc. Income Statement (in millions)
|FY 2015||FY 2016||FY 2017 EST||FY 2018 EST|
The question is when will the company be profitable?
An important risk reminder outlined in the IPO documents.
We have incurred operating losses in the past, expect to incur operating losses in the future, and may never achieve or maintain profitability.
Twitter investors are currently faced with a similar outlook on profitability. Twitter rallied as high as a market cap of $41 billion following their IPO and are currently valued at $11.5 billion. Will Snapchat fare any better?
The point is if you buy Snacpchat stock now you are simply speculating. Your bet is that the company will eventually grow into a profitable company like Facebook. This is certainly not the kind of investing that made Benjamin Graham or Warren Buffet successful value investors. Yet the market speculators are gonna speculate and SNAP may continue to rally further.
The amount of free cash flow that fairly values Snapchat stock
Rather than trying to project future earnings, we can back into the market’s valuation by determining the level of free cash flow that would equate to the current market cap value of $31.4 billion.
First we need to determine the discount rate to use based on the weight-average cost of capital (WACC). Since the company does not have any debt at this point, we just need to determine their cost of equity.
The cost of equity formula is: Risk free rate + Beta (Expected Market Return – Risk Free Rate)
Since the stock just began trading, I will use Twitter’s beta of 1.72. The expected market return is 9.12% (using Bloomberg’s model). The cost of equity formula for Snapchat stock will look like this: 2.48% + 1.72 (9.12%-2.48%). The cost of equity will be 13.9%. This is fairly high but it should be high considering the amount of risk and uncertainty associated with the stock.
There are multiple free cash flow models but the most simple is to use a perpetual free cash flow model. What level of free cash flow in perpetuity would create a $31.4 billion market cap at a 13.9% discount rate?
Here’s one way to estimate it. We will use a long-term growth rate of the overall economy of 2.5%. The formula looks like this:
Market Cap = (FCFF/r – g) – debt – preferred + cash
$31,348.9 = (FCFF/ 13.9% – 2.5%) – 0 (debt) – $149.7m preferred + $987m cash
$30,511.2 = (FCFF / 13.9% – 2.5%)
$3,478.28 = FCFF
We see the perpetual free cash flow to the firm would need to be around $3.5 billion a year. That also assumes that this level of cash flow generation begins in the upcoming year which we know is not going to happen. That means if they begin to generate positive free cash flow in 3 to 5 years, it would need to be even more than $3.5 billion a year since it would be discounted to present value.
Valuation models weigh the earlier years more heavily due to the nature of discounting over multiple periods. Year 1 and Year 2 will impact the valuation much more than year 5 and year 6. Since SNAP is not expected to generate positive earnings in the next 2 years, this will materially lower the current value of the stock.
Relative Value of Snapchat Stock
I mentioned a few other companies trading around $30 billion in market cap. Valero was one of them and currently has a market cap of $29.8 billion. The free cash flow to the firm has been $2.5 to $4.3 billion. The 5 year average FCFF was $3.35 billion. Is it a coincidence that the perpetual FCFF model presented above indicated FCFF should be around $3.5 billion for a $30ish billion company?
This is not a recommendation of Valero but as a comparison their valuation makes more sense because the company is profitable and has a history of positive free cash flow to base the valuation on.
Analysts Covering Snapchat Stock
There are 5 analysts who have come out with ratings on SNAP thus far. All of them are either market neutral or the equivalent of a sell rating. The lowest price target is $10 and the highest is $22 for an average of $16.8. All of these are well below the current market valuation.
The SNAP IPO was a huge success for the founders, employees, and the Silicon Valley high school that was an early investor. Selling into a stock market at all time highs is excellent timing. Early buyers of this stock are in for a wild ride as the current market valuation does not seem remotely reasonable based on the outlook for profitability over the next several years. In addition, shares of SNAP’s Class A common stock are non-voting so if you want to have any say in the direction of this company owning shares won’t do it for you. Some folks just can’t resist and the thrill of speculating on the newest stock deal is worth losing money over.