Before making an investment, it helps to ask, “What’s already in its price?” Although this can sometimes be a difficult question to answer, market prices reflect the expectations of investors as a whole. Viewing investments this way may help us determine whether prices reflect reasonable expectations or whether revisions in expectations, and thus revisions in price, are likely. Price, and the expectations it implies, always matters.
Consider the recent public offering of social media company Twitter. So far, Twitter’s results are characteristic of a very early stage company: Fast sales growth (over 100% in the last 12 months) but short of anything resembling an accounting profit. Its main source of sales is online advertising, and because this is a very fast-growing market, we can expect Twitter to grow quickly in the near term. As for profitability, other companies with major online ad businesses, such as Google, Facebook and Yahoo!, have profit margins ranging from 14% to 30%. This suggests that Twitter could achieve attractive levels of profitability at some point.
Combining very-high growth with above-average margins may sound like a great deal for investors, but how much of this potential success is already reflected in Twitter’s stock price? Given a recent market value of more than $39 billion for Twitter shares, the short answer is “a lot.” Combining very optimistic assumptions, like revenue growth rates of more than 55% over the next several years and profit margins approaching the highest in the industry, a basic cash flow model values the business at about $16 billion. Comparing this to Twitter’s recent $39 billion market valuation suggests investors are expecting a moon shot from Twitter. It’s possible that the company could live up to these expectations or even exceed them. But to do so, Twitter would need to regularly double sales for some time and achieve profit margins exceeding even those of Google, a dominant force in online advertising and a key competitor. Buyers’ expectations may be correct, but I’d avoid a situation that requires clearing such a high hurdle in order to achieve an attractive risk-adjusted return.
Bank of America Corporation has provided a good example of a business with extremely low expectations. As 2011 drew to a close, shares traded around $5. Fully reflected in the stock price was the conventional wisdom that Bank of America was going to be the next bank to risk insolvency. No other expectation could possibly have justified such a low price for a business capable of generating well over $100 billion in annual revenues and billions in cash from operations per year. Although the bank’s operations improved modestly in the last couple of years, its market value has more than tripled. Why? Because investor expectations shifted dramatically from extreme pessimism to a more realistic view of the company as an ongoing, profitable business.
As is often the case, Warren Buffett offers wisdom on this subject, and he reminds us that markets are there to serve investors, not to guide them. Viewed in the context of expectations, market prices may serve investors well by providing useful information for benchmarking their own expectations and gauging the expectations of others.