Thursday, August 19, 2004

Blodget on Google

I was never a big fan of the Google IPO. I didn't understand it when it was announced, and it looks even more stupid now that the prime reason for doing it – allowing big VC investors to monetize some of their stake – hasn't happened. As GOOG starts trading on Nasdaq today, however, Slate has stepped in with a guide to stock-market valuations. A good idea, right? Not really: the author is disgraced stock analyst Henry Blodget.

Blodget's thesis is that "most valuation conclusions are extraordinarily subjective," and that there are much better ways of working out whether or not to buy a stock. This is very dangerous stuff, and anyone who cares about their money should do their best to ignore everything he's saying. We're finally entering a world now where people are starting to pay attention to things like valuation again; this is unambiguously a Good Thing.

Floyd Norris, in the New York Times today, makes an intertesting aside:

The offering's lowered price represented something of a victory for institutional investors who had taken the extraordinary step of going public with analyses suggesting a fair price was in the $80's or $90's, or even lower.

In other words, old Wall Street ways die hard, and people who aren't directly involved in an IPO are still very wary about saying anything about the stock before it starts trading. That's silly, of course: especially with a well-known and well-liked company such as Google, there is likely to be a large number of individual investors who want to buy the stock but don't know whether or not it's overpriced. (This is true regardless of the technique used to price the IPO.) It shouldn't be "extraordinary" for sophisticated participants in the financial markets to share their own analyses of what a fair price is: the underwriters shouldn't have a monopoly on telling people what the company is worth.

To read Blodget, however, the value of the company is more or less irrelevant:

Even if we could establish for certain what a stock was worth, this would be no guarantee—or even indication—that the stock would trade there in any reasonable timeframe (or ever). [empahsis added]

Blodget, of course, was paid millions of dollars a year to tell investors precisely this – that buying a company for god knows how many times its actual value could be a really smart thing to do. But that doesn't make it right. Buying a stock without knowing what it's worth is a fool's game, and Blodget really over-eggs the pudding in trying to persuade us that valuations don't matter. Let me quote at length:

Let's assume, for example, that we know that a company will earn $1 per share per year forever (an other-worldly assumption, but go with it). In this case, all we need to determine the "present value of future cash flows" is a discount rate. Because, in our example, the cash flows are known and guaranteed, we can use the so-called "risk-free" rate, the prevailing rate of interest that an investor can earn without risking a loss of capital. One proxy for the risk-free rate is the yield on short-term Treasury bills, which, as of this writing, is about 1.4 percent. Discount 150 years of earnings of $1 a year (the financial equivalent of "forever") at this rate and—voila!—the value of our hypothetical stock is about $63. If the stock is trading at $50, we have apparently found ourselves a "bargain."
But what if we assume that the "risk-free" rate changes, as it always does? What if, for example, we assume that the return on 3-month T-bills will regress to its long-term mean of about 5 percent, a scenario that, given enough time, is probable? Well, then our $63 stock will only be worth $20. Or what if the T-bill yield jumps to 10 percent, as in the inflation crisis of the early 1980s? Then the stock will be worth $10. In other words, even if we know for a fact that a company will earn $1 per share per year forever—something that, in practice, we will never come close to knowing—we might conclude that the stock's "fair value" is anywhere from $10 to $80 (the T-bill yield could always drop, too), with a central value around $20 (the value generated using the T-bill's long-term mean). Fifty dollars might not be such a "bargain," after all.

Talk about making a simple concept ridiculously complicated! Blodget's hypothetical is, to all intents and purposes, something called a perpetual bond. These things have a simple, unambiguous value in the markets – and that's exactly what Blodget's stock would be worth. No one would ever conclude that the stock's "fair value" was $10, based on the off chance that interest rates are going to rise enormously in the future; similarly, no one would conclude that the fair value was $80, based on the possibility that they might fall. There's something called a yield curve, Blodget – maybe you should bone up on it one of these days.

Blodget really hates the idea that a stock is worth the net present value of future cashflows, though, and he'll use any old argument to discredit it. Here he is right at the beginning:

Given the confidence with which some commentators cite the theory, a casual observer might assume that the "present value of future cash flows" is an indisputable number, akin to a price tag on a can of soup. In reality, however, it is not a number but an argument. [Blodget's emphasis]

Again, he's wrong. The present value is not an argument, and it is a number. There can be an argument over what the number is – it's something mathematicians like to call an "unknown". But numbers can be useful even if you don't know what they are. For instance, when Blodget put his famous $400 price target on Amazon, a lot of people made the very coherent argument that there was simply no way, no matter what assumptions you made about discount rates, future growth, and whatnot, that the present value of Amazon's future earnings per share could ever be $400. That was a good argument, and those people were right, and Blodget, if he disagreed with them, was wrong. He still is.

Today, Blodget is still looking on the sunny side of things:

If one assumes that Microsoft and Yahoo! will develop superior search services, that Google will collapse under its own arrogance, and that interest rates will rise (all reasonable possibilities), one might conclude that Google's "fair value" is in the teens.

No, if Google collapses under its own arrogance and stops making a profit, then the present value of its future earnings is zero. Fair value isn't in the teens, it's nothing. Google has very little in the way of assets, certainly not the $4 billion that a $15 share price, say, would value the company at. If it has few assets and no profits, why should it be worth even that much? Some of the Kool-Aid is still, it would seem, circulating in Blodget's system.

Blodget was completely wrong when he covered the Martha Stewart trial for Slate, and he made the same mistakes there that he makes here: he thought he was still living in the world in which he originally made his name. He isn't: the bubble has popped, and it's not returning. Slate has a very good economics columnist, in Steven Landsburg, who can explain concepts like net present value a lot more clearly than Blodget can. They should use him more, and arrogant former Wall Street BSDs a hell of a lot less.

Posted by Felix at 12:58 EST