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BenjaminDorr

Outrage

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ILLUSTRATION: Sullivan’s Travels • watercolor • 5×7″

Last year my friend Bryan suggested I read Michel Houellebecq’s 2005 novel The Possibility of an Island which I didn’t enjoy very much at all. That said, his recommendation may very well have been, “This novel is very dark, and you’re probably going to hate it. It’s a really hateful book.” John Updike’s book review was titled “90% Hateful.” So it’s not like I should have been surprised.

The main character Daniel is a successful French comedian who specializes in shock comedy aimed at various religions, especially Islam. In a tale as old as time, Daniel falls out of love with his wife, in love with a 22-year-old Spanish girl, and then joins and helps lead a futuristic sex cult obsessed with cloning (or a cloning cult obsessed with sex, it’s hard to say). The progression to dystopia is half narrated by two asexual clones living in the future, creating a story that feels as if you mixed a Lars Von Trier movie with a Paul Verhoeven one, then paid for a novelization by Haruki Murakami in his most unfeeling prose with Bret Easton Ellis as translator, perhaps adding his own disturbing sexual flourishes.

I’d like to hope that the whole of the book’s cynicism is trenchant satire (which I’m ashamed to admit I sometimes miss in practice), but I’m afraid that often Houellebecq may be projecting his worldview quite directly in passages such as this one:

“Like the revolutionary, the comedian came to terms with the brutality of the world, and responded to it with increased brutality. The result of his action, however, was not to transform the world, but to make it acceptable by transmuting the violence, necessary for any revolutionary action, into laughter—in addition, also, to making a lot of dough. To sum up, like all clowns since the dawn of time, I was a sort of collaborator. I spared the world from painful and useless revolutions.”

There’s a lot here to be unpacked, but in summary, Houellebecq gives us no way to win—the complicit comedian forestalls revolution, sublimating people’s anger, while the revolutionary is engaged in a “painful and useless” enterprise. It denies the possibility of change at all. What we have is where we’ll stay, or, in the context of the book, will only get worse. And that’s just one bitter paragraph among 300 pages full of them. Screw you Michel Houellebecq and your portrait of an artist as a middle-aged sellout.

Yet I’ve been thinking a lot about this passage in the last week after the shooting in Paris, thinking about outrage and violence as the emotional counterpoint to laughter. Although feelings of outrage can drive necessary social change, the emotion’s lack of nuance may also be the breeding ground of mob rule and totalitarianism. Sometimes it occurs to me (and frightens me) that outrage might be the defining emotion of our Internet age—the emotion of demagoguery, of participatory hashtags, of surprise over completely-to-be-expected human weakness, of overly earnest agreement, and overly bombastic disagreement. As my friend Inga suggests, we don’t live in a world full of irony, but rather we often live in a world where it’s completely lacking.

It’s occurred to me that if “comedy equals tragedy plus time,” perhaps then laughter equals outrage plus perspective. To improve our lot, it’s perspective we need more of, not outrage. And in that world, comedy is hardly a collaborator to anything we want to avoid.

What books did you read in 2014? What books do you plan to read in 2015? Do you hate Michel Houellebecq? Comment away. Or not. That’s cool too. Happy 2015!

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This Is Why We Can’t Have Nice Things

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ILLUSTRATION: This Is Why We Can’t Have Nice Things • watercolor, ink, & digital (original photo by NASA)

More not-so-famous robots as a respite from writing (and reading)…

Fall of Saigon - resizedILLUSTRATION: ExcuseMePardonMePleaseHoldThatHelicopter • pencil, ink, & digital (original photo by Hubert van Es)

motor oil and unrequited love - resizedILLUSTRATION: Motor Oil and Unrequited Love • pencil, ink, & digital (original photo by Robert Doisneau)

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ILLUSTRATION: Crop of Robots Attack the Morgan Stanley Building (2005) • watercolor & ink • 22×30″

Click here for Part I: Sneakers, Fire Fighters, and McKinsey.

Previously I decided to investigate whether the acquisition strategy of tech companies warrants a different look at standard equity valuation methodology. For this analysis, I’ve ignored eCommerce (which has its own particular challenges with standard retail comps) and focused on digital media: Google, Facebook, Yahoo!, and LinkedIn.

First, a disclosure: I own shares of/am long Google, and I own puts on/am short Facebook. This analysis doesn’t constitute investment advice, nor am I recommending or proposing any set of projections for these companies. This is but one analysis whose purpose is to show what a change in valuation methodology would do to your own company projections. Plus I might be wrong.

Second, a summary:

  • The dilution impact of regular share issuance, whether it be from an acquisition or from employee compensation, seems terribly underestimated in traditional valuation approaches.
    • Traditional discounted cash flows (DCFs) based on treasury share method share counts ignore projected new share issuance.
    • Investors ignore GAAP non-cash stock based compensation (which is, all things considered, still f***ing useless) and instead look to treasury share method diluted shares outstanding for EPS; the former fails to capture issuance timing while the latter ignores the compound effect of future issuance.
    • Analyst EPS estimates usually factor in additional share issuance, but these estimates naturally ignore the cash outlay of buybacks that help maintain shares outstanding.
  • As an example, using Facebook’s current share issuance trends, a traditional DCF would overvalue shares by 35-47% compared to the change in methodology I detail here. Eek. The data on Facebook is probably too thin at this point, but it remains an outlier especially when it comes to the use of stock compensation and stock issuance relative to its peers. That’s kind of what happens when you spend $17 billion on a freemium/$1 subscription business.

Company valuation is an inexact science, if you can even call it that. Knowledgeable and reasonable investors will absolutely disagree on the valuation of even the most mature of companies with the same set of financial projections. I’m pretty sure disagreement on financial matters is the second tenet of Buddhism after “existence is suffering.” For younger companies with higher growth profiles, like those of VCs, valuation and investing is akin to art, almost divorced from financial theory—a combination of golden gut/crystal ball dynamics, non-financial metric alchemy, anchoring bias, and general availability of dry powder, among other things. For both VC and private equity, the art/science of valuation is completely different from public markets and based on return rates.

However, basic finance theory (and common sense) tells us that the theoretical value of a public company is based on an assumption of its future cash flows. By discounting these cash flows back to the present, also known as a DCF, you generate that theoretical value. Since in reality, a public market investor isn’t going to get but a fraction of those cash flows (if ever) and since estimating a company’s next quarter is super difficult, let alone next year or ten years down the line, investors often use near-term earnings-per-share (EPS) estimates and multiples as a shorthand for valuation (or just pull it out of their ass). #TeamHumanities—just trust me on this, and perhaps enjoy the fact that “everything in this world, including money, operates not on reality—but the perception of reality.” (I knew I could connect this back to Sneakers.)

All valuation methods are imperfect and can/will be gamed. Most of the “one-time” adjustment games that go on in adjusting a standard accounting EPS to an investor-friendly one are well-known and accepted due to accounting rules that can distort what’s going on operationally (to a degree). Whereas DCFs are often treated like black boxes and, as such, obfuscate valuation especially for high-growth companies with large terminal values when capital is cheap. With any skill, a finance-type can make a DCF stand up and whistle Dixie if he or she wanted.

Timeo argentarios et DCFs ferentes[1]


Download the Excel spreadsheet referenced herein.

When I started this analysis, I had wanted to see if the use of acquisitions to replace R&D was a distortion being ignored in typical valuation methodology. Here were the assumptions I wanted to test:

  1. Are digital media companies acquiring others for technology that ostensibly would have be developed in-house?
  2. Are digital media companies spending less on R&D and more on acquisitions?
  3. What would be the valuation impact of projected acquisition expense on EPS or a DCF?

To begin I looked at Google’s and Facebook’s acquisitions that have known deal values, and I tried to sort them into either businesses that could have reasonably been developed by an internal R&D team or businesses that would have been a stretch, that feel more like adjacencies or new business lines. For Facebook, an example of the former would be WhatsApp or Instagram, and the latter would be Oculus VR. For Google, an example of the former would be AdMob, and the latter would be Nest. This wasn’t a particularly good analysis, and all it did was confirm my confirmation bias that Google tended to spend money on new business lines and Facebook tended to spend money on existing ones. Bah. You could make a case that Facebook was spending a kind of maintenance capex, but what of it?

So I pulled an analysis together to see whether acquisition expenditures even mattered financially, which is probably where I should have started. How does cash acquisition expense impact free cash flow margin, for example? Or how does cash acquisition relate to R&D expense?

BVII-Chart1

Excluding that crazy Facebook/WhatsApp deal, it seems cash acquisition expenditures historically represent a 5-10% impact on free cash flow margin. It’s a minor distortion, roughly equal to 50% of capex or 50% of R&D spend—something, but nothing ridiculous, especially given the margin of error (not used literally here as in statistics) in most DCFs. And there’s no real way, other than a constant non-cash goodwill impairment, to recognize the cost of an acquisition in EPS, so you have to assume that it’s baked into the P/E multiple assumption as a change in the underlying cash balance/capital structure.

The next step was to understand the impact of stock deals obviously not reflected explicitly as acquisitions on the cash flow statement. Most deals for these companies are cash, and many filings lacked sufficient information on stock or options issued specifically for acquisitions. So I decided to track overall share issuance, and overall share issuance happens to be a lot more interesting.

BVII-Chart2

In this chart, I’ve tracked the dilution of all non-financing share issuance against the total shares outstanding. Google clocks in at an average of 1.5%, Yahoo at 2%, LinkedIn at 4%, and Facebook at 7% to 11% depending on whether you include or exclude WhatsApp as a one-time, Black Swan event. I’m going to give Facebook the benefit of the doubt since they’re a young company.

Still you might think, so what? Who cares about 2% dilution? My cost of capital gets cheaper every time the Fed speaks. Here’s the rub: a 5% decrease in margin that flows through to free cash flow every year has a roughly equivalent impact on valuation depending mostly on the terminal value, but a 2% increase in shares outstanding each year has a compounding impact much, much greater.

Shares are forever, at least until they’re bought back. Let’s take a look.


For simplicity, I’ve built a DCF with $1 in current period EBITDA, 10% capex, no working capital adjustments, a 30% effective tax rate on EBITDA, a 8x terminal multiple, and a 10% weighted average cost of capital. I’ve ignored deferred taxes or tax benefits for stock options, and this scenario implies a 2.3% perpetuity growth rate for free cash flow which is perfectly cromulent. I like using $1 for EBITDA in sample DCFs because the valuation and current valuation multiple are equivalent as you are dividing by one. Plus you strip away all the pretense and black box nature of typical models. You can pretend this is any company where 1 = 100% of current EBITDA.

BVII-Chart3

In most DCFs to get to an equity value per share (after net cash adjustments) you circularly divide by the treasury share method diluted share count with the implied equity value per share as an input for cashless exercise. It’s a perfectly acceptable way to represent the current moment in time. You can also look at the free cash flow per share in the forecast period and resolve to the same valuation.

BVII-Chart4

However, we discussed earlier that diluted share count misses two things that seem to be a matter of course: the shares issued in future acquisitions, and the options/restricted stock granted and exercised year-in, year-out. I’ve built this capability into equity analyst DCFs before, but 1) I’ve only ever turned it on for forecast EPS estimates, and 2) I’ve never thought the dilution rate was so high. We used to forecast 1%, not 7%.

So here’s that same free cash flow per share analysis with 2%, 5%, and 10% growth in shares over the forecast period. You discount the resulting free cash flow per share back to the present, adjust for the capital structure, and then you multiply by the CURRENT treasury share method share count (based on your implied equity value per share) because you’re trying to figure out what a share today is worth. Those share growth assumptions have a compounding impact on valuation of 12%, 26%, and 42% respectively.

Again, shares are forever unless they’re bought back (which happens… a lot).

BVII-Chart5

I’ve also shown what that valuation would look like with the selected companies’ respective average share issuance per year. Facebook takes a 35-47% valuation hit if you assume they continue to issue shares as they have recently. I don’t think they will, but it’s a helpful guidepost.

The above analysis is based on keeping shares at a steady state once you reach the terminal year. It’s way scarier if you assume that shares continue to grow. See below.

BVII-Chart6

Ugh.

Stock compensation is a great deal if you work for these companies. You issue more and more shares as a percentage of compensation, and your stock price still goes up because it looks like you’re improving your margins.

And just in case you were wondering, higher terminal multiples, higher CAGRs, and lower WACCs all result in worse dilution. It’s like a perfect bubblicious storm when return rates and WACCs diverge.


Entrepreneurs and venture capitalists fight for every share and option issued. It’s a zero-sum game. Every share issued takes $$$ away from someone else. So what gives in the public markets? Why do so many investors turn a blind eye to the ongoing shift of compensation from cash to stock because it’s a non-cash accounting adjustment at the outset? I guess I was guilty of this mistake as well in the past.

Investors also clearly understand how future maintenance capital expenditures work. We tend to ignore that acquisitions can serve a similar purpose, to maintain a position, to defend against market share loss, to stifle a future competitor. (And yes, some acquisitions are different. YouTube basically evolved into a new business for Google and probably generated $2 billion in revenue after TAC last year based on an analysis I did for Jefferies this year to estimate YouTube’s financial model since acquisition. But I also estimate Google spent $6+ billion in addition to the $1.65 billion acquisition to get to that revenue level.)

If my logic and math hold up, then between future “maintenance” acquisitions and stock compensation, we might be overvaluing some tech companies by 20-50% or more relative to whatever set of projections you’re using.

It makes you want run to the window and scream, “I’m mad as hell, and ‘Pro forma’ doesn’t mean what you think it means! I took Latin! And pivot means the same thing as turnaround, for goodness sake!”

Not that I’ve done that.


If I can bring myself to do a third post on Bubble Valuation, I’d like to investigate maybe why we ignore these distortions. I’ve posited a few reasons…

First are the accounting rules around GAAP non-cash stock based compensation. For example, Non-cash stock based compensation matches with grants instead of issuance, and its calculation inherently ignores the fact that equity is most valuable to an employee when the stock price is lower and set to rise. Moreover, I would like to see if the move to restricted stock has anything to do with how it’s accounted for at grant price vs. a Black-Scholes-Merton method for traditional incentive stock options.

Second are the accounting rules around amortization of goodwill. Could goodwill’s lack of presence on the P&L inure us to ignoring its effect on the balance sheet? Can you impair something that never makes money if it never made money in the first place? I don’t really know (and I’m happy for someone to tell me, so I don’t have to look it up).

Third is a qualitative/strategic/historical look at why Google and Yahoo and Facebook’s businesses may be different even when they compete for the same advertising dollars. What parts are yellow page/classified-like utility and what parts TV/radio-like media consumption? How will that influence steady-state margin?

That said, I might need a break. Please let me know whether you’re interested in this, have any other ideas, or you’d rather just see more robot cartoons…

[1] Roughly: “Beware bankers bearing DCFs.”

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Notes on the University Cockfight

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ILLUSTRATION: Rejected from the Stanford Freedom Project #1: George Michael at the Alamo • watercolor on paper • 5×7″

It’s the end of the quarter at Stanford which means that it’s time for final papers. A close friend of mine lectures at Stanford teaching literature, philosophy, languages, etc.—fields of study on that lovely campus that are akin, as far as I can tell, to leprosy for many undergraduates. The faster that you can churn out a paper on Wallace Stevens, the sooner you can focus on your Symbolic Systems or MS&E problem set (or maybe just play Call of Duty). STEM, baby, STEM!

The first drafts are always my favorite to read. It often feels like the students are aliens sent on a mission to learn about Earth and report their findings in 1,000 words. How else can you explain sentences such as “Freedom for the humans is contingent on the acceptance of the free will of the humans?” You can imagine some high school English teacher suggesting that students should replace “man” with “human” throughout their papers to avoid thorny gender debates. And the student adds extra articles to get closer and closer to that 1,000 word goal. By the end of their initial thrashing, the students sound like Kang and Kodos.

I told my friend, “At least they’re still kind of trying. Freshmen don’t know yet that that every college paper can be the same paper.”

“What do you mean?” she replied.

“I don’t think they know about Clifford Geertz yet.”

“I’ve heard the name.”

“He wrote Notes on the Balinese Cockfight. Metasocial commentary. You know, stories we tell ourselves about ourselves.”

“Okay. So?”

“You can get a B+ on every undergraduate paper with Clifford Geertz.”


Deep Play: Notes on the Balinese Cockfight is a 1972 essay by the anthropologist Clifford Geertz. It’s a fun read, if you can separate yourself from the whole rooster-on-rooster violence thing. Instead of taking a more traditional anthropological / scientific approach to dissecting Balinese culture, Geertz researches its cockfights as one would close read a literary text. He investigates the cockfight’s implicit societal rules: how fights are organized, how cocks are matched for equal battles, how odds are determined, how kinsmen and alliances bet with each other, how money is exchanged, and what that all means for the Balinese.

“What sets the cockfight apart from the ordinary course of life, lifts it from the realm of practical affairs, and surrounds it with an aura of enlarged importance is … that it provides a metasocial commentary upon the whole matter of assorting human beings into fixed hierarchical ranks and then organizing the major part of collective existence around that assortment. Its function, if you want to call it that, is interpretive: it is a Balinese reading of a Balinese experience; a story they tell themselves about themselves.”

By caring deeply about cockfights of all things, the Geertz essay allows one to take any cultural artifact—high, low, or middlebrow—find its implicit rules of order and imbue them with significance. It provides the perfect hackneyed end to the B+ undergraduate essay. Construct an argument. Find some quotes. Put them in order. Add your transition sentences. And then conclude with Geertz.

Irish myths? Metasocial commentary.

The Day of the Dead? Metasocial commentary.

Listening to Taylor Swift’s 1989? Metasocial commentary.

It won’t be a good essay per se. It may not really say anything. And it might even totally get Clifford Geertz wrong. But you’ll probably get through the class with a B+.


Because after all, writing crappy undergraduate essays that just pass muster are what anthropologist Clifford Geertz would call a “metasocial commentary”—a story we tell ourselves about ourselves. The process of trying to pass one’s poor argument off as lucid and meaningful to frustrated, often disempowered, humanities professors shows us what our “culture’s ethos and… private sensibility (or anyway, certain aspects of them) look like when spelled out externally.” Namely, that pretending to care is a perfectly acceptable B+ path in American life.

P.S. I recommend Mark Slouka’s essay Dehumanized published in Harper’s in 2009 for anyone else on the very lonely #TeamHumanities.

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Abandon All Hope, Ye Who Picnic Here

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ILLUSTRATION: Abandon All Hope, Ye Who Picnic Here • ink & digital (original woodcut by Gustave Dore)

Working in a hotel room outside of Cleveland this week with little time to write and very few art supplies, so please enjoy a few robot pictures in the meantime. More in this series to come…

The Robot Defenestration of PragueILLUSTRATION: The Robot Defenestration of Prague • ink & digital (unknown woodcut artist)

Whoops!ILLUSTRATION: Whoops! • ink & digital (original photo by Charles C. Ebbets)

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