Spreadsheet Fiction: The Delusion at the Heart of Tech Stock Analysis

How Zynga's flop exposed the scheme to hype young companies.

It is not an original observation that technology stocks are priced in wacky ways. Amazon made $82 million in profit last quarter, down 37 percent from the previous year, but based on its high share price, has a market value of $126 billion. Compare that with Macy's, which made $217 million dollars last quarter, up 20 percent from 2012. Its market value? $18.5 billion.

How, exactly, does this happen? Sure, some of it is company hype, popular excitement over new products, and inexperienced investors hoping for a big score. But there's an institution that formalizes the excitement over new technologies into financial projections: Wall Street analysts. And the recent flop of the new gaming company Zynga allows us to see the process that supports tech stocks, even when their financial performances suggests their prices should be lower.

Let's go back to late 2011, when Zynga had successfully completed an initial public offering. The company's shares were priced at $9.50, and research analysts moved in to initiate coverage of the stock. When analysts do this, they release a thick report filled with the background for the "investment thesis," in which they explain the idea behind buying (or not buying) a corporation's shares. They also create a model for the company's financial mechanics, and use it to project the company's future earnings. Working from this numerical conjecture, they assign a "multiple" to their forecasted financials to calculate the "target price" they decide the stock should have. The analysts justify the multiple they give in various ways, looking at similar companies or related industries; sometimes, they give "a premium" to a company deemed to be in a "leadership position" or which is perceived to have a better management team or upcoming products than its competition. 

For investors, what I've described is all old hat. The good ones know to take these reports with salt pills. But for a regular person who is not familiar with the methods, the takeaway from the eight different dispatches that I examined would be the same: Zynga's share price could rise to $14 or perhaps fall to $7. Either way, the company would have revenues of $1.4 or $1.5 billion and gross profit of close to a billion dollars. (All the numbers are in this spreadsheet.) While some analysts like Sterne Agee's Arvind Bhatia and Cowen and Company's Doug Creutz were more skeptical than others like National Alliance's Mike Hickey or JP Morgan's Doug Anmuth, no one predicted what actually happened to Zynga. After a run up in early 2012, within six months of these reports, Zynga's stock price had fallen below $6, and by the end of the year, it was under $3. It hasn't topped $4 since.

Unlike some notable dot-com bubble examples, this was not a case where conflicts of interest seemed to have bent the analyses. This was not a case in which analysts were out touting the company as the next Google. Rather, what's fascinating here is that none of the analysts did anything wrong by our current definitions of the rules of the game. And that's precisely why Zynga points to a deeper rot at the heart of the system by which technology companies are evaluated. 

Public technology companies are valued by an analytical process I'd call spreadsheet fiction. These are simple stories we're told, cloaked in numbers and numbers and numbers. 

But, you might respond, aren't all companies valued this way? Don't analysts create detailed models of the way a company makes money and then calculate out what the enterprise is worth? The answer would be: sorta. Many businesses have long operating histories and metrics you can trust. If you're valuing a supermarket chain, there are many supermarket chains to look at. While each may have different geographical and product specialties, the revenue bump that could be expected from opening 100 new stores, say, would not be that hard to predict.

There wasn't much data that could be applied to Zynga. Analysts were flying blind, comparing it to Netflix or Amazon or other gaming companies like Activision Blizzard or Electronic Arts.  Hell, sometimes Zynga got lumped in with Apple and Google. What traits, exactly, does Zynga  share with Apple and Google, other than that their computing and storage costs might track Moore's Law somewhat? It's not that the whole system is a sham -- that would imply a lack of good faith out of the people involved -- but that with newish technology companies, so many decisions are arbitrary.

First, the most common valuation tactic was to multiply the company's projected 2013 earnings (data encompassing 24 months from the time the projections were made) by some multiple. Well, actually, it wasn't the earnings, per se, but a related figure called Adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). This accounting maneuver allowed Zynga to show investors what its business looked like if you took out the $400 million of stock-related compensation on its books, which made its numbers look bad. Many companies show these kinds of non-standard numbers, so, for the purposes of this analysis, let's accept that using the Adjusted EBITDA metric was a good idea.*

Many analysts chose to calculate the enterprise value (EV) for Zynga at 11-12 times their 2013 EBITDA estimates. For example, JP Morgan ("Our $12 price target is based on ~12x our 2013E EBITDA of $644M"), Piper Jaffrey ("Our target is based on 12x CY13 EV/EBITDA"), and BMO ("Our target assumes approximately an 11 times EV to EBITDA multiple for our 2013 EBITDA estimate."). Wedbush had an outlier projection on the EBITDA side, so used a smaller multipler ("Our 12-month price target of $12.50 reflects an EV/adjusted EBITDA multiple of 9.5x our 2013 adjusted EBITDA estimate."). Sterne Agee used a multiple of 11 on their 2012 EBITDA estimate to calculate enterprise value. Others like Macquarie used another estimation technique called discounted cash flow analysis, which worked out to a 20x multiple on their 2012 earnings estimate. (Cowen and Company used a 25x multiplier on their preferred metric, EBIT.)

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