User Too Subscriber Businesses: The Good, The Bad Too The Ugly!

In a serial of posts over the course of educational activity of the lastly year, I argued that yous tin value users in addition to subscribers at businesses, using starting fourth dimension principles inwards valuation, in addition to receive got used the approach to value Uber riders, Amazon Prime members and Spotify & Netflix subscribers. With each iteration, I receive got learned a few things most user value in addition to ways of distinguishing betwixt user bases that tin create substantial value from user bases that non exclusively are incapable of creating value but tin actively destroy it. I was reminded of these principles this week, starting fourth dimension equally I wrote about Walmart's $16 billion bid for 77% of Flipkart, a bargain at to the lowest degree partially motivated past times shopper numbers, in addition to then 1 time to a greater extent than equally I read a news story most MoviePass and the potential demise of its "too proficient to live true" model, in addition to finally equally I tripped over a LimeBike on my walk home. 

User Based Value

My endeavor to create a user-based valuation model was triggered past times a comment that I got on a valuation that I had done of Uber most a yr agone on my blog. In that post, I approached Uber, equally I would whatsoever other business, in addition to valued it, based upon aggregated revenues, earnings in addition to cash flows, discounted dorsum at a company-wide cost of capital. I was taken to chore for applying an old-economy valuation approach to a new-economy fellowship in addition to was told that that the companies of today derive their value from customers, users in addition to subscribers. While my initial reply was that yous cannot pay dividends amongst users, I realized that at that spot was a gist truth to the critique in addition to that companies are increasingly edifice their businesses around their members. 

Consequently, I went dorsum to valuation starting fourth dimension principles, where the value of whatsoever property is a business office of its cashflows, growth in addition to risks, in addition to adapted that approach to valuing a user or subscriber:

To acquire from the value of existing users to the value of an entire company, I incorporated the value effect of novel users, bringing inwards the cost of acquiring a novel user into the value:

I applied closure past times consider all corporate costs that are non straight related to users or subscribers inwards a corporate cost drag, a drag because it reduces the value of the business:

Cumulating the value of existing in addition to novel users, in addition to netting out the corporate cost drag yields the value of operating assets, i.e., the same value that yous would derive past times discounting the gratuitous cash flows to the entire describe of piece of employment concern past times its overall cost of capital. You would yet involve to create clean up, past times adding inwards cash, netting out debt in addition to dealing amongst outstanding options, but that procedure is the same inwards both models.

I would hasten to add together that a user-based value model is non a panacea to whatsoever of the valuation challenges that nosotros human face amongst young, user-based companies. In fact, the difficulties amongst obtaining the raw information needed on user renewal rates in addition to acquisition costs tin live so daunting that whatsoever potential advantages that yous obtain past times looking at user-level value tin live drowned out past times noise. It is also worth emphasizing that its user-focus notwithstanding, this model is grounded inwards fundamentals, amongst value coming, equally it e'er does, from cash flows, growth in addition to risk. I am yet learning most this model, but I receive got pose downwards what I receive got learned over the lastly year, when valuing Uber, Amazon Prime in addition to Netflix, into a newspaper that yous tin download, read in addition to critique.

Good, Bad in addition to Indifferent User-based Models

One of the motivations for my user-focused valuation was based upon casual empiricism. In my view, many venture capitalists in addition to world investors are pricing user-based companies on user count, amongst exclusively a few seriously trying to distinguish betwixt good, indifferent in addition to bad user-based models. One of the bonuses of using a user-based model is that it provides a framework for differentiating betwixt corking in addition to mediocre user-based companies.

Drivers of Value

Influenza A virus subtype H5N1 touchstone critique that old-time value investors receive got of user-based companies is that they all lose money, but that is non true. There are user-based companies that brand money, but it is also truthful that the user-based model is yet inwards its infancy in addition to that many user-based companies are young, in addition to thus lose money. That said, at that spot are elements of the cost construction that yous tin await at, to brand judgments on which user-based companies are most probable to grow out of their problems in addition to which ones are simply going to grow their problems.

a. Cost Structure: Most young, user-based companies lose coin but at the adventure of sounding unbalanced, at that spot are proficient ways to lose coin in addition to bad ones, from a value perspective. 

1. Servicing Existing Users versus New User Acquisition: From a value perspective, it is far ameliorate for a fellowship to live losing money, because it is spending coin trying to acquire novel users, than it is to live losing money, because it costs so much to service existing users. The latter signals a bad describe of piece of employment concern model, at to the lowest degree for the moment, whereas the onetime offers a semblance of hope.
2. Fixed versus Variable Costs: For mature companies amongst established describe of piece of employment concern models, it is ameliorate to receive got a to a greater extent than flexible cost construction (with to a greater extent than variable costs in addition to less fixed costs). With money-losing, high-growth companies, the contrary is true, since it is the fixed cost portion that yields economies of scale, equally the fellowship grows.

b. Growth: Repeating a value nostrum, growth is non e'er value-creating in addition to non all growth is created equal.

1. Existing versus New Users: Influenza A virus subtype H5N1 user-based model, where yous tin grow cash flows from existing users is to a greater extent than valuable, other things remaining equal, than a user-based model that is subject on adding novel users for growth. The ground is simple. Since a fellowship already has expended resources to acquire existing users, whatsoever added revenue it derives from them is to a greater extent than probable to menses straight to the bottom line. Adding novel users is to a greater extent than expensive, partly because it costs coin to acquire them, but also because novel users may non live equally active or lucrative equally existing ones.
2. Cost of New User Acquisition: This is a corollary of the starting fourth dimension proposition, since the value of a novel user is internet of user acquisition costs. Consequently, user-based companies that are to a greater extent than cost-efficient inwards adding novel users volition live worth to a greater extent than than user-based companies that pass considerable amounts on advertisement on marketing, to the same end.  

This contrast is best illustrated past times looking at Netflix in addition to Spotify, both subscriber-based companies, but amongst real dissimilar models for paying for content. Netflix pays for content equally a fixed cost, in addition to derives economies of scale, when it adds fresh subscribers, whereas Spotify pays for content, based upon how much subscribers hear to songs, making it a variable in addition to existing user based cost. As a result, Netflix derives much higher value from both existing in addition to novel subscribers:

	Netflix	Spotify
Number of Subscribers	117.6	71
Annual Revenue/Subscriber	$         113.16	$         77.63
Subscriber Service Expenses (as %)	18.90%	79.24%
CAGR inwards subscriber count	223.93%	369.86%
Value per Existing Subscriber	$         508.89	$       108.65
Cost of acquiring New Subscriber	$         111.01	$         27.30
Value per New Subscriber	$         397.88	$         81.35
Value of all Existing Subscribers	$    59,845.86	$    7,714.28
+ Value of all New Subscribers	$  137,276.49	$  20,764.56
- Corporate Cost Drag	$  111,251.70	$  13,139.75
=Value of Operating Assets	$    85,870.65	$  15,339.10

c. Revenue Models: There are 3 user-based models, the starting fourth dimension is the subscription-based model (that Netflix uses), the 2nd is the advertising-based model (that Yelp uses) in addition to the tertiary is a transaction-based model (that Uber uses). There are companies that purpose hybrid versions, amongst Amazon Prime (membership fees in addition to incremental sales) in addition to Spotify (Subscription plus Advertising) beingness proficient examples. Each model comes amongst its pluses in addition to minuses. 

1. Subscription models tend to live stickier (making revenues to a greater extent than predictable) but they offering less upside potential (it is hard to grow subscription fees at high rates).
2. Advertising models scale upward faster, since they require picayune inwards working capital missive of the alphabet investment in addition to adding novel users is easier (since they free), but revenues are heavily driven past times user intensity (how much fourth dimension yous tin acquire users to remain inwards your ecosystem) in addition to exclusive information (collected inwards the course of educational activity of usage).
3. Transaction models are the riskiest, since they require users to purpose your production or service, but they also offering the most upside, since your upside is less constrained. Amazon Prime's value, inwards my view, does non stalk primarily from the subscription revenues of $99/year but from Amazon's capacity to sell Prime members to a greater extent than products in addition to services.

While no model dominates, picking the incorrect revenue model tin chop-chop handicap a business. For instance, using a subscription-based model for a transaction business, where usage varies widely across users, tin termination inwards self-selection, where the most intense users select the subscription-based model to relieve money, in addition to less intense users remain amongst a transaction-based model.

Differentiating across User-based Models

With the user-based framework inwards place, nosotros tin start distinguishing betwixt user-based companies. Using existing user value in addition to novel client acquisition costs equally the dimensions, nosotros tin derive a matrix of companies that perish from user-value stars to user-value dogs.

While the combination of high user value amongst depression user acquisition costs may audio similar a piping dream, it is what network benefits in addition to large data, if they exist, hope to deliver. 

• Network benefits refer to the possibility that equally yous grow bigger, it becomes easier for yous to acquire fifty-fifty bigger, making it less costly to acquire novel users. That is the hope of ride sharing, for instance, where equally a fellowship gets a larger portion of a ride sharing market, both drivers in addition to customers are to a greater extent than probable to switch to it, the former, because they acquire to a greater extent than customers in addition to the latter, because they abide by rides to a greater extent than quickly.
• Big data, inwards a value framework, offers user-based companies an advantage, since what yous acquire most your users tin live used to either sell them to a greater extent than products or services (if yous are a transaction-based company), accuse them higher premiums (if yous are subscription-based) or direct advertising to a greater extent than effectively (if advertising-based). 

Many user-based companies aspire to receive got network benefits in addition to to purpose information well, but exclusively a few succeed.

The Pricing Game

As I await at user-based companies, some of which are beingness priced at billions of dollars, I am struck past times how few of them are built to live long term businesses in addition to how many of them are beingness priced on user numbers in addition to buzz words. Using the framework from the lastly section, I would similar to develop some mutual features that bad user-businesses seems to portion inwards mutual in addition to purpose 1 high profile examples, MoviePass , to brand my case.

Mediocre User-based Companies
Given that so many immature companies marketplace themselves, based upon user in addition to subscriber numbers, in addition to that some of them tin perish valuable companies, are at that spot signs that yous tin await for that separate the proficient from the mediocre companies? I intend so, in addition to hither are a few cherry flags:

1. All most users, all the time: If the entire sales pitch that a fellowship makes to investors is most its user or subscriber numbers, rather than its operating results (revenues in addition to operating profits/losses), it is a unsafe sign. While large user numbers are a positive, it requires a describe of piece of employment concern model to convert these users into revenues in addition to profits, in addition to that describe of piece of employment concern model volition non develop spontaneously. Companies that practise non operate on developing feasible describe of piece of employment concern models perish bankrupt amongst lots of users.
2. Opacity most user data: It is ironic that companies that marketplace themselves to investors, based upon user numbers, are oft opaque most key dimensions on users, including renewal (churn) rates, user conduct in addition to side costs related to users. The companies that are most opaque are oft the ones that receive got user models that are non sustainable.
3. Bad describe of piece of employment concern models: If having no describe of piece of employment concern model to convert users to operating results is a bad sign, it is an fifty-fifty worse sign when yous receive got a describe of piece of employment concern model that is designed to deliver losses, non exclusively inwards its electrical current form, but amongst no lite at the terminate of the tunnel. That is ordinarily the upshot of having losses that scale upward equally the fellowship gets bigger, because at that spot are economies of scale. 
4. Loose utter most data: The autumn dorsum for many user based companies that cannot defend their describe of piece of employment concern models is that they volition abide by a agency to purpose the information that they volition collect from their users to brand coin inwards the hereafter (from targeted advertising or additional products in addition to services), without whatsoever serious endeavor to explicate why the information volition give them an edge.
5. And externalities: Many user based companies fence that their "innovative" twists on an existing describe of piece of employment concern volition both expand in addition to modify the business, leading to benefits for other players inwards that business, who, inwards turn, volition portion their benefits amongst the user based companies.

The bottom describe is simple. It is slow to create user numbers, if yous sell a production or service at agency below cost, but if your objective is create a long-standing user-based companies, yous involve a pathway to profitability that is defined early on in addition to worked on continuously.

MoviePass: Too Good to live True? 

If yous subscribe to MoviePass, for a monthly subscription of $10, yous acquire to sentry 1 theatrical movie, every day, for the entire month. Given that the average toll of a theatre ticket inwards the US is $9, this sounds similar an insanely proficient deal, in addition to for an avid motion painting goer, it is, in addition to the service had ii 1 G k subscribers inwards May 2018. MoviePass, though, pays the theaters for the tickets, creating a model that is to a greater extent than designed to drive it into bankruptcy than to deliver profits.

MoviePass Economics

When confronted past times the insanity of the describe of piece of employment concern model, Mitch Lowe, the CEO of MoviePass, argued that afterwards an initial burst, where subscribers would encounter iv or 5 movies a month, Valuing Uber Riders

Valuing Amazon Prime Members

Valuing Spotify Subscribers

Valuing Netflix Subscribers

Twists As Well As Turns Inward The Tesla Even Out : A Boring, Boneheaded Update!

There are lots of complaints that you lot tin accept nearly Tesla, but beingness irksome is non ane of them. It helps to accept a CEO who seems to notice novel ways to create himself newsworthy, inward practiced in addition to bad ways. In fact, if Tesla were a reality show, the twists in addition to turns inward its fate would laissez passer on it sky-high ratings in addition to set the Kardashians to shame. Consequently, it should comes equally no surprise that at that spot is no other companionship where investors disagree to a greater extent than nearly the futurity than Tesla, with bulls finding novel reasons for pushing it toll upward in addition to brusk sellers picking the stock equally their favorite, albeit elusive, target. 

Tracing my Tesla Past

I am oftentimes tabbed equally a Tesla bear, in addition to piece I accept never institute it to live on an attractive investment, I accept admired the company, in addition to past times extension, Elon Musk, for shaking upward the auto business. In my start valuation of Tesla inward September 2013, I valued it equally a luxury motorcar companionship that would require large cash infusions to acquire to steady state. Factoring inward the resulting negative cash flows in addition to failure risk, the value per portion that I obtained was good below the marketplace toll then. In the years since, I accept revisited the companionship many times, in addition to what I accept learned nearly the stock has led me to to telephone band it the ultimate story stock, which is how I described it inward a shipping service inward 2016, explaining both its toll volatility in addition to its capacity to conditions bad news. I too argued inward that shipping service that investors inward Tesla were investing inward Elon Musk, non the company, with the companionship reflecting his strengths, a surplus of vision in addition to out-of-the-box thinking, in addition to his weaknesses, which include an unwillingness to pay attending to operating details in addition to fiscal start principles inward running the company.

While Tesla's post at that time, at that spot was no practiced ground that could live on offered for that borrowing, since none of the commons arguments for debt applied.

• Tesla gets no taxation benefits from debt: When a companionship is losing money, equally Tesla was inward 2017, at that spot are no taxation benefits to borrowing money, in addition to to the declaration that they mightiness create coin inward the future, the response is that it in addition to then best to hold off until in addition to then to borrow money. Borrowing coin inward anticipation of futurity profits is non only stupid, but it is dangerous.
• Tesla has piece of cake access to equity capital: It is truthful that Tesla needed working capital alphabetic character to build upward its production capacity, peculiarly given its hope to deliver hundreds of thousands of Tesla 3s inward 2018, but it is too truthful that the best agency to heighten this working capital alphabetic character for a companionship with negative earnings in addition to cash flows in addition to meaning growth potential is to job equity, non debt. To the counter that this volition displace dilution, it is amend to accept a diluted portion inward a much valuable companionship than a concentrated portion of a defaulted entity.
• Musk's command of Tesla is absolute: There is the possibility that the debt number was motivated past times Elon Musk's wish to maintain command of Tesla, but given his exalted condition with shareholders in addition to a condom postage board of directors, I consider rattling footling threat to his absolute command from issuing to a greater extent than shares inward the company.

In sum, the Solar City acquisition was ill-advised inward 2016, in addition to at that spot were no practiced reasons for the Tesla debt number inward September 2017, suggesting either that the companionship does non accept a functioning CFO inward Deepak Ahuja or that Elon Musk is taking on that role equally well.

Tesla: News in addition to Data Updates

As I said at the start of this post, the Tesla story is never a dull ane in addition to the terminal few months has brought that lesson home. Not only accept their been multiple intelligence stories nearly the company, but Elon Musk has outdone himself equally a newsmaker:

1. Financial filings: There accept been 3 quarterly filings since my terminal valuation of Tesla in addition to the companionship has only made the hole it is in, equally a outcome of its operating losses, worse past times adding debt to the mix. The nautical chart below captures the tendency lines inward revenues, operating income in addition to internet income for the companionship on a quarter-by-quarter basis:
   
   Looking at the terminal 3 quarterly reports delivered since my terminal valuation of Tesla, at that spot is footling that would atomic number 82 me to radically reassess what I call back nearly the company. The practiced intelligence is that revenues expire along to grow but the bad intelligence is that losses are growing proportionately, since there is no improvement inward margins. Backing upward the bespeak made inward the terminal department nearly the debt issue, Tesla's borrowing has made the hole that the companionship is inward much deeper.
2. Earnings Call: Earnings calls are usually staid affairs, where top managers stick to the script in addition to analysts trip the lite fantastic toe with them, quest questions nearly operations in addition to seeking guidance on futurity growth. The Tesla earnings telephone band subsequently the most recent earnings study certainly did non fit this script, since Elon Musk, a few minutes into the call, blew upward at at Toni Sacconaghi, a Sanford Bernstein analyst, calling his enquiry nearly futurity working capital alphabetic character needs "boring in addition to boneheaded". He in addition to then proceeded to halt taking questions from analysts alone in addition to answered only questions posed past times investors gathered past times a recent YouTube start-up. While the marketplace reaction to the bizarre earnings telephone band was negative, with the stock dropping 5.5%, the stock, equally it has thence many times before, recovered inward the weeks subsequently in addition to climbed to to a greater extent than or less all-time highs.
   
3. Other News: In the weeks subsequently the earnings call, Musk has added to the intelligence stories with to a greater extent than announcements, many of them taking the shape of tweets. First, he announced that given Tesla's fiscal constraints, the companionship would focus. at to the lowest degree for the side past times side few months, on turning out the "sleeping on the manufacturing flora floor" in addition to at to the lowest degree partly pulled dorsum on its excogitation to supervene upon workers with robots.

Tesla's Value Drivers

No affair what your story is for Tesla, the value of Tesla is determined past times 4 large drivers in addition to to assist inward structure your story, it is worth looking at background:

1. Revenue Growth: In the trailing twelve months, ending March 2018, Tesla had revenues of nearly $12.5 billion in addition to to justify the marketplace capitalization at which the companionship trades at currently, these revenues accept to grow significantly. To acquire perspective on how large revenues tin become, I looked at the xx largest auto companies inward the world, ranked based upon trailing revenues:
   
   Note that most of the companies on this listing are volume marketplace auto companies, with Daimler (arguably) in addition to BMW beingness the only exceptions. Put differently, the enquiry of whether Tesla volition live on able to deliver on a $35,000 Tesla 3, straight off or inward the future, becomes cardinal to estimating revenue growth.
2. Operating Margin: No affair how you lot piece it, Tesla is losing money, in addition to it happens to operate inward a sector where turn a profit margins accept been nether pressure level for a while, driven partly past times contest in addition to partly past times changes inward the describe of piece of work organisation itself. In the nautical chart below, I accept a distribution of operating margins for global auto companies inward June 2018:

   

   Global Auto Data

   Note that the median pre-tax operating  margin for auto companies is only 4.81%, with double digit operating margins putting you lot at the 80th percentile of all auto companies. It is too worth noting that with the 10 largest auto companies, at that spot is non a unmarried ane that generates an operating margin higher than 10%; BMW has the highest margin, at 9.89%.
3. Reinvestment: Scaling upward revenues volition require meaning reinvestment, peculiarly inward the auto business. One uncomplicated stair out of this reinvestment is the sales to invested working capital alphabetic character ratio, measure how much revenue a dollar inward invested working capital alphabetic character generates. Looking at this stair out across the global auto business, hither is what I see:
   
   Note that the global auto describe of piece of work organisation is working capital alphabetic character intensive, with a dollar inward working capital alphabetic character invested generating only $1.29 inward revenue at the median firm, in addition to that Tesla, over its history, has been fifty-fifty to a greater extent than working capital alphabetic character intensive, generating less revenue per dollar invested than the typical auto firm, with working capital alphabetic character intensity increasing subsequently the Solar City acquisition. Tesla's counter to this has  been that past times bringing inward applied scientific discipline into assembly lines, they volition acquire to a greater extent than efficient than other auto companies, but that declaration has lost some of its luster subsequently the terminal few months, with Musk openly admitting that the robots that Tesla had hoped to set on the manufacturing flora flooring were non doing their jobs. 
4. Risk: There are ii dimensions through which hazard affects Tesla's value. The start is the cost of capital, which reflects the operating hazard at the company. As an auto company, Tesla is exposed to economical cycles in addition to its cost of working capital alphabetic character volition reverberate that risk:

   

   Global Auto Data

   The 2nd is the hazard of failure in addition to distress, in addition to piece beingness a small, money-losing companionship is ane ground for exposure, Tesla has magnified its hazard past times borrowing billions of dollars. 

Possible, Plausible in addition to Probable Tesla Stories

I accept long argued that every valuation tells a story in addition to that ane agency to cheque your valuation is to cheque to locomote past times your story through the 3P test: Is it possible? Is it plausible? Is it probable? If this sounds similar a play on words, notation that each seek out sets a higher measure than the previous one. There are lots of possible stories, a subset of plausible stories in addition to an fifty-fifty smaller laid of in all probability stories. 

Tesla is a stock where at that spot are widely divergent stories, with bullish investors telling large stories with happy endings, that deliver large values for the company, in addition to bearish investors pushing much smaller stories, some with bad endings. In this section, I volition start past times offering some solace for Tesla bulls past times looking at a plausible story that delivers a value greater than the electrical flow stock price, in addition to then debate that Elon Musk's story for the company, or at to the lowest degree the version that he is telling correct now,  is an impossible story in addition to unopen with my (still upbeat) story for the stock in addition to resulting value.

Getting to $400/share: H5N1 Plausible Story?

Is it plausible that Tesla, notwithstanding all of the troubles weighing it down, is nether valued, at its electrical flow stock toll of $340/share? Yes, but only it tin set together the next results:

1. Increase revenues ten-fold over the side past times side decade: Tesla's electrical flow revenues of $12.5 billion volition accept to increase to $120 billion or to a greater extent than inward the side past times side 10 years, giving it revenues to a greater extent than or less those of BMW today. Assuming an average motorcar toll of $60,000, that would interpret into 2 ane chiliad 1000 cars sold inward twelvemonth 10, illustrating why the focus on whether Tesla tin hitting its target of 5,000 cars a calendar week is missing the large picture.
2. Improve operating margins to check the most profitable auto companies: While Tesla scales upward its revenues, it volition non only accept to acquire profitable (a minimal requirement) but much to a greater extent than thence than the typical auto company. In fact, its pre-tax operating margin volition climb to 12%, good higher upward the median auto margin of 4.81% or BMW's 9.89%, powered past times create advert in addition to pricing power.
3. Invest to a greater extent than efficiently than the sector: To achieve its objectives of increasing revenues in addition to ramping upward profitability, Tesla volition accept to reinvest in addition to reinvest efficiently, delivering nearly $2.25 inward revenues for every dollar of working capital alphabetic character invested, much higher than than the typical auto firm. To furnish perspective, Tesla inward twelvemonth 10 volition accept to deliver BMW-like revenues ($120 billion) with nearly a 3rd of BMW's invested capital; with the estimated sales to working capital alphabetic character ratio, Tesla's invested working capital alphabetic character inward twelvemonth 10 volition live on $64 billion, whereas BMW's invested working capital alphabetic character inward 2018 was $185 billion).
4. Navigate its agency through debt to safety: Finally, equally it moves towards becoming a much larger, to a greater extent than profitable firm, Tesla volition too accept to run across its commitments on electrical flow debt in addition to non add together to the mix, at to the lowest degree for the close term. In terms of operating risk, Tesla volition accept to human face upward a cost of working capital alphabetic character of 8.29%, inward describe with the typical auto firm.

Download spreadsheet

With these assumptions inward place, the value that I acquire per portion is $412, but equally you lot tin consider from the assumptions, it would live on the equivalent of a Royal Flush inward poker. Note too that inward this optimistic story, Tesla volition accept to accept to heighten $14 billion inward fresh working capital alphabetic character over the side past times side few years in addition to volition non acquire operating cash flow positive until 2025. I am sure that at that spot are people who volition live on unfazed past times this story, peculiarly if they are truthful believers inward Elon Musk, but I am non ane of them.

The Musk Story for Tesla: H5N1 Fairy Tale?

With a story stock, it is imperative that you lot accept a CEO who non only is able to acquire the marketplace to purchase into a large story, but ane who stays focused in addition to disciplined. To me, at that spot is no amend instance of how to do this good than Amazon, where Jeff Bezos has been consistent inward telling the same story for the company, since its inception inward 1997, in addition to delivering on that story. Elon Musk is a gifted story teller, but equally the terminal few months accept shown, focus in addition to dependent acre are non his strong points.

If you lot are a Tesla investor, your primary concern should live on that Musk, with his numerous in addition to oftentimes conflicting claims nearly the company, has muddled the Tesla story in addition to perchance set the companionship at risk. If Musk is to live on believed, in addition to the companionship volition plough the corner on profitability shortly in addition to volition non demand to expire dorsum to working capital alphabetic character markets inward the close future, piece too scaling upward production in addition to revenues. While that would live on wonderful, from a value perspective, it is fantasy. Put bluntly, at that spot is no run a hazard that Tesla tin deliver what it needs to, inward terms of scaling upward revenues in addition to improving profitability, to justify its market capitalization, without raising novel equity along the way. Either Musk knows this, in addition to actually does not mean what he says, inward which instance he is beingness deceptive, or he does not, inward which instance he is delusional. Neither is a practiced graphic symbol character inward a CEO, peculiarly ane at a immature companionship that needs investors on its side.

The fact that Tesla's stock toll has remained at elevated levels, in addition to fifty-fifty risen, may atomic number 82 some to conclude that Musk's behaviour has no consequences, but I believe it non only will, but it already has  hurt the company. For instance, I call back that Tesla has got a bum's rap for some of the accidents that its cars accept been in, either from malfunctioning auto-pilots or combustible cars. However, Tesla's manus is weakened past times Elon Musk non only acting equally the spokesperson for the companionship but past times his responses, which are a mix of arrogance in addition to victimhood (blaming the media, brusk sellers in addition to analysts) that sap whatever sympathy bystanders may accept for the company.

My Tesla Story inward June 2018

My story for Tesla is withal an optimistic one, but it is much less thence than the Royal Flush story that delivered a value inward excess of $400. I do call back that Tesla volition live on able to grow revenues substantially over the side past times side decade in addition to improve margins to rank with the to a greater extent than profitable auto companies. I too call back that Elon Musk volition dorsum rails on his hope of non having to heighten fresh working capital alphabetic character in addition to that Tesla volition invest billions into novel flora in addition to equipment, in addition to do thence to a greater extent than efficiently than other auto companies, partly because it is non saddled with legacy investments. On the hazard front, I am comfortable with assuming that operating hazard volition stabilize over time, but I do call back that the debt burden volition pose a danger to survival, at to the lowest degree for the side past times side twelvemonth or two. Pulling these assumptions together, I revalued the theater at nearly $186/share.

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In this story, Tesla's working capital alphabetic character needs volition live on fifty-fifty higher than nether the Royal Flush story, with negative cash flows for the side past times side viii years, in addition to $22 billion inward novel working capital alphabetic character over that period. That may strike some equally pessimistic, but notwithstanding all the speak nearly robots in addition to technology, this remains a working capital alphabetic character intensive business. It is alone possible that over the side past times side few weeks, Tesla mightiness live on able to acquire its production upward to 5000 cars a week, using tents in addition to spare parts, but that is non a long term solution. There is no tent large plenty to arrive at 30,000 cars a week, which would live on Tesla's target inward my story, inward twelvemonth 10. 

Bottom Line

There is no denying the fact that Elon Musk has been cardinal to the Tesla story in addition to that his vision in addition to charisma accept been largely responsible for pushing the stock toll to its electrical flow levels. That said, nosotros are at a bespeak inward Tesla's history where I call back that the enquiry tin live on raised equally to whether the negatives that Musk brings to the undertaking are starting to grab upward with, in addition to perchance overwhelm the positives. Picking fights with equity enquiry analysts in addition to short sellers may acquire the blood flowing for Tesla bulls, but they are distractions from what Tesla has to do correct now. Promising the marketplace that the companionship volition plough the corner on profitability in addition to live on cash flow positive shortly may signal Musk's faith inward his ain story, but they do to a greater extent than damage than practiced for the company's long term value. I know that it is inconceivable for many investors to call back of Tesla without Elon Musk at its helm, but this is a companionship inward clear demand of checks in addition to balances, either from a strong management squad or a powerful board of directors. Unfortunately, neither exists at the companionship now, in addition to if you lot are bullish on Tesla, that should scare you.

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Spreadsheets

1. Auto companies data
2. Tesla - Royal Flush Valuation (June 2018)
3. Tesla - My Valuation (June 2018)

Past posts on Tesla

1. Keystone Kop Valuations: Lazard, Evercore in addition to the TSLA/SCTY deal
2. Tesla: It's a story stock, but what's the story?
3. A Tesla  2017 Update: H5N1 Disruptive Force in addition to a Debt Puzzle

Share Count Confusion: Dilution, Employee Options In Addition To Multiple Percentage Classes!

In my finally post, precisely nigh 4 weeks ago, I valued Tesla, together with equally alongside all of my Tesla valuations, I got feedback, much of it heated. My valuation of Tesla was $186, inwards what I termed my base of operations case, together with in that location were many who disputed that value, from both directions. There were some who felt that I was beingness also pessimistic inwards my assessments of Tesla's increment potential, but in that location were many to a greater extent than who argued that I was beingness also optimistic. In either case, I receive got no wishing to convert you lot to my betoken of view, since the essence of valuation is disagreement. In the context of some of these critiques, in that location was give-and-take of how my valuation incorporated (or did non incorporate) the expected dilution from time to come part issuances together with what part count to occupation inwards computing value per share. Since these are broader issues that recur across companies, I decided to dedicate a post service alone to these questions.

Share Count together with Value Per Share

There was a time, non so long ago, when getting from the value of equity for a companionship to value per part was a picayune exercise, involving dividing the aggregate value past times the number of shares outstanding.

Value per part = Aggregate Value of Equity/ Number of Shares outstanding

This computation tin give the axe larn problematic when you lot receive got i or to a greater extent than of the next phenomena:

1. Expected Dilution: As immature companies together with start-ups larn listed on world marketplace places, investors are increasingly beingness called upon to value companies that volition involve to access upper-case alphabetic lineament markets inwards time to come years, to encompass reinvestment together with operating needs. To the extent that some or all of this novel upper-case alphabetic lineament volition come upwards from novel part issuances, the part count at these companies tin give the axe live expected to climb over time. The enquiry for analysts together with so becomes whether, together with if yes, how, to conform the value per part today for these additional shares.
2. Share based compensation: When employees together with managers are compensated alongside shares or options, in that location are 3 issues that comport on valuation. The offset is whether the expense associated alongside stock based compensation should live added dorsum to brand it at cash flows, since it is a non-cash expense. The instant is how to conform the value per part today for the restricted shares together with options that receive got already been granted to managers. Third, if a companionship is expected to piece of work on alongside its policy of using stock based compensation, you lot receive got to determine how to conform the value per part today for time to come grants of options or shares.
3. Shares alongside unlike rights (voting together with dividend): When companies number shares alongside unlike voting rights or dividends, they are inwards effect creating shares that tin give the axe receive got unlike per-share values. If a companionship has voting together with non-voting shares, together with you lot believe that voting shares receive got to a greater extent than value than non-voting shares, you lot cannot split upwards the aggregate value of equity past times the number of shares outstanding to larn to value per share.

Note that piece none of these developments are new, analysts inwards world markets dealt alongside them infrequently a few decades ago, together with could, inwards fact, larn away alongside using curt cuts or ignoring them. Today, they receive got larn to a greater extent than pervasive, together with the old evasions no longer volition stand upwards you lot inwards skilful stead.

Expected Dilution

The Change: An investor or analyst dealing alongside publicly traded companies inwards the 1980s by together with large valued to a greater extent than mature companies, since going world was considered an choice only for those companies that had reached a phase inwards their life cycle, where profits were positive (or close) together with continued access to upper-case alphabetic lineament markets was non a prerequisite for survival. Young companies together with start-ups tended to live funded past times venture capitalists, who priced these companies, rather than valued them. In the 1990s, alongside the point com boom, nosotros saw the modify inwards earth listing paradigm, alongside many immature companies listing themselves on world markets, based upon hope together with potential, rather than profits or established job organisation models. Even though the point com bubble is a distant memory, that pattern of listing early on has continued, together with in that location are far to a greater extent than immature companies listed inwards markets today. An investor who avoids these companies precisely because they do non gibe old metrics or models is probable to honor large segments of the marketplace to live out of his or her reach.

The Consequence: If you lot are valuing a immature companionship alongside increment potential, you lot volition by together with large honor yourself facing ii realities. The offset is that many immature companies lose money, equally they focus their attending on edifice businesses together with acquiring clientele. The instant is that increment requires reinvestment, inwards flora together with equipment, if you lot are a manufacturing company, or inwards technology scientific discipline together with R&D, if you lot are a technology scientific discipline company. As a consequence, inwards a discounted cash flow valuation, you lot tin give the axe await to regard negative expected cash flows, at to the lowest degree for the offset few years of your forecast period. To live on these years together with brand it to positive earnings together with cash flows, the companionship volition receive got to elevate fresh capital, together with given its lack of earnings, that upper-case alphabetic lineament volition by together with large accept the shape of novel equity, i.e., expected dilution, which, inwards turn, volition comport on value per share.

The Right Response: If you lot are doing a discounted cash flow valuation, the right reply to the expected dilution is to do nothing. That may audio also skilful to live true, but it is true, together with hither is why. The aggregate value of equity that you lot compute today includes the acquaint value of expected cash flows, including the negative cash flows inwards the upwards front end years. The latter volition bring down the acquaint value (value of operating assets), together with that reduction captures the dilution effect. You tin give the axe split upwards the value of equity past times the number of part outstanding today, together with you lot volition receive got already incorporated dilution. 

I know that it sounds similar a reach, but allow me occupation my base of operations instance Tesla valuation to illustrate. In the tabular array below, I receive got my expected cashflows for the side past times side 10 years, alongside the terminal value inwards yr 10.

Download Tesla Valuation and Dilution Spreadsheet 

The acquaint value of the expected cash flows across all 10 years is $41,333 million, together with netting out debt together with adding dorsum cash, yields an equity value of $33,124 million; the value per part is $189.23. However, this value includes the acquaint value of expected cash flows from years 1 through 8, which are negative inwards my forecast,s together with receive got a acquaint value of $16,157 million. If these cash flows had non been considered, the value of the operating assets would receive got been $57,490 meg together with the value of equity would receive got been $48,282 million, a value per part of $284.41. In effect, nosotros receive got applied a 33.46% discount to value, for time to come dilution. 

Implicitly, I am assuming that the theatre volition fund 88.06% of its upper-case alphabetic lineament needs alongside equity, consistent alongside the debt ratio that I assumed inwards the DCF, together with that the shares volition live issued at the intrinsic value per part (estimated inwards the valuation), alongside that value per part increasing over fourth dimension at the cost of equity. That may strike some equally unrealistic, but it is the selection that is most consistent alongside an intrinsic valuation. If Tesla is able to number shares at a higher cost (than its intrinsic value), nosotros volition receive got nether estimated the value per share, together with if it has to number shares at a cost lower than its intrinsic value, nosotros volition receive got over estimated value. There is i finally reality check. While nosotros receive got implicitly assumed that Tesla volition receive got access to upper-case alphabetic lineament markets together with live able to elevate capital, in that location is a run a risk that upper-case alphabetic lineament markets could unopen downwardly or larn inaccessible to the firm. That risk is non inwards the discounted cash flow valuation together with has to live brought inwards explicitly inwards the shape of a run a risk of failure. In my base of operations instance valuation, it is i of the reasons that I attached a run a risk of failure (albeit a minor i of 5%) to the company.

A Viable Alternative: There is an alternative approach, where you lot forecast the number of shares that volition live issued inwards time to come years to encompass the negative cashflows, together with count them equally shares outstanding today. If you lot occupation this approach, you lot should laid the cash flows for the negative  cash flow years to live zero. The risk inwards this approach is that in that location is a circularity that tin give the axe campaign your valuations to larn unstable, since you lot volition involve to forecast a cost per part inwards time to come years to larn an gauge of value per part today. To illustrate this process, assume that you lot believe that the issuance cost for Tesla for the novel shares volition live $200, alongside a cost appreciation of 9% a yr for the side past times side 8 years. The tabular array below computes the novel shares that volition involve to live issued each year, assuming that 88.06% of upper-case alphabetic lineament comes from equity, together with the dilution that volition resultant equally a consequence:

Download dilution spreadsheet

Note that, alongside the assumptions nigh the issuance cost of $200, Tesla volition number 69.35 meg shares over the side past times side viii years. Adding that to the electrical flow part count of 169.76 meg shares yields total shares outstanding of 236.85 meg shares. If you lot laid the cash flows inwards years 1-8 to null together with compute the value of equity, you lot brand it at a value of equity of $48,282 million, which tin give the axe live divided past times the 239.11 meg shares to brand it at a value per part of $201.92. This is slightly higher than the value that I obtained inwards the cash flow approach, but it is partly because I receive got assumed an issuance cost that is higher than the intrinsic value.

But Never Do This: Reviewing the ii approaches, you lot tin give the axe either contain the acquaint value of the negative cash flows into the value of operating assets today together with occupation the electrical flow part count, inwards estimating value per share, or you lot tin give the axe seek to forecast expected time to come part issuances together with split upwards the acquaint value of only positive cash flows past times the enhanced part count to larn to value per share. You cannot do both, because you lot are together with so reducing value per part twice for the same phenomenon, i time past times discounting the negative cash flows together with including them inwards value together with and so i time to a greater extent than past times increasing the part count for the shares issued to encompass those negative cash flows.

Share Based Compensation (SBC)

The Cause: Over history, businesses receive got used equity to compensate employees, either to align incentives or because they lack the cash to pay competitive wages. That said, the occupation of part based compensation exploded inwards the 1990s due to ii reasons. The offset was an ill-conceived endeavor past times the US Congress to position a cap on management compensation, piece non counting options granted equally purpose of that compensation. Not surprisingly, many firms shifted to using options inwards compensation packages. The instant was the point com boom, where you lot had hundreds of immature companies that had heaven high valuations but no earnings or cash flows; these companies used options to attract together with maintain employees. Aiding together with abetting these firm, inwards this procedure were the accountants, who chose non to care for these choice grants equally expensed at the fourth dimension they were granted, together with thus allowed companies to study much higher income than they were real earning.

The Consequence: As companies shifted to part based compensation, in that location were ii side effects that analysts had to bargain with, when valuing them. The offset was the drag on per-share value created past times past choice together with part grants to employees, alongside options, inwards particular, creating trouble, since they could create dilution, if part prices went up, but could live worthless, if part prices dropped. The instant was the enquiry of how to element inwards expected choice together with part grants inwards the future, since the value of these grants would live affected past times expected time to come part prices. As alongside the dilution question, analysts faced a round down reasoning problem, where to value a part today, you lot had to brand forecasts of the value per part inwards time to come years.

The Right Response: To bargain alongside part based compensation correctly, you lot receive got to interruption it downwardly into ii parts:

1. Past choice together with part grants: If you lot ain shares inwards a company, the shares together with options granted past times the theatre inwards prior years to employees stand upwards for claims on the equity, that reduces your value per share. The shares issued inwards the past times are uncomplicated to bargain with, since adding them to the part count volition bring down the value per part today. The fact that employees receive got to vest (which requires staying alongside the theatre for a specified fourth dimension period) together with that the shares receive got restrictions on trading tin give the axe brand them less valuable than unrestricted shares, but that is a relatively minor problem. The options that receive got been granted inwards the past times are a bigger challenge, since they stand upwards for potential dilution, but only if the part cost rises inwards a higher house the exercise price. Option pricing models are designed to capture the probabilities of  this happening together with tin give the axe live used to value options, no thing how inwards or out of the coin the options are. In an intrinsic valuation, you lot should value these options offset (using an choice pricing model) together with cyberspace the value out of the estimated value of equity, earlier dividing past times the existing part count :

• SBC Adjusted Value per part = (DCF Value of Equity - Value of Employee Options)/ Share count today including restricted shares

Note that the shares that volition live created if the options larn exercised should non live included inwards part count, inwards this approach, since that would live double counting.

2. Expected time to come grants: To the extent that a companionship is expected to piece of work on to compensate its employees alongside options or restricted shares inwards time to come years, the most logical agency to bargain alongside these grants is to care for them equally expenses inwards time to come years, together with bring down expected income together with cash flows. Rather than larn by alongside expected time to come part prices, you lot should gauge the expenses (associated alongside SBC) equally a per centum of revenues, together with occupation that forecast equally the footing for expenses inwards the future. Until accounting came to its senses inwards 2004 and required companies to expense part based  compensation at the fourth dimension of grant, this was an onerous exercise for analysts, since it required estimating the value of choice together with part grants inwards past times years to larn historical numbers on the value of SBC grants. With the prevalent accounting rules inwards both GAAP together with IFRS, the earnings that you lot regard for companies should already live adjusted for SBC expenses together with reported income should so give you lot a fair footing for forecasting. (The operating together with cyberspace margins that I study past times sector, on my website, are margins afterwards stock based compensation expenses). At offset sight, it may appear similar double counting to lower time to come earnings because you lot await choice together with part grants inwards the future, together with and so i time to a greater extent than lower the value of equity that you lot obtain past times the value of options that are already outstanding. It is not, since nosotros are dealing alongside ii separate issues. H5N1 companionship that has had a history of stock based compensation, but has decided to suspend using SBC inwards the future, volition live affected past times only the instant adjustment, whereas a companionship that has never used part based compensation inwards the past times but plans to occupation it inwards the future, volition live affected only past times the former. H5N1 companionship that has part based compensation inwards its past times together with expects to occupation it inwards the time to come volition live affected past times both adjustments.

Tesla uses stock based compensation, together with its most recent annual together with quarterly statements supply a mensurate of the magnitude.

Tesla 10K for 2017 and Tesla 10Q, First Quarter 2018

The compensation tin give the axe accept the shape of restricted stock or options, together with the annual filing provides the cumulative effect of this part based activity. At the goal of 2017, according to Tesla's 10K, the company had 10.88 meg options outstanding, alongside a weighted average exercise cost of $105.56 together with a weighted average maturity of 5.30 years together with 4.69 meg restricted shares. The restricted shares are already included inwards the part count of 169.76 meg shares, but the options involve to live accounted for. We value the options, using a modified version of the Black-Scholes model, to brand it at a value of $2,927 million. Netting this value out of the value of equity that nosotros obtained from the cash flows allows us to larn to a corrected value per share:

Download Tesla valuation

The value per share, afterwards adjusting for options, is $171.99. There is an elephant inwards the room inwards the shape of a gigantic grant of 20.26 meg shares to Elon Musk, alongside the issuance contingent on coming together operating milestones (revenues together with adjusted EBITDA) together with marketplace milestones (market capitalization). The complexity of the vesting schedule on this grant makes it hard to value using choice pricing models, but the effect of this looming grant is to lower value per part today together with hither is why. If Tesla succeeds inwards growing revenues together with turning to profitability, these choice grants volition vest, creating large expenses inwards the yr inwards which that occurs together with putting downward pressure level on margins. In making my forecasts of time to come margins for Tesla, I receive got been to a greater extent than conservative at to the lowest degree inwards the early on years, only for this reason.

A Sloppy Alternative: There is an alternative approach to bargain alongside options outstanding from past times grants. They value options at their exercise value, i.e., the departure betwixt the stock cost together with strike cost today, together with ignore out of the coin options. This is called the treasury stock approach together with the value of equity per part inwards this approach tin give the axe live written equally follows:

Treasury Stock Value per part = (DCF value of equity + Exercise Price * # Options outstanding) / (Share Count today + Options Outstanding)

By ignoring the fourth dimension premium on options, this approach volition over value shares today together with past times ignoring out of the coin options, you lot exacerbate the problem. In the instance of Tesla, using the exercise stock approach would yield the next value per share:

Treasury Stock Value per part (Tesla) = ($32,124 + $105.56 * 10.88) / (169.76 + 10.88) = $184.19

The analysts who occupation this approach often justify it past times disputation that choice pricing models tin give the axe yield noisy estimates, but fifty-fifty the worst choice pricing model volition outperform i that assumes that options merchandise at exercise value.

And Nonsensical Practices: There are ii woefully bad practices, when it comes to stock based compensation, that should live avoided. The offset is to precisely conform the part count for options  outstanding together with brand no other changes. In this "fully diluted" approach, you lot are counting inwards the dilution that volition arise from choice exercise but ignoring the cash that volition come upwards into the theatre from the exercise.

• Fully Diluted Value per part =  DCF value of equity / (Share Count today + Options Outstanding)

With Tesla, for instance, this approach would yield the following:

• Fully Diluted Value per part (Tesla) = $32,124/ (169.76 + 10.88) = $177.83

This approach volition yield also depression a value per share, together with peculiarly so if you lot count out of the coin options equally good inwards the denominator. The instant together with fifty-fifty to a greater extent than indefensible do is to add together dorsum part based compensation to earnings to larn to adjusted earnings. The rationale that is offered for doing so is that part based compensation is a non-cash expense, a unsafe bending of logic, since it allows companies to occupation in-kind payments (shares, services) to evade the cash flow test. Using this logic, Tesla would add together dorsum the $141.6 meg they had inwards share-based compensation expenses to their income inwards the offset quarter of 2018 together with study lower losses. Carried into time to come forecasts, this volition inflate time to come earnings together with cash flows, pushing upwards estimated value. Since these ii bad practices force value away from fair value inwards unlike directions, the only logic for their continued occupation is that, inwards combination, the mistakes volition magically offset each other. Good luck alongside that!

Shares alongside unlike rights

The Cause: Founders together with families who accept their companies world receive got ever wanted to receive got their cake together with consume it too, together with i agency inwards which they receive got been able to do so is past times creating unlike part classes, normally built unopen to voting rights. The founder/family handgrip on to the higher voting right shares together with thus maintain command of the company, piece selling off large shares of equity to the public, together with cashing out. In the United States, shares alongside unlike voting rights were rare for much of the finally century, primarily because the New York Stock Exchange, which was the preferred listing house for companies, did non allow them. Again, the tech nail of the 1990s changed the game, past times making the NASDAQ, which had no restrictions on shares alongside unlike voting rights, an alternative destination, peculiarly for large technology scientific discipline companies. The floodgates on shares alongside unlike voting rights opened upwards alongside the Google listing inwards 2004, together with the Google model, alongside shares alongside unlike voting rights, has larn the default model for many of the tech companies that receive got gone world inwards the finally decade.

The Consequence: When you lot receive got unlike classes of shares, alongside unlike voting rights, you lot receive got ii effects on value. The offset is a corporate governance effect, since changing management becomes much to a greater extent than difficult, together with that tin give the axe comport on how you lot value together with thought badly managed firms. The instant is a unit of measurement problem, since a voting right part together with a non-voting right part stand upwards for unlike equity claims together with cannot live treated equally having the same value. Thus, you lot tin give the axe no longer split upwards the aggregate value of equity past times the total number of shares outstanding.

The Right Response: When valuing firms alongside unlike voting rights, you lot receive got to bargain alongside it inwards ii steps. When valuing the firm, you lot receive got to contain the fact that changing management is going to live to a greater extent than hard to do inwards your estimates. Thus, if you lot theatre borrows no coin (even though it tin give the axe lower its cost of upper-case alphabetic lineament past times moving to an optimal or target debt ratio fo 40%), you lot should leave of absence the debt ratio at null rather than modify it. This volition lower the value that you lot gauge for the operating assets together with equity inwards the firm. Once you lot receive got the value of equity, you lot volition receive got to brand a judgment on how much of a premium you lot would await the voting shares to merchandise at, relative to non-voting shares, inwards i of ii ways. In the first, you lot tin give the axe facial expression at studies of voting shares inwards publicly traded companies inwards the US together with Europe, which honor a premium of betwixt 5-10% for voting shares, together with occupation that premium equally your base of operations number. In the second, you lot tin give the axe occupation an approach that uses intrinsic valuation models to gauge the premium, which I force inwards my newspaper on valuing control. Once you lot receive got the estimate, you lot tin give the axe occupation algebra to consummate your gauge of value per share. 

Value per non-voting part = Aggregate Value of Equity/ (# Non-Voting Shares + (1+ Voting Share Premium) # Voting Shares)

For example, if the value of equity is $210 million, in that location are 50 meg non-voting shares together with 50 meg voting shares together with the voting part premium is 10%, your value per non-voting part volition be:

Value per non-voting part = 210/ (50+ 1.1*50) = $2.00/share

Value per voting part = $2.00 (1.10) = $2.20/share

The Bottom Line

I know that some of you lot volition thought this post service equally nit-picking, but you lot volition live surprised at how much of an effect on value you lot tin give the axe receive got past times non beingness careful nigh part count. Those of you lot who occupation multiples (PE, EV/EBITDA) may live secretly happy that you lot don't receive got to bargain alongside the issues of part count, since you lot don't do discounted cash flow valuations. Unfortunately, that is non true. Dilution, part based compensation together with shares alongside unlike rights are precisely equally much an number when you lot compare multiples across companies, together with ignoring them or using curt cuts (like total dilution) volition only skew your comparisons together with atomic number 82 to mis-pricing stocks. I would advise 4 full general rules:

1. Aggregate versus Per-share numbers: Given how dilution together with options tin give the axe play havoc alongside part count, it is ameliorate to occupation aggregate than to occupation per part numbers, inwards valuation together with inwards pricing. Thus, to obtain PE, split upwards the marketplace capitalization of the companionship past times its total cyberspace income, rather than cost per part past times earnings per share.
2. When SBC is rampant, command for differences: If the occupation of restricted stockand options vary widely across sector, you lot involve to command for those differences when comparing pricing inwards the sector. If you lot do not, companies that receive got large choice overhangs volition facial expression cheap, relative to those that do not.
3. Don't occupation SBC adjusted earnings: Adjusting earnings together with EBITDA, past times adding dorsum stock based compensation, is an abomination, used past times desperate companies together with analysts to present you lot that they are making money, when they are non fifty-fifty close. Don't autumn for the sleight of hand.
4. With frontward multiples, banking company check on together with command for dilution: Analysts, when valuing immature companies, often split upwards today’s marketplace capitalization or enterprise value past times expected revenues or EBITDA inwards the future. The dilution that volition live needed to larn to time to come EBITDA has to live brought into the equation.

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Spreadsheets

1. Tesla Valuation (June 2018)
2. Tesla Dilution 

Blog Posts on Tesla

1. A Tesla  2017 Update: H5N1 Disruptive Force together with a Debt Puzzle
2. Twists together with Turns inwards the Tesla Story: H5N1 Boring, Boneheaded Update!

Country Risk: A Midyear Update For 2018

While political together with merchandise wars are brewing to a greater extent than or less the world, centered on globalization, the enduring truth is that the globalization genie is out of the bottle, together with no political forcefulness tin set it back. Encouraged to spread their bets to a greater extent than or less the world, investors take away maintain shed some of the abode bias inwards their investing together with added unusual equities to their portfolios. Even those that take away maintain stayed invested amongst companies inwards their ain markets are finding that those companies derive large chunks of their revenues from unusual markets. In short, in that location is no house to enshroud from assessing global risk together with analysts who bury their caput inwards the sand are missing large parts of the large picture. In this post, I revisit the assessments of province risk that I take away maintain made every yr for the lastly 25 years together with reiterate how to utilisation those assessments when valuing companies or analyzing projects. The full version of this postal service is a newspaper that y'all tin download together with read, but I take away maintain to warn y'all that I am verbose together with it is to a greater extent than than a hundred pages long.

The Fundamentals of Country Risk
So, what makes investing or operating inwards ane province to a greater extent than or less risky than another? Most line of piece of work concern people betoken to iii factors. The kickoff is the prevalence of corruption inwards a country, amongst the corrosive influences it has on line of piece of work concern practices together with fiscal reports. The instant is the increased exposure to violence from state of war or terrorism inwards some parts of the world, creating non precisely additional operating costs (for insurance together with protection) but also the existent possibility of a consummate loss of the business. The tertiary is the legal scheme for enforcing holding rights, since a part inwards fifty-fifty the most valuable line of piece of work concern inwards the reason is worth lilliputian or nothing, if holding rights are ignored or violated on a whim. In this section, nosotros volition facial expression at the province of the reason on these iii dimensions.

I. Corruption
Why nosotros care: Operating inwards an surroundings where corruption together with bribery are accepted every bit mutual exercise has 2 consequences for value. 

1. It is a hidden tax: You tin persuasion the cost of corruption every bit a hidden tax, paid non straight to the regime but to its functionaries to larn line of piece of work concern done. As a consequence, the effective taxation charge per unit of measurement that a society pays inwards a corrupt economic scheme volition live much higher than the statutory taxation rate. Since it is non legal for companies to pay bribes inwards much of the developed world, it is non explicitly reported every bit such inwards the fiscal statements but it is a drain on income, nevertheless.
2. It tin live a competitive wages or disadvantage: In many corrupt economies, in that location are companies that are non solely to a greater extent than willing but are also to a greater extent than efficient at playing the corruption game, giving them a leg upwards on businesses that human face moral or legal restrictions on playing the game.

Global differences: While businesses are quick to attach labels to entire regions of the world, in that location are entities that attempt to mensurate corruption inwards dissimilar parts of the world, using to a greater extent than objective measures. Transparency International, for instance, has a corruption index that it has developed together with updates every year, amongst lower scores indicating to a greater extent than corruption together with higher scores less. The mid-2018 motion painting on how dissimilar countries mensurate upwards is below:

For heat map together with for raw data

While I am certain that in that location are some who volition facial expression at this nautical chart together with attribute the differences to culture, I mean value that it tin live improve explained past times a combination of poverty together with abysmal political governance.

II. Violence
Why nosotros care: At the risk of stating the obvious, operating a line of piece of work concern is much to a greater extent than difficult, inwards the midst of violence together with state of war than inwards safety. There are 2 consequences. The kickoff is that protecting the line of piece of work concern together with its employees against the violence is expensive, amongst to a greater extent than security built into fifty-fifty the everyday practices. To the extent that this protection is non complete, in that location is the added cost of the devastation wrought past times violence. The instant is that inwards extreme cases, the violence tin drive a line of piece of work concern to fail. It is truthful that y'all tin insure against some of these events, but that insurance is never consummate together with its cost volition live high together with cut back turn a profit margins.

Global Differences: The tidings headlines, particularly nearly state of war together with terrorism, give us clues nearly the parts of the reason where violence is most common. To mensurate exposure to violence, though, it is useful to reckon indices similar the Global Peace Index developed past times the Institute for Peace together with Economics, amongst depression scores indicating the most together with high scores the to the lowest degree violence.

For heat map together with for raw data

There are some surprises on this score. While some parts of the developed world, similar Europe, Canada together with Commonwealth of Australia are peaceful, the United States, Red People's Republic of China together with the U.K. don't score every bit well.

III. Private Property Rights together with Legal System
Why nosotros care: In valuation, nosotros value a line of piece of work concern or a part inwards it, on the supposition that that y'all are entitled, every bit the owner, to a part of its assets together with cash flows. That is true, though, solely if private holding rights are respected together with are backed upwards a legal scheme inwards a timely fashion. As holding rights weaken, the claim on the cash flows together with assets also weakens, reducing the assessed value, together with inwards extreme circumstances, such every bit nationalization amongst no compensation, the value tin converge on zero.

Global Differences: Influenza A virus subtype H5N1 grouping of non-government organizations has created an international holding rights index, measuring the protection provided for holding rights inwards dissimilar countries. In their 2018 update, they measured holding rights on iii dimensions, legal, physical holding together with intellectual property, to come upwards up amongst a composite mensurate of holding rights, past times country. The province of the world, on this measure, is inwards the motion painting below:

For heat map together with for raw data

In 2018, holding rights were most strongly protected inwards Oceania (Australia together with New Zealand) together with North America together with were weakest inwards Africa, Russian Federation together with South America.

IV. Overall Risk Scores
As y'all facial expression at the global differences on corruption, violence together with holding rights, y'all tin reckon that in that location are correlations across the measures. Regionally, Africa performs worst on all iii measures, but in that location are private countries that perform improve on ane mensurate together with worse on others. Consequently, a composite province risk score that brings together all of these exposures into ane number would live useful together with in that location are many services, ranging from world entities similar the World Bank to private consultants, that attempt to mensurate that score. We volition focus on Political Risk Services, a private service, together with the motion painting below captures their measures of composite province risk, past times province inwards July 2018:

For heat map together with for raw data

There are few surprises here. Eight of the 10 riskiest countries inwards the world, at to the lowest degree according to this measure, are inwards Africa amongst Venezuela together with Syrian Arab Republic rounding out the list. Influenza A virus subtype H5N1 preponderance of the safest countries inwards the reason are inwards Northern Europe, though Taiwan together with Singapore also brand the list. The occupation amongst province risk scores is that in that location is non solely no standardization across services, but it is also hard to convert these scores into numbers that tin live used inwards fiscal analysis, either every bit cash menstruum or discount charge per unit of measurement adjusters.

Default Risk
There is ane dimension of province risk where measurements take away maintain non solely existed for decades but are also to a greater extent than inwards melody amongst fiscal analysis together with that is sovereign default risk. Put simply, in that location is a much higher that some countries volition default than others, together with default risk measures attempt to capture that likelihood. 

I. Sovereign Ratings
Ratings agencies take away maintain rated corporate bonds for default risk, using a missive of the alphabet degree scheme that goes dorsum almost a century. In the lastly iii decades these agencies take away maintain turned their attending to sovereign debt, using the same rating system. Between Moody’s together with S&P, in that location were 141 countries that had sovereign ratings, together with the motion painting below captures the differences across countries:

For heat map together with for raw data

While North America together with Europe stand upwards for the greenest (and safest) parts of the world, y'all do reckon shades of light-green inwards some unexpected parts of the world. In Latin America, historically a hotbed of sovereign default, Republic of Chile together with Republic of Colombia are straightaway highly rated. The patch of light-green inwards the Middle East includes Saudi Arabia, indicating perchance the biggest weakness of this province risk measure, which is its focus on the capacity of a province to encounter its debt obligations. As an crude ability amongst a little population together with lilliputian debt, Kingdom of Saudi Arabia has depression default risk, but it is exposed to pregnant political risk. While ratings agencies take away maintain been maligned every bit incompetent together with biased, I mean value that their biggest weakness is that they are besides deadening to update ratings to reverberate changes on the ground. In the lastly decade, it took almost 2 years later Hellenic Republic drifted into problem earlier ratings agencies woke upwards together with lower the company’s rating. 

II. Default Spreads
To those who are skeptical nearly ratings agencies, in that location is a marketplace seat alternative, which is to facial expression at what investors are demanding every bit a spread for buying bonds issued past times a risky sovereign. That spread tin live computed solely if the sovereign inwards inquiry issues bonds inwards a currency (like the US dollar or Euro) where in that location is a default complimentary charge per unit of measurement (the US treasury bond charge per unit of measurement or High German Euro bond rate) for comparison. Since in that location solely a few countries where this is the case, it is provident that the sovereign CDS marketplace seat has expanded over the lastly decade. This market, where y'all tin purchase insurance, on an annual basis, against default risk, has expanded over the lastly few years together with in that location are straightaway nearly lxxx countries where y'all tin uncovering the traded spreads. The motion painting below captures global differences inwards sovereign CDS spreads:

For heat map together with for raw data

The sovereign CDS spreads are highly correlated amongst the ratings, but they also tend to live both to a greater extent than reflective of events on the reason together with to a greater extent than timely.

Equity Risk Premiums
If y'all are lending coin to a business, or buying bonds, it is default risk that y'all are focused on, but if y'all ain a business, your exposure to risk is far broader, since your claims are residual. This is equity risk, together with if in that location are variations inwards default risk across countries, it stands to argue that equity risk should also vary across countries, leading investors together with line of piece of work concern owners to need dissimilar equity risk premiums inwards dissimilar parts of the world.

Global Equity Risk Premiums: General Propositions
As a prelude to looking at dissimilar ways of estimating equity risk premiums across countries, allow me lay out 2 basic propositions nearly province risk that volition animate the discussion.

Proposition 1: If province risk is diversifiable together with investors are globally diversified, the equity risk premium should live the same across countries. If province risk is non fully diversifiable, either because the correlation across markets is high or investors are non global, the equity risk premium should vary across markets.
One of the primal tenets of modern portfolio theory is that investors are rewarded solely for risk that cannot live diversified away, fifty-fifty if they pick out to live non-diversified, every bit long every bit the marginal investors are diversified. Building on this idea, province risk tin live ignored, if it is diversifiable, together with it is this declaration that some high-profile companies together with consultants used inwards the 1980s to fence for the utilisation of a global equity risk premium for all countries. The problem, though, is that province risk is diversifiable solely if there is depression correlation across equity markets together with if the marginal investors inwards companies hold international portfolios. As investors together with companies take away maintain globalized, the correlation across equity markets has increased, amongst marketplace seat shocks running through the globe; a political crisis inwards Sao Paulo tin drag downward stock prices inwards New York, London, Bombay together with Shanghai. Consequently, beingness globally diversified is non going to fully protect y'all against province risk together with in that location should thus live higher equity risk premiums for emerging markets, which are to a greater extent than exposed to global shocks, than developed markets.

Proposition 2: If there are variations in equity risk premiums across countries, the exposure of a line of piece of work concern to that risk should live determined past times where the line of piece of work concern operates (in terms of producing together with selling its goods together with services), non where it is incorporated.
If y'all take away maintain the proffer that equity risk premiums vary across countries, the adjacent inquiry becomes how best to mensurate a society or investment's exposure to that risk. Unfortunately, a combination of inertia together with bad logic leads many analysts to gauge the equity risk premium for a society from its province of incorporation, rather than where it does business. This is absurd, since Coca Cola, patch a US incorporated company, faces significantly to a greater extent than operating risk exposure when it expands into Myanmar or Republic of Bolivia than when it invests inwards Poland. It stands to argue that to mensurate a company's equity risk premium, y'all take away maintain to facial expression at where it does business.

Equity Risk Premiums
The measure approach for estimating equity risk premiums for emerging markets has been to start amongst the equity risk premium for a mature market, similar the US or Germany, together with augment it amongst the sovereign default spread for the province inwards question, measured either past times a sovereign CDS spread or based on its sovereign rating. Since equities are riskier than bonds, I modify this approach slightly past times scaling upwards the default risk for the higher equity risk, using a relative risk measure; the relative risk mensurate is computed past times dividing the measure divergence of equities inwards emerging markets past times the measure divergence of world sector bonds inwards these same markets:

My melded approach, using default spreads together with equity marketplace seat volatilities, yields additional province risk premiums slightly larger than the default spreads. In July 2018, for instance, I started amongst my estimate of the implied equity risk premium of 5.37% for the S&P 500, every bit my mature marketplace seat premium. To gauge the equity risk premium for India, I built on the default spread for India, based upon its Moody's rating of Baa2, of2.20%, together with multiplied it past times the relative equity marketplace seat scalar of 1.222 yields a province risk premium of 2.69%. Adding this to my mature marketplace seat premium of 5.37% at the start of July 2018 gives a premium of 8.06% for India. For the 2 dozen countries, where in that location are no sovereign ratings or CDS spreads available, I utilisation the PRS score assigned to the province to uncovering other rated countries amongst similar PRS scores, to gauge default spreads together with equity risk premiums. Applying this approach yields the next motion painting for global equity risk inwards July 2018:

Download total spreadsheet

Incorporating Country Risk in Valuation
With the estimates of province risk inwards hand, let's speak nearly bringing them into play inwards valuing companies. Staying truthful to the proffer that risk comes from where companies operate, non where they are incorporated, nosotros human face upwards the inquiry of how best to mensurate operating exposure. The simplest together with most easily accessible is revenue breakdown. For a society similar Coca Cola, for instance, amongst revenues spread across the globe, the equity risk premium would live a weighted average of their regional exposures:

Coca Cola 10K for 2017

If the suspension downward of Coca Cola's revenues, past times region, bang y'all every bit beingness overly broad, Federal Reserve annotation that this is the solely geographical breakdown that the society provides. If in that location is ane expanse of corporate reporting that requires to a greater extent than clarity together with detail, it is this.

Using revenues to mensurate risk exposure does opened upwards y'all upwards to the criticism that patch risk tin also come upwards from where a society produces its goods together with services. This is particularly truthful for natural resources companies, where risk tin live traced dorsum to where the society extracts its commodity, non where it sells it. Applying this to Royal Dutch Shell inwards 2018, for instance, yields the following:

Royal Dutch Annual Report for 2017

You could fifty-fifty create a composite weighting that brings into line of piece of work concern human relationship both revenues together with production for a company, if y'all take away maintain the information.

Incorporate Country Risk In Investment Analysis
While province risk plays a key role inwards valuation, it plays an fifty-fifty bigger ane inwards working capital missive of the alphabet budgeting together with investment analysis, every bit multinationals wrestle amongst comparing investment decisions made inwards dissimilar parts of the world. Using Coca Cola to illustrate, assume that the society is considering making investments inwards Nigeria, Republic of Chile together with US together with is trying to gauge the "right" cost of equity to utilisation inwards its assessment. Even if all of the investments are inwards identical businesses (soft drinks) together with are inwards the same currency (US dollars), the costs of equity volition vary across them (the beta for Coca Cola is 0.80 together with the risk complimentary charge per unit of measurement is 3%):

• Nigeria project: Risk Free Rate +Beta*  (Nigeria ERP) = 3% + 0.80 (13.15%) = 13.52%
• Chile project: Risk Free Rate +Beta*  (Chile ERP) = 3% + 0.80 (6.22%) = 7.98%
• US project: Risk Free Rate +Beta*  (Canada ERP) = 3% + 0.80 (5.37%) = 7.30%

It is worth noting that many companies silent adopt the exercise of using the same hurdle charge per unit of measurement for investments inwards dissimilar markets together with if Coca Cola adopted this practice, they would live using the cost of equity of 8.52%, computed using their weighted average equity risk premium of 6.90%, or worse silent a cost of equity of 7.30%, using an equity risk premium of 5.37%, based upon Coca Cola's  country of incorporation,. Consider the consequences of this practice. It volition cut back the cost of equity for the Nigerian investment together with heighten it for the Chilean together with  Canadian investments, together with over time, it volition Pb Coca Cola to over invest together with over expand inwards the riskiest markets.

For a multi-business, multi-national society similar Siemens, the estimation becomes fifty-fifty messier, since to gauge the cost of equity for a project, y'all volition require to know non solely where the projection is situated (to gauge the equity risk premium) but also which line of piece of work concern it is inwards (to larn the correct beta).

Incorporating Country Risk In Pricing
If y'all don't do intrinsic valuation, but base of operations your investment decisions on pricing metrics (multiples together with comparable firms), y'all may mean value that y'all take away maintain dodged a bullet, but that relief is fleeting. If equity risk varies across countries, y'all should also await to reckon it exhibit upwards inwards PE ratios or EV/EBITDA multiples, amongst companies inwards riskier markets trading at lower values. This tin live viewed every bit an declaration for finding comparable firms inwards markets of equivalent risk, but every bit nosotros saw amongst Coca Cola together with Royal Dutch, that tin live hard to do. In fact, since in that location are ofttimes far fewer companies listed inwards many emerging markets, y'all take away maintain no alternative but to facial expression exterior your marketplace seat for comparable firms, together with when y'all do so, y'all take away maintain to at to the lowest degree consider differences inwards province risk, when making your judgments. If y'all do not, together with y'all are comparing publicly traded retailers across Latin America, companies inwards riskier markets (like Venezuela, Argentine Republic together with Ecuador) volition facial expression inexpensive relative to companies inwards safer markets (like Republic of Chile together with Colombia).

YouTube Video

Papers

1. Country Risk Premiums: Determinants, Measures together with Implications - The 2018 Edition

Data

1. Country Risk - Data tables
2. Equity Risk Premiums, past times Country