American "Noblesse Oblige"

In America, we dwell in the comfort of our circumstances.   With a current GDP per capita of $46,000, we are considered to be one of the richest nations in the world.  A vast majority of the people own cars or have access to public transportation.   Almost everyone owns a mobile phone with some sort of Internet connectivity.  Even in the poorest neighborhoods, people are able to afford to have a television in the living room.  By any measures, we are considered nobles and must adhere to what the French coined as “noblesse oblige”, which simply means the obligations of the nobles. 

As a wealthy nation, we have an obligation to help the people in the poorest countries.  Most economists had this backwards in the 1980s by helping the poor nation’s Governments and relying on them to support its people.  The net results of such initiative led to corrupt government officials, where the vast majority of the wealth stayed within the bureaucrats and none of its funds trickled down to its people. In order to alleviate this problem, the funds need to go from people to people rather than from Governments to Governments. 

Today, with the birth of micro-finance, some of this conundrum was solved but still not yet perfect.  The problem with micro-finance is that there is an expectation of return on investment.  This causes several problems in one of which is that given two mutually exclusive investments; an opportunity cost is associated with going with one investment over another.  That is, after the risk/return matrix makes sense giving it a positive internal rate of return after discounting the risk factors, one investment would yield more than the other.  Hence, it is wiser to take on the investment with a higher yield.  However, the investments underlying micro-finance are high-risk low yielding investments.    

This brings us to the best viable option available as charitable donations.   Whether it is through a non-profit charitable organization or through a religious organization, giving to charities that support the needs of people living in penury can change the scale of the global economy.  We, as a wealthy nation need to be more proactive in this measure and take initiative to support the people living in destitution.   

Is Facebook Overvalued?

Facebook has last reported to trade on the secondary market at 75 Billion Dollars, which is trading at 35 times the last reported revenue of 2 Billion Dollars.  To better understand the valuation, we will compare it to Google at its IPO.  Like Facebook, Google’s revenue has double almost every year growing up to 1.4 Billion for its first half of the fiscal year leading up to its IPO in August 2004.  I was at Morgan Stanley at the time and even my colleagues were divided on whether the Post IPO market pricing after the auction was a result of media hype or from true fundamentals.  At the time of Google’s IPO, the initial market cap was at 23 Billion Dollars, trading at about 7 times the year end 2004 revenue and 58 times the earnings.  Even at the height 2005 when Google was trading at $430 per share, it was only trading at 21 times the revenue and that is even after their margins drastically improved.  Here is closer look at the comparison points.

Linkedin IPO will give us a better understanding of where Social Media headed

Secondary market trading for Social Media suggests that these companies are overvalued.  Facebook with last reported revenue of 2 Billion Dollars is trading in the secondary market at a valuation of $75 Billion Dollars. That is 35 x revenue and we have no idea how many times earnings its trading.  However, Linkedin with over 90 million users in over 200 countries is valued on the secondary market at around 2.5 Billion Dollars and is set to go public sometime this year.  They reported a nine months ending 2010 revenue of 161 million dollars and net earnings of 10 million dollars.  Compared to Facebook’s 35 times revenue, Linkedin is currently valued at 16 times the revenue and 250 times the earnings.

Linkedin is one of the most popular social media sites and has three streams of revenue income.  The revenue sources are from Hiring Solutions, which makes up 41% of total revenue, Marketing Solutions, which makes up about 32% of total revenue and the remaining 27% is from Premium Subscriptions.  This suggests the bulk of their revenue is coming from Hiring Solutions and may continue to do so going forward.  Furthermore, according to the Company’s S-1 filing, 2010 was their first profitable year.  Given these numbers, the valuation at 2.5 Billion is too large to justify.  Even with the most optimistic Price to Earnings Growth forecast, I am giving it 800 Million Dollars at most. 

Moreover, as the jobs market continue to improve; I don’t foresee the same level of growth continuing for the Hiring Solutions side of the business.   Although I use Linkedin to stay connected with professionals in my network and to source for future deals, I personally have not used and do not foresee myself using the subscription services in the near future.  The only sustainable model for continual high growth is the Marketing side of the business as advertisers continue to target professionals categorized by industries.  

However, Linkedin IPO will tell us whether the hype in social media will continue or if it will be a timely exit for the VCs heavily invested in these companies.  What the market has taught me in the last ten years is that we have to switch back and forth between fundamental and behavioral finance.   Remember back in 1995 when the Dot Coms were overvalued?  Well, the true fundamentalist missed out on the next four years gain.  

Which types of Start-Ups are allowed to have Negative Cash Flows from Operations?

There is a time and place for capital injection for startups making no revenue with zero equity.  Most entrepreneurs believe that if they concentrate on building and perfecting their product or services, large sums of money will automatically flow in.   Although some start-ups may get capital injection from investors at the seed stage, it is not typical.  Most start-ups need to make money from day one and may never see external financing other than the line of credit from their bank.  Others may not even have such luxury and may need to resort to bootstrapping and maximizing all of their personal credit cards.   There are basically two types of start-ups of which deserve different treatment in its early stages.  

The first types of start-ups are e-commerce, brick & mortar retail stores, and consulting/professional services, practically majority of the business in existence.  These types of start-ups need to have positive free cash flows from operations to fund the continuing operations of the business.  Holy grails of these business are ones that have either negative or zero cash flows from financing.  That is, the business can survive without having external financiers. 

The next type of start-ups are those that are launching innovative products and/or services.  Think newly formed drug companies with a patent on a drug or a software companies with an innovative product that will soon launch to market.  A negative cash flow from operations for these types of business is acceptable.  That is, they may fund the operation from financing activities.  The only main criterion is that the internal rates of return have to be positive.  If the internal rates of return from R&D expenses are deemed to be positive, then it will only make sense for the business to seek external financing for their business.  However, the question than becomes, which products or services are considered to have positive internal rates of return and what type of business are considered innovative products and/or services? 

To answer the first question, the product or service has to be innovative enough to withstand on its own and generate astronomical rates of return by capturing a large percentage of the market.  For example, if the product is a prescription drug that can potentially cure terminal cancer, the demand for such product is definitely there.  It may just need to complete the clinical trial phase and gain FDA approval before it can come to market.  This would mean the business would not generate any revenue until the clinical trial phase ends and the drug gets approved by the FDA.  Until that happens, the business will need some sort of capital injection in order to bring to market.  The capital injection at this point needs to be large enough to create a buzz in the market.  That is, when people refer to a drug that cures cancer, they will think of that particular drug.  The reason for this is simple.  If the drug gains popularity but fails to capture a large market presence, there will be copycat firms coming out with similar products and they may corner the market instead.

To answer which start-ups are considered innovative think of Picasso, Da Vinci, and Polack.  They were considered the greatest artists of their time because they brought to the art world a new medium, becoming the pioneers of their styles.  Others have followed suit, but when one thinks of cubism, they quickly point to Picasso.  In essence, for a start-up to be truly innovative, the product or services has to be something that the markets wants but hasn’t realized yet.  In the course of a day, I come across several start-ups telling me why they are different.  In reality, however, they are the same service or product that is already in the marketplace but with a little twist to it.  For example, almost every other start-up that I come across is some sort of social media that does not make any revenue.  The first question that I ask is how they will generate revenue and the typical answer that I get back is nothing more than having a glorified website that may or may not attract traffic.  If that is the case, their business is more like the first type of start-up and needs to make money from day one in order to survive.

If you must play the lottery, play by these rules

Every now and then, economist, statisticians, and anyone else in the business of calculating risk will tell you that you have a better chance of getting struck by lighting than winning the lottery.  No matter how you argue against this point, the fact of the matter is, it is not worth the gamble.  However, if you happen to be filling up the your car at the gas pump and have dollar to spare, why not donate it to the state to spend it on social programs.  After all, your State, like many other states are probably faced with budget crisis.   So, if you are going to play, play smart and up your chances of winning by a just a hair.  Before getting too excited by the miniscule factional basis point increase in the probability of winning, lets go over the basics of why the dollar you spend is a lot riskier than most and almost every other gamble you can think of.

Perceived Risk verse Actual Risk

Which one would you rather risk, a dollar on a lottery or three thousand dollars on a call option of particular technology company?   Most people at this point would probably choose the dollar on the lottery over the three thousand dollars on a call option.  Without going into all the complexity of a call option, basically a call option is bet that a particular stock will rise above the strike price plus the premium, which in this case is three thousand dollars.   For example, a stock is trading at $50 and the strike price is $55.  Lets suppose you bought 10 contracts (each contract = 1 Lot or $100, so three thousand dollars equal 3 Lots).  In this case the premium is $3.  So in other words, the stock has to rise above $55 + $3 = $58 to gain any money from your bet of three thousand dollars.  On the flip side, if the stock does not go above the strike price minus the premium, in which this case is $55 – $3 = $52, you lose everything.

It is perceived that losing three thousand dollars on an options contract is riskier than the dollar that you spend on the lottery, but is it really?  To answer this question, lets take a look at the expected return of both.  Finding the probability of winning the lottery is a lot easier than finding the probability of a certain stock reaching a target price.  For one, anyone can go to www.megamillions.com to get the exact probability of winning the jackpot or they can calculate it themselves by using the following formula:

(5/56) x (4/55) x (3/54) x (2/53) x (1/52) x (1/46)

The above formula is based on choosing five numbers 1 – 56 in any particular order and one mega ball number 1 – 49.  That gives you a 1 in 175,711,536 chance of winning, a probability of 0.0000006 percent.  This also means that you have a 9.9999994 percent chance of losing.  So what is the expected return on this gamble?  It depends on what the actual jackpot is for that week.  To keep it simple, if the jackpot is more than 175,711,536, than the expected return is positive.  But wait a minute, what about taxes and time value of money.  Okay, we will go over that later but for now, lets go find the expected return of options.   The actual formula for calculating the expected return for option is as follows:

However, for simplicity purposes, lets say the average volatility of a given stock price is +/-20 percent, which is pretty realistic for tech companies.  Lets further assume that this particular stock has a 50 percent chance of gaining 20 percent, 25 percent chance of gaining 12 percent, and 25 percent chance of losing 12 percent.  These are pretty realistic percentage.  The simple calculation is as follows:

0.5 x 0.20 + 0.25 x 0.12 + 0.25 x – 0.20

Hence, you have an Expected Return of 8 percent

To complicate this matter even further, we have to consider the ex-alpha rate of return for the investment. That is the risk adjusted return.  But to satisfy the average readers, I will leave that for the Journal of Finance or any other paper read by people who actually care about these types of things.  For now, lets get back to the topic at hand, the Lottery.  As you can see, from a risk perspective, a person has a greater chance of gaining money in an option compared to winning a lottery. 

So why do people still believe they have a better chance of winning lottery compared to betting on options?   Behavioral finance would say people are irrational and only view a jackpot of several hundred million as a better gamble compared to even the stock market.  For one, the reward is perceived to be bigger.  However, as illustrated above, people do not always calculate the amount of risk that they take in order to win the jackpot. 

Going back to the probability of winning the lottery, it seem that if the probability of winning the lottery is 1 out of 175,711,536, then as long as the prize money is more than 175,711,536, we could pay to get 175,711,536 combination to win the difference.  Right? Wrong!  First, we have to consider the time value of money.  If you win, lets say $200,000,000 on a $175,711,536 bet, it seems as you won the difference of about $24 Million Dollars, a gain of about 13 percent.  However, this money will be distributed over the next 26 years.  That is approximately 7.7 Million per year and taxed every year. Given the level of inflation, opportunity costs, and among other things, the value of winning will never reach the original gamble leaving you with a negative rate of return.  

If you were to choose a cash option, your prize money is a little less than half so that would not work either.  So the natural question that you would ask is, what if the prize money exceeds $350 Million?  At this level of prize money, a lot more people will play the lottery increasing the chance of, wait for it, splitting the pot.  Oh no!   Even if the participating States do not have a total population of 175 million, the people who play would spend on average $20 when the prize money reaches more than even $200 Million.   Given these facts, the odds are really stacked against you. 

But if you still must play, play by these rules:

First, play only when the Jackpot hits above $175,711,536 and never ever spend more than $100 minus the full tank that you put into your car.  The best option is to just play a dollar.  Yes, buying more ticket will increase your chances of winning, but not by a significant amount.  Your money is better off invested elsewhere.  Moreover, you have 1 in 40 chance of winning something and at least 1 in 75 chance of winning at least two dollars.  If you win two dollars, you double your investment and if not, no biggie.  You just donated your dollar to the State. 

Second, computer generated random numbers gives you a 70 percent higher chance of winning verses picking your own numbers.  This is a time-tested approach, where 70 percent of past Jackpot winners got their numbers through random picks.  Furthermore, if you pick your own numbers and win, the more likely you will end up splitting the pot.  The science behind this is that people tend to choose the same numbers.  For instance, they tend to choose lower numbers under 12 or 31.  This is because numbers under 12 or 31 signifies special dates or birthdays.  The most popular numbers people tend to choose are 7 or any number that are multiple of 7 such as 21.  They also have a tendency to pick numbers associated with the jersey worn by their favorite basketball or football players.

Finally, if you insist on picking a number, pick a mega ball number that hasn’t shown up in a while.  This will increase the likely-hood that the number in question will show up.  It uses the same logic of flipping a coin.  If you flip a coin six times and all six times, you get heads, then on the next subsequent flip, your chances of getting tail is a lot greater.