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.