Friday, August 24, 2012

eBay's Valuation

A follow up to this prior post on eBay (EBAY).

In that post, I contrasted how little eBay's free cash flow had changed in the past five years or so relative to what have been huge changes in enterprise value.

The story didn't sound great at the time (and headlines certainly weren't good) but the company's free cash flows were persistent even during the depths of the financial crisis.

Hardly a meaningful wobble in the scheme of things even if growth was unimpressive.

Free cash flow has hovered consistently at $ 2 billion or slightly above over the past five years. (Though, as I mentioned in the previous eBay post, free cash flow is reduced quite a bit when stock-based compensation is taken into account. I use the adjusted number to value the company.) Yet, since just 2010, the company's enterprise value has fluctuated from roughly $ 20 billion to, more recently, around $ 55 billion.*

Quite a range of values for similar free cash flows. The story itself sounds better now, and to an extent actually is.

Unfortunately, when the story sounds and feels good you can't usually buy an attractive business at a discount.

eBay's Free Cash Flow

In early 2010, I took a look at how little respect eBay was getting as far as valuation goes while Amazon (AMZN) certainly was. Both stocks are up substantially since then. In fact, eBay is now a rather expensive stock, at least by my criteria, while the already expensive Amazon has just become even more so.**

Then, like now, I had no idea what either stock would do. I just thought eBay was available at a discount to a conservative estimate of its intrinsic business value. Both remain businesses that seem to have good or better long run prospects.

I'm certainly not saying eBay isn't doing better these days. I'm just saying price matters and whatever the company has going for it now that it didn't have 2 to 3 years ago didn't make enterprise value nearly 3x higher. It was a good business then. It's a good business now. Real intrinsic values rarely change that quickly but perceptions of value certainly do. All a good story does is make an investor pay more for the privilege of ownership. Better to buy when the story sounds pretty horrible. A working assumption that eventually even good businesses will go through ups and downs (some of them more material than others) isn't a bad one to have at all. Buy shares of sound businesses when the headlines are unflattering (and the share price reflects it) then wait for the good times to return. This takes patience and an even temperament, not genius.
(And, well, at least decent judgment of business value.)

Stock prices will always fluctuate much more so than actual business value and a long-term investor can make those fluctuations work for them. Those with a shorter times horizon are slaves to price action.

"Absent a lot of surprises, stocks are relatively predictable over twenty years. As to whether they're going to be higher or lower in two to three years, you might as well flip a coin to decide." - Peter Lynch

The word invest -- from the latin vestire -- means to wrap oneself up in something. Well, those willing to get wrapped up in owning part of a business for a long time improve their chances of really understanding it. A greater depth of knowledge about what one owns is likely to lead to better judgments over the long haul. It is tough for one person to truly understand the risks and prospects of lots of different businesses. Getting to know a smaller number very well and owning them a very long time seems, at least to me, much more doable.

The key, as always, is to avoid businesses that lack a sustainable moat. I mean, it's just as possible to wrap oneself up in something that will fail miserably. A business with a collapsing moat is no fun to own at all. What seems cheap is an illusion. Not exactly a recipe for outsized returns.

Successful long-term investments do not come down to whether a business runs into near-term difficulties. Missing a quarter of earnings or even several is no disaster. I know some will jump in and out of what they own based upon near term factors. They may even be very good at it. I suppose that's fine but, for most mortals, that's tough to do consistently well.

It naturally also triggers lots of unnecessary frictional costs.

It's not that eBay is one of my favorite businesses (and I would not even consider buying the stock near the current price), but I liked it well enough to buy when it had that nice margin of safety not too long ago.

The stock also remained cheap for an extended period so there were plenty of chances to buy it. So for what was a few years it was given little respect. Ugly headlines and unresolved very real business issues kept the buyers away. The best long-term investments will sometimes look and even feel pretty dumb at the time (and occasionally for an extended time). Cheap stocks often get even cheaper. That's no problem if intrinsic value isn't being destroyed.***

The focus needs to be on changes to the factors that determine value not price action. Hanging in there while the business issues, sometimes rather serious ones, are being resolved can be the toughest part.

Good times make it nearly impossible to buy any good business with enough margin of safety. Lacking that margin of safety, it's much more difficult for investors to ride out the inevitable storms and deal with unpredictable changing tides.

The most important thing, of course, is to distinguish between a business that may have stalled but will regain traction from those that will not. Easier said than done. Those not justifiably confident they can tell the difference will likely end up losing lots of money.

Otherwise, a business with stalled growth still producing an attractive return on capital that's sustainable can make for a sound long-term investment when bought at the right price.

Growth is often overrated.

Adam

I maintain a long position in eBay established at much lower than recent prices. No intention to buy or sell shares near the current price.

Related posts:
eBay's Free Cash Flow
Technology Stocks

In 2010 stock prices had rebounded substantially from the financial crisis lows. eBay's enterprise value actually briefly dropped to under $ 10 billion back in 2009. I've used the 2010 valuation because at least things had settled down a bit. Like many others, eBay's extremely low valuation in 2009 was heavily influenced by macro factors.
** I have very substantial respect for what Amazon seems to be trying to do long-term. I'm speaking strictly of market price relative to what I think is an extremely difficult to estimate (at least for me) intrinsic valuation.
*** A lower stock price is actually a good thing since more shares at a cheap price can be bought back by the company (and can be accumulated by long-term oriented owners).
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