Monday, March 31, 2014

eBay 10 Years Later: Business Performance vs Stock Performance

There was a time, a bit less than 10 years ago, that the enthusiasm for eBay's (EBAY) prospects rivaled some of today's high flyers.

Also, much like today's highest flyers was a stock price that reflected that enthusiasm.

The stock was selling, give or take, for roughly 100x earnings in 2004.

Now, the company has run into it's fair share of challenges -- as even the very best business do -- while management was both smart and fortunate to buy PayPal when they did at a price that, at least with the benefit of hindsight, looks rather cheap. Still, even if it has been a bumpy ride at times, nearly ten years later the company has delivered some fine results.*

                                   2004                       2013
Revenue                 $ 3.3 billion         $ 16.0 billion

Net Income           $ .78 billion         $ 2.9 billion

I think it is reasonable to say that financial performance qualifies as not too bad at all. Though what matters, naturally, is what those numbers indicate, if anything, about the company's future prospects and trajectory.

It's worth noting that the revenue and net income increases have been backed by solid free cash flow**. The company has, more or less, over that time also maintained a healthy balance sheet. So it's just not hard to argue they've put together more than a pretty solid decade.

So the business did just fine but, in 2004, those who were buying eBay's stock at prevailing prices were assuming the recent positive trajectory would continue for, at the very least, quite a long time.

Buyers of the stock back then were willing to pay a very high multiple of earnings in the hopes those earnings would rise dramatically and, well, very quickly.
(It's been long enough that some might forget eBay was once viewed as a high flyer not unlike some of today's favorites.)

The end result being that, while eBay put together quite a nice decade of business performance, the buyers who paid those prevailing late 2004 prices expecting to get an attractive investment result (in contrast to those who might have been betting on a good speculative outcome) have not been rewarded.

At ~ $ 55 per share now, the stock now sells at a price that's not much different than back in late 2004.

The point being, of course, is it's no fun to own a business that delivers good business results over a decade or so yet delivers an unsatisfactory return to the owners.
(The S&P 500's total return has been nearly a double over that same time frame with none of the business specific risks.)

By the way, I'm only using eBay as an example. There are a number of examples over the past 10-15 years of, to varying degrees, an enterprise with good prospects but a valuation that was unlikely to compensate the investor sufficiently (though the most exceptional surely did reward investors).

Again, even very good businesses run into real difficulties from time to time. There's almost certain to be an ebb and flow and it's unwise as an investor to not expect as much. Sometimes, near-term price action is merely a reflection of perceived prospects based upon recent news not actual changes to intrinsic worth.

That's true in both directions.

Emotions and psychology more generally rule price action in the shorter run; intrinsic values drive prices over the longer run.

There is no doubt some high flyers today that are good businesses with fine prospects. Yet, due to the upfront price that must be paid, the returns are also likely to not compensate the long run owner sufficiently.

Of course, some of these high flyers will perform well; others will end up disappointing. Telling them apart beforehand is much easier said than done (or easier to describe after the fact). In fact, a too high risk of permanent capital loss usually exists in or near the same neighborhood as the potential big winners. A wilder ride, maybe, but the combined net impact of those winners and losers will too often offer a less than impressive overall result.

Back in 2004, alternatives to eBay had not only less difficult to judge prospects (and, yes, less exciting price action), but also were priced in a way that increased the likelihood of a nice investment outcome.

Investment must always be viewed in the context of opportunity costs. It's not whether a business can eventually "grow into its valuation". (A description or justification that's so often associated with the high-flyers.) It's whether something well understood is judged likely to deliver -- considering the specific risks and relative to alternatives -- attractive absolute forward returns. If an investment does end up someday validating an initial seemingly high valuation, it doesn't logically follow that the risk of permanent capital loss compared possible rewards was well managed. Sometimes, for example, the price is so high that just about everything has to go right. So it might be a perfectly good business, but justifying the price paid depends on lots of continued good fortune. Well, in those instances, an extreme valuation will too often offer no protection against permanent capital loss if there's an unforeseen bump or two in the road. The price paid should, as a principle, always protect the investor against such unforeseen and often mostly unforeseeable things.
(Another way to think about this: even if eBay had delivered a positive return over those ten years or so, it still might not be a sufficient return considering risks and alternatives.)

The world is always uncertain; pay a price that reflects this reality and protects against surprises (or, at least, all but the very worst outcomes).

Some of the current highest flyers are selling for what certainly looks like extreme valuations. No doubt a number of these will do great things in terms of business performance over the next decade or longer.

More than a few will also inevitably run into business challenges; some that will get sorted out and, well, some that will not.

In enough cases to matter, I'm guessing that the current dreams that are propping up prices will come no where near being realized.

The most exceptional ones, once again, might actually even exceed what now seem like lofty expectations.

The problem is that it's often not at all easy to predict these long-term outcomes; to reliably foresee which high flyers have sustainable advantages and prospects on a scale that ends up making sense of what, in too many cases, now looks like nonsensical valuations. Speaking generally, putting capital at risk based on an optimistic long-term forecast is usually a fool's errand. This becomes especially unwise when the capital at risk depends on consistently and correctly predicting what the economics of businesses in the most dynamic industries will look like many years down the road. It moves from being unwise to just plain financially dangerous when what's paid upfront depends on the best possible outcomes.

Placing capital at risk that's dependent on consistently correct long-term predictions is folly; developing a robust investment process and based upon sound principles is not. The investor may not be able to control outcomes, but still can increase the likelihood of good results with a sound approach.
(Including the development of what Charlie Munger calls "a latticework of models".)

The approach is under investor control. What ultimately happens is not.

For investors, it's just generally more wise to focus less time and energy on that former "p" and more on the latter two.

Margin of safety is, of course, just one of the many essential investment principles but seems rather appropriate to highlight here. It's a recognition of an investor's limitations -- the inevitable mistakes that get made -- and, to varying degrees depending on the business, an uncertain range of future outcomes for the business itself.***

Now, since those high eBay market prices prevailed back in 2004, many opportunities arose to buy shares of the company at more reasonable valuation levels.

In fact, at least in my view, the company's shares sold several years back at a significant discount to intrinsic value for an extended period.
(Though, at or near current prices, to me the shares are very far from being cheap.)

This happened, at least in part, when eBay's perceived prospects changed in the minds of apparently rather impatient market participants (with an assist from the financial crisis). Now, the company did have to transition through some very real difficulties (again, this is almost inevitable from time to time), but its sound core business economics remained mostly intact even if growth, for a time, became subdued. So the very fast growth that some like to pay a premium for wasn't there but, crucially, they continued to produce lots of free cash flow at a high return. They've had a fine business throughout -- even if with real difficulties -- but the price of admission changed dramatically. It's been essentially the same business, but what makes sense to buy at one price makes no sense at another. Business prospects can't be viewed in a vacuum; the price paid dictates risk and reward.

Durable high return on capital in the long run trumps modest growth especially if the right price is paid in the first place.

Of course, the investor who bought eBay's shares when cheap and hung in there had to endure, over several years, many very real unresolved business challenges and the inevitable lousy headlines that followed. Nothing like hearing and reading how stupid it is to own a particular stock day after day to test conviction.
(BTW - possessing a high level of unwarranted conviction is obviously never a good thing. Stubbornness combined with confirmation bias is a great way to lose a lot of money.)

So, beyond buying shares at a plain discount to intrinsic value, owning eBay's shares several years back required lots of patience in combination with the ability to ignore the noise and terrible price action. Attractive discounts don't usually exist when the headlines are rosy and future prospects are clear.
(Though sometimes a business has problems that are just plain intractable. Correctly separating, beforehand, the sound business with real but fixable problems from those that are truly broken is easier said than done.)

Today, eBay's stock appears rather expensive -- though not at all as much so as some of the current highest flyers, or the company's own extreme valuation a little less than a decade ago -- but their overall business prospects continue to appear not too bad at all.

In other words, intrinsic value would seem likely to increase just fine over time. It's just that compensation isn't likely to be sufficient considering risks and alternatives. It's just that margin of safety isn't, at least for me, as plain to see.

The fact is, near the current valuation, risk/reward is nothing like what it was several years back. That's a simple matter of the price one now has to pay, not the prospects for eBay itself.

Still, I won't be surprised at all if eBay does quite well as a business over the long-term. If so, valuation will follow.

In any case, this is not a view of what the shares might do in the next days, weeks, or even several years. Trying to figure out that sort of thing is mostly a waste of time and energy.

"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

Having said that, my preference is to generally not sell shares of a somewhat overvalued but otherwise good business -- one that was bought at a nice discount in the first place -- unless the opportunity costs are high; my preference is for increases to per share intrinsic value to be the primary driver of returns. To me, attempting to generate satisfactory or better outcomes via the clever trading into and out of various marketable securities is folly. In fact, I'd argue that just about the opposite behavior is what generally gets results, especially when done in a thoughtful and persistent manner.

That usually means, in order for selling to be warranted, the shares need to be plainly expensive -- selling for a significant premium to intrinsic value -- and/or something else well understood needs to become very mispriced on the low side. At times, an investment that has a substantial margin of safety must be funded by another investment that lacks such a margin of safety. When a switch is warranted, the advantage in terms of risk and reward between the investment alternatives should be very obvious.
(Though, reducing the size of a position as the shares become more fully valued often makes sense to me. I've, in fact, recently done just that with eBay. Where I tend to NOT do this is with shares of my favorite businesses. Well, eBay surely does not fall into that category even if it does possess a number of attractive business characteristics.)

Trading into or out of something because it is merely somewhat mispriced makes little sense. Minimizing moves in a portfolio isn't just about reducing frictional costs, it's about reducing mistakes.

Focusing on the upside of a move but not carefully considering the downside of a move is an easy mistake to make.

Mispricings, on both the high and low side, can occur when recent success or difficulties is used to extrapolate forward what something might be worth. Sometimes what's growing takes a pause. The opposite is also true. Paying a premium price that assumes growth will continue indefinitely is just asking for trouble. The fact is it's nearly impossible to foresee what challenges or opportunities might arise much further down the road. If the price paid depends not on continued good fortune to get an attractive result, there'll be no complaints if prospects turn out to be somewhat, or maybe a whole lot, better.

I'd add that a good investment outcome should never depend on selling at a premium price. Those who need to sell at a premium price to achieve a good outcome make themselves vulnerable to something they have no control over. A modest multiple of, conservatively estimated, future per share normalized earning power -- at least 7-10 years down the road and, ideally, even much longer -- should be all that's required, considering risks and alternatives, for a nice overall investment result.

For most assets, it will not be possible to figure out future earnings power. When that's the case it's best to just move on. That doesn't mean the opportunities never appear on the radar with some patience. When they do appear -- and confidence is both high and warranted -- that patience must to be followed by decisive action.

A sound investment approach, applied consistently over a long period of time, still guarantees nothing but can, at least, increase the likelihood that good things more frequently happen and overall results improve.

It's at least worth mentioning -- as I have before on more than a few occasions -- that there's really no pure technology business I'm comfortable with as a long-term investment. Most are involved in exciting, dynamic, and highly competitive industries; that's precisely what makes them unattractive long-term investments. It's the fact that the range of possible outcomes is often just too wide to get, on a consistent basis, the valuation at least mostly right. 

Now, while technology is very important to eBay, it seems not difficult to argue that the company is a very different animal than the most pure of technology businesses.

Adam

Long position in eBay established at very much lower than current market prices. This once larger position (bought years back when eBay was experiencing some difficulties) has been reduced to a smaller position near and above recent prices. Generally speaking, my preference is to absolutely minimize buying/selling but, as eBay's margin of safety has decreased (at least by my math and assumptions which, of course, could prove to be very wrong) the position has been trimmed consistent with how I view risk/reward and current alternatives. Those funds will be redeployed if and when shares of an attractive business becomes cheap enough to buy again. We are, in general, surely a long way from the valuation environment that existed 3-5 years ago.

Related posts:
eBay's Valuation
eBay's Free Cash Flow
Technology Stocks

* Rev. (billions $) 2004-13: 3.3, 4.6, 6.0, 7.7, 8.5, 8.7, 9.2, 11.7, 14.1, 16.0;

Net Inc. (billions $) 2004-13: .78, 1.1, 1.1, .35, 1.8, 2.4, 1.8, 3.2, 2.6, 2.9
** Though I'm not a fan of how expensive eBay's stock-based compensation actually is, though I realize some choose to treat it -- and I'd argue incorrectly -- as a non-cash expense. Well, the specific cash cost might not be easy to estimate upfront but that makes it no less real. One alternative way to roughly, but meaningfully, show the true cash cost of equity compensation plans at eBay (and at a number of other companies) is to add up what's been spent on buybacks over several years then compare it to how the share count has been impacted. In eBay's case lots of cash has been expended on buybacks over the past five years yet there's been no reduction in share count. Well, if the share count isn't reduced much (or, in this instance, not at all), that cash used -- to simply offset equity compensation related dilution -- can no longer be returned to or benefit shareholders. So this is hardly some non-cash expense; it's, instead, a very real cost. Naturally, one could simply choose to consider the GAAP stock-based compensation as a useful, if imperfect, way to estimate this cost in the first place. Still, there is certainly no way to do more than very roughly estimate this cost going forward. The above alternative approach is simply one way to help reveal that the equity compensation eventually ends up having a very real economic impact. When stock options are initially granted, and for a period of time after that, the real cash cost is generally not going to be clear but must be accounted for some way to get the economics as right as is possible. So, while it's true that estimating these stock related expenses isn't easy to do upfront, that's hardly a reason to assume they don't exist at all then look past them altogether. (To me, it's still rather amazing that many choose to, when it comes to valuation, ignore what ends up being very costly for long-term shareholders.) When reasonable adjustments are made for these expenses, eBay's free cash flow is meaningfully less than it might first appear to be (though it is still impressive). Keep in mind that, even if share count drops due to a buyback, yet insufficiently compared to the cash used, an adjustment to free cash flow still needs to be made for the cash expended in excess of what should have been needed -- at reasonable prices per share compared to intrinsic value per share -- to lower the share count. In any case, ignoring these costs makes little sense. Naturally, my way of valuing the company takes these real expenses fully into consideration. Put another way, the price to free cash flow (or adjusted P/E) becomes quite a bit higher when the cost of equity compensation is taken into account. In addition, a company that relies on lots of equity compensation -- since the ultimate future impact is difficult at best to estimate -- necessarily leads me to require a larger margin of safety and, all else equal, the preference for a smaller position size. Now, eBay certainly isn't alone in this regard. For many tech and tech related businesses (of more or less quality), these costs must be carefully considered in order to understand the core business economics and to estimate value. As it turns out, there's a number of earnings estimates that do not take into account such costs.
*** I am referring to paying a price now where, let's say 10-15 years down the road, what the business produces -- it's intrinsic worth (incl. dividends, if applicable) on a per share basis -- leads to a good result. I am not referring to near-term or even intermediate-term price action. Once something is barely anchored by value and, instead, maybe is driven more or less by difficult to nail down but exciting future possibilities, just about anything goes. Stocks that sell at apparent speculative prices can easily become 2x, 3x, 4x, and even much more than that speculative amount. Now, I'm not a big believer that speculative activities in the market will end up being particularly lucrative for most, but no doubt some know how to do such things successfully. Buffett recently wrote about, among many other things, his own skepticism about speculating successfully on a sustained basis. From his latest letter: "If you...focus on the prospective price change of a contemplated purchase, you are speculating. There is nothing improper about that. I know, however, that I am unable to speculate successfully, and I am skeptical of those who claim sustained success at doing so."
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