Pricing an imaginary IPO

- by Paul Murphy -

If a couple of guys build a company from scratch and then do a billion dollar IPO, where does the market value come from? More importantly, what does the valuation process mean to the typical business employee?

I got to thinking about this during a review of on-line gaming a couple of weeks ago because the business models underlying games development and marketing are so entrenched that no existing competitor can be expected to implement a new idea until a new company arrives to demonstrate its value. Coming up with a new financial model isn't hard - I have one that can probably be patented - but getting financing is. Imagine, however, that you know how to make financing happen and together we get to the point where our financial management suggests that doing second round financing via an IPO would make more sense than the traditional route becuase doing so can simualtaneously hype our first game product and raise the money for the marketing push needed to recruit our first two hundred thousand on-line users.

Imagine further that we've spent, at that point, around sixteen million bucks and are ready for the first 10,000 user trial. Our prospectus therefore promises that another ten million in marketing plus a million or so a month in continuing run-time support and development will give us a breakeven, including debt retirement, with about 100,000 users and earn nearly two million a month in pre-tax profits at 400,000 users.

Now how should our shares be priced?

The received wisdom on this is that a company's market valuation reflects shareholder's expected returns. Those returns can occur in four ways:

  1. through the tax system;

  2. through earnings distributions;

  3. through market or other risk reduction; and,

  4. through share appreciation.

According to the theorists, today's share price should reflect a risk based blending of the discounted present value of these four sources of value to the buyer.

In practice the theory looks a lot better as a prescription for long term rational market behavior than as a description of actual market behavior.

As I write this, for example, google is selling at 215 times earnings with a market capitalization of about 49 billion dollars.

There aren't any regulatory reasons to buy google - trivial assets and no pollution producing plants in Kyoto signatory countries mean nothing to raid, nothing to write down, and nothing to shut down for saleable credits. Google's earnings are a triviality relative to that market cap: less than one half of one percent per year, and there's not that much upside room. Worse, it's high risk: what happens if a competitor like clusty catches on. Anyone remember Altavista?

That leaves the expectation of share appreciation. For an equities trader there are margin, arbitrage, and brokerage opportunities here, but all of these depend on market fluidity rather than anything intrinsic to the shares used. For an equities owner, however, market appreciation provides value only if someone else is willing to pay more for the shares than their last traded value. Unfortunately that person's willingness to do so, has to be driven by the same rational pursuit of self interest and therefore ultimately the same belief that yet another person will eventually offer yet more cash.

History calls that a bubble - based on verified earnings, google should be worth a bit less than 10% of its current selling price - and it's bad news for anyone left holding the stock when reality eventually sets in.

Our problem, of course, is that our games company has the earnings potential to justify twenty-five million shares at about $10, but we'd much rather ride a bubble to well over $100 per share before cashing out. If we succeed, that $90 in unearned "consumer surplus" will come from the market itself, not our company's real ability to earn profits -it's as if that extra $2.2 billion is created from nothing at all.

To understand where it comes from, lets look at a municipal taxation idea from the 19th century: land value taxation. The core idea here is that municipal land taxes should be based on the value of the land, not the value of the "improvements" (mainly buildings) on it.

The big benefit of this approach is that taxing "improvements" creates barriers to development by penalizing people who build things that can be taxed, while taxing the land based on its value for building penalizes people who fail to maximize the commercial value of improvements on their land. Thus the traditional system penalizes people who put up skyscrappers while rewarding those who hold parking or tenement lots downtown waiting for the price to rise while the land value tax approach rewards builders and penalizes speculators.

What's interesting and applicable about this is the underlying theory. An acre of land is an acre of land; value that acre based on its real earnings potential and a cornfield in Iowa should be worth more than a lot in Manhattan. In reality, however, that acre in Manhattan is worth more, not because it will grow more crops or make a nicer park, but because society as a whole has decided to build a city around it - and it's this social decision that gives the land in Manhattan its value advantage. Land value taxation is therefore held to be fairer than improvement taxation because it merely takes back for society part of the extra value society has created without any effort on the part of the taxpayer.

That's exactly the situation with our games company. We can grow around $10 a share in corn, but putting that share in play on the market adds some societal value and getting a buzz going around it can have the effect of positioning it in the market's equivelent of downtown Tokyo.

That's the real basis for the "traders surplus" we see when Wall Street society overvalues Googles and undervalues a company like Sun, neither share price has much to do with how much corn they'll grow - and 4dt's price doesn't have to either. Get the market buzz on-side to begin with, and we'll get that $100 valuation for our $10 share.

Eventually, of course, some trader will start to short us and bring the value down to realistic levels -but who cares, we'll have our cash and it's just a game, right?

Well, yes and no. There are real consequences for real people. Many of the country's most creative businesses are constrained by a history of just this kind of disconnect between their actual productive capacity, and the valuation created by people who knowingly or unknowingly manipulate the company's trading surplus. Whether the market artifically raises the share price, as in google, or artifically depresses it, as in Sun, the resulting distortions affect every major decision management makes -generally in the direction of forcing them to exaggerate their real earnings potential during upswings and focus on very short term decision making, including laying off the people who comprise the company's real value, during downswings.

Paul Murphy wrote and published The Unix Guide to Defenestration. Murphy is a 20-year veteran of the IT consulting industry.