A Discount Rate fit for a KING.

$KING’s IPO yesterday was the worst first day performing IPO in 15 years for a US IPO raising at least $500M (via @IPOtweet)

For value investors and people that believe that equity prices reflect the value of earnings and cash flow of the company discounted back to today, this had to be real concerning.

There were so many huge IPO winners over the last few months, a few triple-digit winners in the biotech space, a few monster technology winners, and many more entering the pipeline. Many of these companies have little profits, if any. Some were subsequently trading at multiples of revenues that would normally be considered fair… if they were multiples of profits.

Then came $KING, with over $500M in FY ’13 profits, and their stock crashes? The stock closed today (the day following the IPO) at less than a $6B market cap and now trades at only 10.6x TTM earnings. Has the whole market gone haywire? (Don’t answer that please.)

DCF Basics. Why Discount Future Cash Flows?

One of the principals of fundamental analysis is called “DCF“ or “Discounted Cash Flow”.

An asset should be worth the money it will pay you over its lifetime. For example, a 5yr – 5% annual bond is straightforward. You know (assuming no credit risks) you will receive a payment annually for the next 5 years, and then at the end of the 5th year, you will receive the last interest payment as well as your principal back. So say you put in $10k, you will receive 5% or $500 each year, and then at the end of the 5th year, you will get the last $500 as well as the “original” $10k.

Now, although you are getting $12,500 in total, you will never pay $12,500 for those cash flows today. That is because there are many risks associated with you receiving those cash flows. There’s credit risk, (will the company / government / municipality have the ability or willingness to pay you) interest rate risk, (the higher interest rates go, bond prices will decline, all else equal,) inflation risk etc. You therefore have to “discount” all the money that you are expected to receive. The rate that you will discount the cash flows is called the “discount rate”. This rate should be comprised of all of the risks associated with receiving the cash flows. So say you want to discount the above cash flows (5yr bond) using a 7% discount rate, you plug it in your faithful BAII and you will get today’s current fair value of the bond… = $9,179.96.

The discount rate is an extremely crucial variable in the equation of finding the fair value of a security. In the above example if you were to change the discount rate to 3%, the current fair value would rise to $10,915.94.

Back to real life, people are currently willing to pay over 30x cash flow for certain investments (a 10 year Treasury bond), yet are unwilling to to pay less than 5x FCF for others.

The Treasury bond’s cash flows are guaranteed to come to you, you’ll get the interest payment every 6 months for the next 10 years, and you also know that the principal at the end will stay constant. So you only have to discount that money coming back to you for interest rate risk and inflation risk, but not for the risk that the cash won’t be there.

I recently read someone questioning why $AAPL has lower multiples than $MSFT. It actually makes a lot of sense. Even when you include the ecosystem $AAPL has built, $MSFT’s business is still way more predictable and certain.

Back to $KING, their profitability is undeniable. Their future profitability is what’s being question here. I believe they deserve a king’s size discount rate.

As a value investor – since it’s all about discounting future cash flows – many times a non-profitable company might actually be worth more than a currently profitable one.

If a company is currently non-profitable because they are investing in their business and building competitive advantages, a moat, barriers to entry etc. then their future earning – because of these current investments – are actually more reliable and predictable. This causes investors to discount these future expected earnings by a lower discount rate.

$KING on the other hand is in the business of creating hit games. 78% of  2013 Q4′s gross bookings came from a single hit game (Candy Crush)! Add their second and third highest grossing games and you accounted for 95% of the companies Q4 gross bookings!

Look at $ZNGA and their Farmville franchise, look at OMGPOP and their Draw Something game which $ZNGA paid $183M for only to shut it down a little over a year later.

(I owned $ZNGA in the past, we began to recommend it to clients when it was trading at a tiny premium to their cash and RE value. We were paying almost nothing for their “hit” potentials, so it had tons of optionality with little downside risk from a margin of safety perspective.)

Make no mistake, this is a fickle hit driven business! How can anybody with any kind of certainty, conviction, or even a high level of probability predict what $KING will earn in 2 or 3 years, let alone 5 or 10?!

Off the top of my head, I can’t think of any other business / business model that builds so little in regards to protecting its future.

Even $FB – who crushed MySpace, the then overwhelming leader, who supposedly had built a moat via its network – even they have created a real entrenched business. I would wager that a majority of all websites have code written into their sites with Facebook in mind.

Looking at content creators (movies, shows etc) at least have relationships with writers, actors, production sets, equipment etc. not anybody off the street can come in and start producing quality movies.

From $KING’s F-1: “We face significant competition, there are low barriers to entry in the digital gaming industry, and competition is intense.”

The only game I’ve been hearing about the last few days is this 2048 game that was written by a 19 year old just a few weeks ago! A few months ago it was all about Flappy Bird, a game that was created over a span of just two to three days by a single developer! There are absolutely no barriers to entry, no start up costs, no patents, nothing.

Will $KING stay profitable? Very possibly. They are investing so much more money than their competitors so it’s so much more likely they will have at least a few hits each year. Will these hits be the size of Candy Crush? I doubt it.

If the past is any indication, it’s just a matter of time before gamers churn away from Candy Crush and $KING’s MAUs fall off a cliff along with 78% of the company’s revenues.

- Aron

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4 Responses to A Discount Rate fit for a KING.

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  2. Michael D. says:

    King’s ipo has proven that sometimes the market disregards that you are profitable.
    King is being punished for an expected downtrend that has not happened yet.
    King is punished for having developed the most profitable game franchise in game history. With billions of games played weekly, it is absurd that the market reacts this way to a company that is KING.
    Any company that is not profitable deserves to be punished.
    But KING with an IPO size of 24 million shares, the sp movement is clearly
    a manipulation by a few big traders….
    The opinion of the market and many of its columists does not make sense, but it does line up, if some of the bloggists are paid to give KING a thumbs down on its IPO the day of its offering while some Hedge Funds play games with the tape.
    For greed, market players will do anything, sometimes borderline illegal.
    In one of the most contreversal interviews posted on YouTube Jim Cramer explains how, he as a hedge fund managers, would manipulate people into believing “altered truths” so that the share would jump oe crash , in line with his position.
    I do not own KING.
    But I do believe that KING will deliver better results, way above theo expectations of a misinformed group of analysts.
    In the end, as games are released, for as long as the improvements enhance user satisfaction, users have their favourites , just as people have their favourite restaurants.
    They will try out that new pizza parlour, or sign up to the new gymm, but people love to return to their habits.
    If I was in the drivers seat at KING, I would keep improving the games, because in the end, you want your customers to come back right?

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  4. Aron,

    Point taken and well-put. Although I personally question whether an investor should fidget with the discount rate to get to an NPV value. My reasoning is that since enough assumption already goes into the drivers, where uncertainty of outcome and the wide/narrow NPV distribution should already be reflected, having a fixed hurdle rate as the discount rate is sufficient (let’s say 10%). Having a variable discount rate, I think, complicates the decision process unnecessarily since the % difference is rather un-intuitive (what’s the difference between a 8% dis. rate vs. 10%?) . In other word, the variablility should come from the driver side (which is explicit and easy to understand), not the discount & compounding side.

    On King in particular, I have a framework for these hit-driven companies similar to yours — I simply calculate the NPV of 1 Candy Crush (the whole life cycle), and back-out how many of the hits the current EV implies. At this point I am getting to about 4-5 Candy Crushes WITHOUT discounting, and that’s ludicrous in my count, similar to Nintendo’s valuation in 2007. Anyone valuing the company based on whatever forward earnings / FCF is simply dilusional, and i feel like the best way, as you pointed out, to speculate in these companies is to buy them when the market is not implying any successful hits in the future while scuttlebutt research suggests otherwise.

    Best,
    Dislocated Value

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