Reach for the Stars?

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The SpaceX IPO has led to a lot of debate between professional investors, journalists, and individual investors.  At risk of base simplification, I sense there are two camps: “SpaceX and Elon Musk strive and succeed in endeavours others believe are impossible” and “How can 131x revenue be a sensible valuation when it only takes one rocket to explode for it to go wrong?”.

A tech CEO's perspective

When asked which camp I fall in, my natural instinct is to fall back on one of my favourite quotations in finance from Scott McNealy who was the CEO of Sun Microsystems during the Tech Bubble.  Reflecting on the valuation of his firm in 2002, he noted that the shares were changing hands at 10x revenue.  Paraphrasing his comments, he outlined the absurdity of what this actually meant noting to get this valuation back in cash, he would have to pay out all revenue as a dividend, pay no costs, no tax (which would have been illegal) and no Research & Development for a decade just to break even.  In his words to investors after the event, “what were you thinking?”.

With this perspective in mind, I have attempted to estimate how many years one must wait to get one’s cash back if all net profit was paid out as a dividend (the payback period).  For my own interest, I undertook the same calculations for Apple (not owned, but the most profitable company in the world and widely owned), Shopify (an ecommerce operating system provider owned at Ptarmigan Capital) and Cigna (a US health insurer, also owned) as I feel these four businesses would be owned by investors with a broad range of risk appetite.

A quick explanation of discount rates

Discount rates mean different things to different people, but at its simplest a discount rate is the annual return you require before parting with cash today to receive cash later.  At purchase, it’s the price of risk and for waiting, at sale, it’s the annual return you would have made if your assumptions were perfectly correct.  Given this, the more confident you are in your assumptions, the lower return (discount rate) you require, the more uncertain your assumptions, the higher return you should require.

How many years before I get paid back by my investment if I don't sell it?

I have used the following assumptions, and please note these are designed to be illustrative “back of the envelope” calculations, not predictions!

I also assumed that after 5 years, revenue growth faded linearly to 3% for SpaceX, Shopify and Apple over 20 years, Cigna’s revenue continued to grow at 3%, and the net profit margins remained stable at the 5-year net margin rate.  This produced a surprising and interesting result in terms of nominal payback period in years, as well as under different discount rate assumptions:

The order was not what I, or I suspect most readers, would expect.  Cigna repays in roughly 11 years, Shopify 14, SpaceX 17, and Apple comes last at about 23.  Using the assumptions above, a 0.3×-sales insurer and a 131×-sales rocket maker both return your money faster than the most profitable company in the world.  This is because growth, even improbable growth, floods the later years with cash that a 3% compounder never produces. 

Conclusion

None of this makes SpaceX, Shopify, or Cigna cheap, nor does it make Apple expensive.  This analysis depends on my assumptions which could be wildly optimistic or conservative for all these companies.  Furthermore, there is no accounting for changes in financing or individual share counts.  But this simple analysis demonstrates that the safer looking investment on an optically lower valuation may be worse value than a riskier looking investment on an optically higher valuation.

In short, certainty is not the same as value and the believer reaching for the stars may, if the rocket flies, have his money back, while the prudent man may never be fully repaid.  Perhaps Francois Guizot was right, and the world really does belong to the optimists.

CDAJ

If you have enjoyed this article and would like to test the same arithmetic to see what the payback period is for another company, the model is available below:

Risk Warning & Disclaimer

This article is provided for general information purposes only and is not intended to constitute investment advice, investment research, or a personal recommendation. It does not take into account the investment objectives, financial situation, or particular needs of any individual or entity.

The model used in this article is for illustrative purposes only and is not intended to provide, and should not be relied on for, investment advice.  The conclusions drawn from the model are for informational purposes only.  Model outputs are only as good as the assumptions used as inputs, and no reliance should be placed on assumptions used in this article which have been selected to help demonstrate the impact of future growth on cash flow, rather than as detailed forecasts.  Ptarmigan Capital accepts no responsibility for any conclusions drawn from using this model.

The views expressed are those of Ptarmigan Capital as at the date of publication and are subject to change without notice. References to investment concepts, asset classes, or portfolio construction approaches are included for illustrative purposes only and should not be construed as a recommendation or a solicitation to buy or sell any security or financial instrument.

Drafting tools, including artificial intelligence and automated systems, may be used as part of our content production process, however all materials are subject to human review and approval.

The value of investments and any income derived from them may fall as well as rise, and investors may receive back less than they originally invested. Past performance is not a reliable indicator of future results. Where investments involve overseas assets, returns may be affected by movements in exchange rates.

Ptarmigan Capital Limited is an employee-owned investment management firm providing discretionary investment management services to private clients, trusts, charities, and family offices. This article is intended to explain the firm’s perspective on bespoke investment management and the factors some clients consider when choosing such an approach. It does not relate to any specific investment product or strategy.

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