5 Things Twitter Needs to Answer on Its IPO Roadshow Under traditional metrics, there is no way to justify Twitter's expected valuation. More answers are needed.

By Peter S. Cohan

Opinions expressed by Entrepreneur contributors are their own.

Michael Macor, The Chronicle

Twitter executives will fan out starting October 25 across the world's biggest money pools in search of a big first-day pop when it goes public on the New York Stock Exchange in November.

Unfortunately, Twitter does not appear to be concerned about showing investors that it can make a profit. And thus it will be impossible for them to have a reasonable basis for deciding whether its IPO price is fair in relation to the value of its cash flows.

This brings me to what I think is the most problematic part of investing in individual stocks: How do you know whether the price at which a stock is being offered is too high or too low? If you had a way to make that choice, you could buy when a stock was priced too low and sell when it got too dear.

All the techniques I know for figuring out a fair price for a stock are based on guesses about the future being plugged into equations. And there is no compelling evidence that the equations work or that there's a way of knowing that those guesses are right or wrong at the time of buying or selling the stock.

Two of many ways for guessing a fair price are the discounted cash flow (DCF) and price-earnings-to-growth (PEG) ratio approaches. With the DCF approach, you make a forecast of all the cash flows that you expect the company to generate in the future and then divide them by a factor that takes account of the risk and the timing of the cash flows.

If the stock price is less than the DCF of the company's cash flow, the theory is that you will make money if you buy the stock.

With the PEG-ratio approach, you have a simpler challenge. Simply divide the Price/Earnings ratio of the stock by its expected earnings per share growth rate. If that ratio is less than 1, the stock is cheap and you should buy it; if the PEG ratio is higher than 1, the stock is too expensive and you should stay away.

This brings us to Twitter's IPO. Unfortunately, we can't apply either approach based on Twitter's most recent financial filing. That's because Twitter is losing money at an accelerated rate – its third quarter 2013 loss was almost as big as the amount of money it lost in the first half of the year.

The good news for Twitter is that its revenue growth is nearly 100 percent – the $169 million in revenue that it generated in the third quarter of 2013 was almost double its 2012 revenue in that same quarter.

Thanks to the losses, investors have no history of profit on which to base either a DCF or PEG valuation of Twitter's offering price. But there is no doubt that investors will put a price on Twitter shares meaning that in theory people who attend its road show should be able to get the answers to five questions that would help investors to assign a value to its shares.

1. How fast will revenues grow over the next five years? How will that growth vary by source (e.g., advertising vs. selling user data)?

2. When will Twitter make a profit?

3. How much will Twitter's profit margin increase each year after that before leveling off?

4. What are the big investments that Twitter is likely to make and how big will they be?

5. What is the rate of return that Twitter's management expects to get from these investments?

I am not expecting Twitter's management to shed light on any of these questions, but I would be glad to get the answers to them. Based on reports that Twitter will be worth $15 billion when it goes public, with an estimated $560 million in 2013 revenue and what looks like could be a loss of about $180 million, I am struggling with how to justify that valuation.

And I do not know how Twitter's management could persuade investors that the answers to those five questions could plausibly justify what is likely to start off as a $15 billion valuation.

Nevertheless, I expect Twitter's shares to pop when it goes public, even though the people who buy those shares will be in no position – beyond saying that the shares are going up because they are going up -- to defend the logic for owning them.

Wavy Line
Peter S. Cohan

President of Peter S. Cohan & Associates

Peter Cohan is president of Peter S. Cohan & Associates, a management consulting and venture capital firm. He is the author of Hungry Start-up Strategy (Berrett-Koehler, 2012) and a full-time visiting lecturer in strategy at Babson College in Wellesley, Mass.

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