Tuesday, November 19, 2013

Value in the eye of the storm: Why you should welcome uncertainty!

One of the responses to my last post on valuing young companies was that even if you can value companies early in the life cycle, you cannot do so with any degree of confidence. I concede that point, but that is exactly why I would try to value them! I know that statement makes little sense, but to solidify my argument, take a look at the following list of five assets/entities and rank them on the basis of the confidence you will feel in valuing each one (I have provided my rankings and the reasons in the table).
Valuation Setting Your precision ranking My precision ranking My reasons
$20 in an envelope

(1) Absolute  Nothing to forecast & no risk to adjust for.
A mature, money making company in a stable macroeconomic environment

(2) Very high You can use both company & macroeconomic history in making forecasts.
A mature, money making company in an unpredictable macroeconomic environment

(3) Average While company is stable, macroeconomic shifts can cause earnings/cash flows to change.
A young, money losing company in a stable macroeconomic environment

(4) Low You have no history and know little about market. Lots of unknowns, at least at the company level.
A young, money losing company in an unpredictable macroeconomic environment

(5) Very little The uncertainties you face at the company level are multiplied by uncertainties about interest rates and economic growth.
My guess is that your rankings will match closely to mine. Cash in an envelope is easier to value than an ongoing business, an ongoing stable business is easier to value than a young, growing business and valuations in general are easier when interest rates and economic growth are stable/predictable than when they are not.

Now that we have dispensed with that formality, I think it is worth asking a more complex question. If valuation is designed to find investment bargains, what is the payoff to doing valuation in each of these settings? Note that the game is now different, since your advantage does not come from the precision of your valuation but in its relative precision: How much more precise is your estimate of value for a given asset is than the estimates of others valuing exactly the same asset? Here is my attempt to look at my potential differential advantages (and I would encourage you to do the same).
Valuation Setting
Differential Precision
$20 in an envelope
(5) None.
A mature, money making company in a stable macroeconomic environment (4) Very little (unless I cheat and use inside information, which would of course bring the SEC's wrath to bear on me). The estimates come from historical data and are unlikely to shift very much, since the macroeconomic setting is stable. Valuation modeling is trivial and you can use historical PE ratios or stable growth cash flow discount models to value the company.
A mature, money making company in an unpredictable macroeconomic environment (3) Your differential advantages can come from being able to incorporate the macroeconomic uncertainty into company forecasts and valuing the company. If the macroeconomic uncertainty is large enough (say, at crisis levels), other investors may stop trying to value even mature companies (remember late 2008), essentially conceding the game to you.
A young, money losing company in a stable macroeconomic environment (2) Your differential advantage comes from researching the business the company is in, understanding the company's products and being willing to make forecasts (knowing that you are going to be wrong). Again, with enough uncertainty, other investors will not even try to value these companies , focusing instead on rules of thumb, unusual value metrics (value per user) or short term numbers (earnings next quarter).
A young, money losing company in an unpredictable macroeconomic environment (1) Your differential advantage will come from just trying to make estimates, in the face of immense uncertainty, when everyone else has long since given up any attempt to estimate value.
My motto is that you don’t have to be right to make money, but just less wrong than everyone else in the market. That makes my odds best in exactly those environments where I am uncomfortable and uncertainty is overwhelming.

Wielding Ben Graham’s tome on security analysis as a weapon, old-time value investors will probably take issue with this argument, pointing to the efficacy of the time-tested value investing conventions, where you are told to stay focused on companies with solid earnings and cash flows, with superior management. I would be inclined to concede the argument, if active value investing, as practiced today, actually worked, but there is little evidence that it does, at least in the aggregate, as I argued in this paper. In fact, there is evidence, albeit weak, that the average active growth investor beats a growth index more frequently and by more than the average active value investors beats a value index. That does not surprise me in the least, since it is in keeping with my thesis that the best investment opportunities are in the volatile, growth sectors.

I think that Ben Graham, if he were writing his book today, would be much less rigid in his view of value than the classicists. The real lesson that I get from reading Graham’s writings is that value is determined by fundamentals and that markets sometimes misread or ignore those fundamentals. My addendum is that investors are more likely to misread and/or ignore fundamentals, when they are faced with large uncertainties than with small ones.

In closing, there are three general propositions about valuation that flow from my view of uncertainty.
  1. The more comfortable you are in valuing a company, the less point there is to doing that valuation. After all, the factors that comfort you are just as likely to comfort others valuing that company.
  2. If you wait for the uncertainties to resolve themselves before you value a company, it is too late for a valuation. In the midst of crises or uncertainty, it is human nature to want to wait, until there is resolution, before committing to valuation or investing. It is precisely at the moment of crisis, though, that your valuation skill set will provide the biggest payoff, if employed. So, you should have been valuing banks in November 2008, Greek companies in 2009 and 2010 and emerging market companies earlier this year. Using a specific example, many global investors are holding back on investing in India, waiting for the election that is scheduled next year, making me more interested in valuing Indian companies today, and especially those that are more likely to be affected by the election results.
  3. If most investors contend that something cannot be valued, you should try to value it. As I noted in my last post, I think that the status quo (where young companies are not valued) suits both investors and traders, the former, because they can stay above the fray, attributing any profits to be made in in these companies to gambling, and the latter, because they feel no obligation to even pay lip service to fundamentals.
If you have found conventional valuation to be an extension of accounting and therefore boring (I am sorry! My biases are showing!), you should try valuing young, growth companies instead, to see how much fun it can be to connect stories to numbers and narratives to value. So, rather than value 3M or Coca Cola for the hundredth time, why not try valuing Tesla, Yelp or Pandora? And if in the process, you make some money, that is just icing on the cake, right?

Monday, November 18, 2013

Valuation Myths: Young companies cannot be valued

Twitter is now officially a publicly traded company, and I am glad that we no longer have to debate the IPO price and what will happen in the aftermath. While the opening may have veered a little off script, to the extent the price popped a little more than “desirable”, I am sure that the bankers, the preferred clients who were able to get the shares at $26/share and even the owners who left money on the table (just over a billion dollars) are all happy with the outcome, at least so far. While they may be tempted to claim “mission accomplished”, I think that there are a few more rounds to go before we make that judgment.

In an earlier post, I noted the divergence between investors, who trade based on value, and traders, who make judgments about price movements, and how they often talk past each other. If you have been following the conversation about Twitter online or in the financial media, the last week has also brought reminders about enduring myths about the valuing and pricing of young, growth companies that both sides seem to hold dear. At the risk of irking both groups, I would like to argue that they are holding on to preconceptions that are not only shaky and self serving, but also damaging to their portfolios.

Investor Myths
Let’s start with the three misconceptions that some “value” investors have about young, growth companies.
  1. Young, growth companies cannot be valued: How often have you heard someone say that young companies cannot be valued because there is too much uncertainty about the future? This rationale is used by value investors not only to avoid entire segments of the market but as a shield against even discussing the value of young, growth companies. While it is true that there is more uncertainty about the future prospects of a young company than for a mature business, you can still make estimates of expected earnings and cash flows into the future and value the company, as I tried to do in these spreadsheets to value Tesla and Twitter. You can and should take issue with my assumptions and come up with your own values for both companies but you cannot argue that these companies cannot be valued.
  2. Even if you can value companies, that value will change significantly over time (making it pointless): As you learn more about a new company, from its early operating successes and failures, you will reassess value and your estimates will change, often significantly over time.I know that bothers some value investors, because they have been taught (wrongly in my view) that intrinsic value is stable and should not change over time. I am not bothered by the volatility in my value estimate, since the information that causes my estimate of value to change will also cause the price to change, and generally by far more. As an illustration, let me point to Facebook, a company that I have valued a half dozen times since its initial public offering in March 2012. My initial estimate of value for the company on the day of the offering was $27.07, well below the offering price of $38. A few months later, after a disappointing earnings report that suggested that their mobile advertising revenues may be lagging, I re-estimated the value of Facebook to be $23.94, a drop of approximately 13%, but the stock was trading at just under $19 (a drop of 50%). In fact, my value for Facebook has ranged from $24 to $30, while the price has fluctuated from $18 to $51. If your payoff in value investing is in finding mispriced stocks, I think that your odds are much better with stocks like Facebook and Twitter, where both your estimates of value and the market prices are subject to change, than in mature companies like Exxon Mobil or Coca Cola, where there is more consensus about the future, and fewer uncertainties.
  3. Young, growth companies are always over valued. This is an insidious myth that can be attributed to one of two forces. The first is that some value investors are born pessimists, who seem to believe that making bets on the future is a sign of weakness. The second is that some value investors rely on approaches for estimating value that are not only outdated, but simplistic. If your measure of value is to apply a constant PE (say 12) to next year’s earnings or to use a stable growth dividend discount model to value equity, you will never find a young, growth company to be a bargain. If you are creative in estimating value, willing to make assumptions about the future, persistent in tracking that value and patient in terms of timing (your buying and selling), there is no reason why you should not find growth companies to be bargains. I did not like Facebook at $38/share in March 2012 but I loved it at $18/share in September 2012, and while I would not touch Twitter today at $42/share, I would be interested at $15/share.
Trader Myths
On the trading side, there are two broad misconceptions about “value” that are just as misplaced and as dangerous as the three myths that value investors hold on to.
  1. With young growth companies, value does not matter. This is, of course, the mirror image of the value investors’ lament that a young growth company cannot be valued. While value investors use it as a reason to not invest in the company, traders use it as a reason to ignore value, arguing that if no one can value a company, its price is entirely a function of what the market thinks it is, rather than fundamentals. Perception may be all that matters if you are pricing a piece of art (like this one that just sold for $142 million), but it cannot be with a share of a publicly traded business. After all, no matter what the promise or potential of a company, the stories eventually have to show up as numbers (revenues and earnings), and if perception is at odds with reality, it is perception (price) that will change, not reality.
  2. Even if value does matter, it is best determined by focusing on the short term, where you have a chance of estimating numbers, rather than on the long term. With young, growth companies, analysts seem to prefer that the focus stay on the short term – next quarter, next year or perhaps two years out, using the excuse that going beyond that is an exercise in speculation. Ironically, it is the end game (the long term) that determines the value of young companies, rather than the near-term results. Put differently, it is not how Twitter does in 2014 that will be the arbiter of its value, but how the choices it makes in 2014 affect its long-term growth path. 
I know that you are probably still skeptical about whether you can value young, growth companies and I empathize. I have struggled with young company valuations both technically (in coming up with cash flows, growth rates and discount rate) and psychologically (in fighting the instinct to flee from uncertainty) and I know that I will never quite master the process. However, each time I value one of these companies, I learn something new that I can incorporate into my tool kit. I have taken some of these lessons and put them into this paper on dealing with uncertainty that you are welcome to read (or ignore). Better still, pick a company that you are convinced cannot be valued and try valuing it. You may find it difficult, the first time around, but I promise you that it will only get easier. And it is so much more fun that valuing a utility or a bank!

Monday, October 28, 2013

The Twitter IPO: Thoughts on the IPO End Game

The Twitter IPO moved into its final phase, with the announcement last week of the preliminary pricing estimates per share and details of the offering. The company surprised many investors by setting an offering price of $17 to $20 per share, at the low end of market expectations, and pairing it with a plan to sell 70 million shares. Having posted on my estimate of Twitter’s price when the IPO was first announced and following up with my estimate of value, when the company filed its prospectus (S-1) with Twitter, I thought it would make sense to both update my valuation, with the new information that has emerged since, and to try to make sense of the pricing game that Twitter and its bankers are playing.

Updated valuation
In my original valuation of Twitter, just over a month ago, I used the Twitter's initial S-1 filing which contained information through the first two quarters of 2013 (ending June 30, 2013) and the rough details of what investors expected the IPO proceeds to be. Since then, Twitter has released three amended filings with the most recent one containing third quarter operating details and share numbers that reflect changes since June 30. Incorporating the information in this filing as well as the offering details contained in the report leads me to a (mostly minor) reassessment of my estimate of Twitter’s value.

Operating Results: Twitter’s third quarter report contained both good news and bad news. The good news was that revenue growth continued to accelerate, with revenues more than doubling relative to revenues in the same quarter in 2012, but it was accompanied by losses, which also surged. The table below compares the trailing 12-month values of key operating metrics from June 2013 (that I used in my prior valuation) with the updated values using the September 2013 reports:

As with prior periods, the R&D expense was a major reason for the reported losses and capitalizing that value does make the company very mildly profitable. Note that while the numbers have shifted significantly, there is little in the report that would lead me to reassess my narrative for the company: it remains a young company with significant growth potential in a competitive market. Consequently, my targeted revenues in 2023 ($11.2 billion) and the operating margin estimates (25%) for the company remain close to my initial estimates (October 5).

IPO proceeds: In the most recent filing, the company announced its intent to issue 70 million shares, with the option to increase that number by 10.5 million shares. In conjunction with the price range of $17-$20 that is also specified, that implies that the proceeds from the offering will range anywhere from $1.19 billion (70 million shares at $17/share) at the low end to $1.61 billion (80.5 million shares at $20/share) at the high end. In my valuation, I will assume that the offering will happen at the mid-range price ($18.50) and that the option to expand the offering will not be utilized, leading to an expected proceeds of $1.295 billion.

Share number: As with most young companies, the share number is a moving target as options get exercised and new shares are issued to employees and to fund acquisitions. In the table below, I compare the share numbers (actual, RSU and options) from the first S-1 filing with those in the most recent filing:
The share count has increased by about 8.02 million shares, since the last filing, while there has been a slight drop off in options outstanding. (Note: The most recent filing also references 80.3 million shares for future issuance to cover equity incentive & ESOP plans that I have not counted.)

The final valuation is contained in this spreadsheet, but it has changed little from my original estimate, with the value per share increasing to $17.84/share from my original estimate of $17.36/share. The picture is below:

Reading the pricing tea leaves
Now that the company (and its bankers) have announced a price range ($17-$20) that is close to my estimate of value, my ego, of course, wants me to believe that this is a testimonial to my valuation skills but I know better. There is a fairy tale scenario, where my value is right, Goldman Sachs has come up with a value very close to mine and the market price happens to reflect that value. It is a fantasy for a simple reason. As I noted in my price versus value post, the IPO process has little to do with value and everything to do with price, and given how the market is pricing other social media companies, I find it difficult to believe that price and value have magically converged, with Twitter.

Accepting that the closeness of Goldman’s pricing of Twitter to my estimate of value is pure coincidence frees me to think about what it does tell me about the bankers' (and the company’s) view of what they see as a “fair price” for Twitter. If Goldman and the banking syndicate are pricing Twitter at $17-$20, I am inclined to believe that they think that the “fair price” today is higher for the following reasons:
  1. The underwriting skew: The Twitter IPO, like most public offerings, is backed by an underwriting guarantee from bankers that they will deliver the agreed upon offering price. If the offering price is set too high, relative to the fair price, that creates a substantial cost to the bankers, whereas if it is set too low, the cost is much smaller. Not surprisingly, IPOs tend to be underpriced, on average, by about 10-15% as I noted in this prior post.
  2. The PR twist: There is a public relations and marketing component to what happens on the offering date that cannot be under estimated. To provide a contrast, look at the reactions to the Facebook and Linkedin offerings in both the immediate aftermath of and in the weeks after the offering. While both IPOs were mispriced by the same lead banker (Morgan Stanley), with Facebook being over priced and Linkedin being under priced, Morgan Stanley was bashed for doing the former and emerged relatively unscathed from the latter. In the months after the offering, Facebook saw its shares lose more ground, as institutional investors abandoned it, while LinkedIn shares were carried higher, at least partly because of the opening day momentum. 
  3. The feedback loop: I know that the bankers have been testing out the level of enthusiasm among investors for the Twitter offering and I find it difficult to believe that they are not incorporating that into their pricing. In other words, if they want excitement at the road show, it will come from investors thinking that they are getting a bargain and not from being offered a fair deal.
My completely uninformed guess is that the bankers think that Twitter’s fair price is closer to $25/share and that they have set the range at roughly 20% below those estimates. If the offering goes as choreographed, here is how it should unfold.

  1. The road show will be well received and the bankers will announce (reluctantly) that the high enthusiasm shown by investors has pushed them to set the offering price at $20/share. 
  2. Institutional investors will start lining up for their preferred allotments at that offering price and the enthusiasm bubble will grow.
  3. On the offering date, the stock will jump about 20%-25%, leading to headlines the next day about the riches endowed on those who were lucky or privileged enough to get the shares in the offering.
  4. Some of the rest of us, who were not lucky or privileged enough to be part of the offering, will be drawn by these news stories into the stock, pushing the price higher, and keeping the momentum game going. 
  5. In a few months or perhaps a year, some of the owners of Twitter (big investors and venture capitalists) will be able to sell their shares and cash out. 

So, what can go wrong with this script? The biggest actor in this play is Mr. Market, a notoriously moody, unpredictable and perhaps bipolar (though that may require a clinical judgment) character. As was the case in Facebook, a last minute tantrum by Mr. Market can lay waste the best laid plans of banks and analysts. 

Winners and Losers
Some of you may take issue with my cynical view of the IPO process, arguing that this is not a play or a game and that there are real winners and losers in the process. While this is generally true for any investing process, who are the losers in this process? By under pricing IPOs, the existing owners of the company going public are leaving money on the table. In the aftermath of the Linkedin offering, where the offering price doubled on the opening day, there were stories that the company had been scammed by bankers. Before you feel too sorry for Evan Williams and the venture capitalists, who are the primary owners of Twitter, you should take into account two facts:
  1. Only a small fraction of the equity is being offered to the public on the offering date: If all of Twitter being offered for sale on the offering date, an underpricing of 20% (selling the shares at $20, when the fair price is $25) would cost investors almost $3 billion in value (since the company would be priced at $12 billion instead of $15 billion). However, as noted earlier, only $1.2 to $1.6 billion will be offered to investors in the IPP. Even if you take the upper end of this amount ($1.6 billion), a 20% under pricing would translate into a loss of $400 million to the owners. While that may be a lot of money to most of us, it would work out to about 3% of overall value for the existing owners.
  2. The existing investors in Twitter are neither babes in the wood nor naïve fools: The current owners in Twitter are a who's who of venture capital investing, entirely capable of watching out for their own interests and just as likely to use bankers as they are to be used by them. Rather than being victims here of the under pricing, they are willing accomplices in this pricing process, who view the loss on the opening day as a small cost to pay for a more lucrative later exit.
There are some winners, though none of them emerge unscathed from the process. The first are the bankers, who by under pricing the offering enough, render the underwriting guarantee moot and get paid for it anyway. Here again, though, issuers are not entirely helpless and Twitter managed to get a discount on the underwriting fees. The second are those investors who are allotted shares at the offering price, many of whom are preferred clientele for the banks. They generally tend to be wealthier investors (institutions and individuals) who bring in revenues in other ways to the banks (as private banking clients or through trading). Since banks are not altruistic, I am not sure that these preferred clients end up with a bargain if you count the other fees they fork out to banks. The third is the financial media (and that includes bloggers) that can use the IPO as grist for the mill, churning out endless stories (and blog posts) about the IPO.

Cut out the bankers?
If you buy into my cynical view of the Twitter IPO, it does make the whole process seem like a charade and raises questions about whether it is needed. What if we could skip the bankers, the offering price, the road shows and the endless debate about what will happen on the offering date and just go directly to the offering?  It is true that bankers play other roles in the process that may be difficult to replace in some IPOs, but I am not sure that can be said about their role in Twitter.

Banker's role
The Twitter IPO
If investors have never heard off or know little about a company, the banker may provide credibility to the company with investors.
Not only is Twitter as recognized a name as Goldman Sachs, it may have more credibility with investors.
Bankers can price the stock, not only by looking at what the market is paying for similar stocks, but also by testing the price with investors.
Since the stock has had VC transactions as well as acquisitions where the stock has been effectively priced, the banker has less work to do.
Use their sales forces and road shows to get investors interested in the stock and excited about the offering.
The sector is already "buzzed" and if you set the price at 25% below the “fair” price, you don’t really have to sell it very much.
Post-offering price support
In the months after the offering, the bankers may step in and provide  price support in the face of selling.
With a $12 billion company, banks don’t have the capital or deep pockets to provide more than surface support.
Corporate Finance advice
Guide the company in financing & dividend policy and in interactions with markets.
Bankers know little about running social media businesses, which don't use much debt and have no cash to pay dividends/ buy back stock.

Looking at the facts, I think that Twitter could have saved itself some money and time if it had followed Google and chosen an auction process for its public offering. After all, if your job is pricing, who does it better than the market? On the other hand, the ceremony and ritual of the IPO process, useless and predictable though it might be in most cases, may play a role in easing the transition of the company to the public market place and setting a narrative for the momentum game.

What now?
So, now that we have a sense of where Twitter will be priced and what will happen on the offering date, what next? Here are the four options:
  1. Try to get an allotment of shares at the offering price:  While the odds may be in your favor, it is definitely not a risk free or costless strategy and please do pay heed to some of the suggestions in this post
  2. Wait until the offering date and play the momentum game: The trading game begins on opening day and stocks like Twitter are a momentum investors' dream (and nightmare) as prices are moved up and brought down by wisps of information and mood changes. If you are good at this game, you can play it for profit, as long as you do not let delusions of being an investor get in the way.
  3. Buy the stock as a long term investor: I do not have a  deep rooted aversion to buying young or money losing companies, if the price is right. Given my estimate of value ($18/share), the stock would be, at best, a fair value at the offering price and I can think of far less ulcer-inducing investments that earn their fair value. That does not mean that Twitter will never be on my radar. If the momentum game turns against the stock and the price drops to $10/share, I will be ready to buy.
  4. Entertainment/ educational value: I am enjoying and will continue to enjoy every moment of this IPO for sheer entertainment value, as I listen to analysts make hilariously ill conceived arguments for or against the stock and portfolio managers act as if they are making reasoned judgments about value while desperately checking out momentum indicators. This is the ultimate reality show and I am just waiting for Ashton Kutcher, Kanye West and Lady Gaga to show up as Twitter IPO experts on CNBC.

Tuesday, October 22, 2013

Valuing Athlete Earning Potential? Tracking Arian Foster!

In a week during which both Google and Netflix hit all-time highs, you would think I would pick one of these high fliers for special valuation attention. While I still plan to look at these companies, I am going to spend this week on a quirky valuation challenge: valuing tracking stock on a star athlete’s future income. Last week, a company called Fantex filed an S-1 (prospectus for a forthcoming security issue) with the Securities Exchange Commission, making public its intention to issue tracking stock on Arian Foster, a star running back for the Houston Texans in the National Football League (NFL). In the filing, Fantex reported that it had paid $10 million in early October to Mr. Foster in return for 20% of all contract and endorsement income that he will earn after February 28, 2013. The S-1 also specifies that Fantex plans to raise approximately $10 million (thus covering its outlay) from the issuance of 1.055 million Arian Foster tracking shares to the public, and use its share of Mr. Foster’s income to pay dividends to these shareholders. The picture below captures the initial set up: 

Fantex intends to use its platform to attract more athletes and celebrities into the mix, thus creating a portfolio of tracking shares that can be traded by investors. 

Arian Foster: Background 
Arian Foster was born on August 24, 1986, and is a running back for the Houston Texans. He played college football at the University of Tennessee and was signed as an undrafted free agent by the Texans in 2009. In 2010, he had a monster year, leading the NFL in rushing, yards from scrimmage and touchdowns. He continued with impressive performances in 2011 and 2012, as can be seen in his career statistics page

Arian is also clearly a self-promoter (in the best sense of the word) and has aspirations beyond the gridiron. He has his own website, where he characterizes himself as an all-pro running back, entrepreneur, philosopher and father. 

On March 5, 2012, Arian signed a five-year contract with the Texans worth $43.5 million. The contract had a guaranteed payment of $20.75 million, including a signing bonus of $12.5 million, his first year salary (2013) and $3.25 million of his second year salary (2014).  He is also entitled to bonus payments, based on performance in games, of up to $5.25 million in 2013, $5.75 million in 2014, $6 million in 2015 and $6.5 million in 2016. He is a free agent in 2017. 

Claim and Contract details 
To value the claim on Arian Foster’s income, you need to break down the cash flow claims that you have on the income. Note that while Fantex has a contractual claim on 20% of Foster’s future income, investors in the tracking stock don’t have that direct claim. Instead, they are dependent on the dividends that Fantex chooses to pay out from that income. 

As noted in the figure, there are at least two expenses that Fantex will incur that will make the dividends paid less than the income that they get from Foster. The first is that a portion will be set aside to cover the expenses associated with managing and maintaining the Fantex platform. The second is that Fantex views its role as not just a contractual intermediary but also as a brand building organization. Effectively, that implies that Fantex can and will use some of the Foster income to market him better (and hopefully increase endorsement income). 

To value the Foster tracking stock, we will go through three steps. In the first, we will lay out broadly the risks faced by investors in the tracking stock. In the second, we will value the cash flow claim that Fantex has on Foster’s contract and endorsement income. In the third, we will evaluate the claim that investors in the Foster tracking stock have on the dividends they receive from Fantex.

The Risks 
The S-1 goes to great lengths to emphasize the point that this is a speculative investment, but since that should have been obvious to anyone thinking about the investment, it is important that we break down the risks at each stage of the process: 

Working the risks through the pipeline, here at the layers of risks that we see, starting with risks to the earning stream and then moving on to risks in the intermediary and ending with risks at the investment level.
Earnings Risks
1. Player Risks
The most immediate impact on player earnings comes from the athlete with two big risks to earnings: injuries that are career ending or a drop off in performance skills, either as a result of age or earlier injuries.
1.1. Player Skills/Longevity
A. Player Injuries: If you are laying claim on a professional athlete’s future earnings, you are exposed to any injury/event risk that impedes his or her capacity to perform on the field. Part of this risk can be mitigated at the contract level, if you have guaranteed income (that will be paid even if the athlete is injured) but it will still affect the athlete's earnings power in terms of getting contract renewals & bonus income.
Arian Foster shares: Foster's guaranteed income on his contract has dwindled down to $3.25 million and almost all of his remaining income will be at risk if he is injured. While Foster has been durable through his early years, there are two reasons to worry. The first is that he just hurt his hamstring this season, an injury that may keep him out for a portion of the season and may be a harbinger of things to come. The second is that injuries tend to climb as athletes age, and especially so for running backs whose bodies take significant punishment on the field. 

1.2. Player performance
While a player’s current contract may be unaffected by declining performance, there are two reasons why it will feed through into the earnings claims. First, if there are bonus payments, as is the case with Arian Foster, they will clearly be put at risk, if performance deteriorates. Second, to the extent that you are counting on a continuation of earnings from a contract renewal (from the current team or another team), future earnings will be lower, if the player’s performance deteriorates. 
Arian Foster shares: Age has to be factored into the equation since he is 27 in a sport where running backs seem to age faster than everyone else in the field. One assessment of running back output based on age yielded the following graph on production for running backs (and quarterbacks): 

Note that output for running backs peaks early (24-25), levels off until about 27 and starts deteriorating after that age. Foster may very well be the exception to this rule, but it is dangerous to bet against history. 

2. Macro Factors
There are two macro level risk factors that can affect a player’s earnings. 
2.1. Collective Bargaining Constraints
In most sports, there is a players’ union that negotiates with team owners on both contract rules and constraints. While individual players may negotiate on their own behalf with teams, the constraints imposed by collective bargaining agreements may affect earnings potential for individual players. For instance, the hard caps on team payrolls imposed in the NBA and NHL and even the soft caps in the MLB (soft, because they can go over the cap as long as they pay the penalty tax) have affected player negotiations and contracts. 
Arian Foster Tracking stock: The NFL’s current salary cap is $123 million per team and each team is required to spent more than 95% of that cap. Both teams and players, though, have become adept at evading the cap constraints by loading more of the payment into future years. With Arian Foster, I am going to assume that this will be a minor factor. 

2.2. Economic factors
The magnitude of a player’s earnings may be affected by the overall economy, especially if a large proportion comes from endorsement income and that income is expected to grow over time. The growth in the aggregate economy can also affect revenues to a sport in the aggregate and thus indirectly affect how much can be paid out in contracts to players. 
Arian Foster Tracking stock: Since only a small portion of Foster’s current earnings (less than one million) came from endorsements in 2013, the impact of the overall economy on his earnings is likely to be small. 

3. Player Default 
Even if the athlete in question generates high earnings, the earnings stream to investors is dependent upon that athlete carrying through his side of the contractual agreement and delivering the promised portion of earnings to investors. If the athlete defaults on that obligation, your earnings down stream are at risk. You could, of course, seek legal recourse but given that an athlete who defaults is also likely to have other financial problems, it is unlikely that you will get much of your promised payback. 
Arian Foster shares: We have little evidence on Arian Foster’s default history. The strongest case that can be made for him is that he is ambitious and hopes to parlay his pro career into entrepreneurial ventures. Presumably, that will mean that he will not be cavalier in defaulting on contract obligations. That does not mean that there is no default risk but we will assume low default risk. 

4. Intermediation Risks
Investors don’t have a direct claim on Arian Foster’s earnings, since those earnings will be first collected by Fantex, which will then decide how to much of these earnings will be returned to investors as dividends. Consequently, there are three additional risks to factor into the assessment: 

4.1. Poor brand building investments
Fantex views itself as a brand builder for the athletes who decide to use it. That would imply that some of the earnings collected from the athlete will be spent in trying to increase earnings in the future, primarily from endorsements. There are no guarantees, though, that this trade off will be a positive one. Thus, it is possible that Fantex will expend 20%, 30% or even 50% of Foster’s earnings, trying to increase his marketability, with no discernible effect on endorsement earnings. 

4.2. Spillover risks
 One of the stranger features of the Arian Foster stock is that investors in the stock may be called upon to bear losses incurred by Fantex on other athletes that it may have in its portfolio. Thus, if Fantex makes a big up front investment in a potential superstar (Andrew Luck) and that star suffers a career ending injury, investors in the Foster stock may take a hit. 

4.3. Corporate governance risk
The nature of tracking stock is that holders of the stock are onlookers when it comes to corporate governance, since they have no power to change or even influence managers. This is going to be a factor on two levels. The first is that Fantex will take a portion of the collective revenues it gets from player earnings to cover management expenses & fees; if it keeps “too large a portion” of the earnings for these expenses, there is little recourse for you as an investor. The second is that Fantex is not required to pay the residual earnings (after brand building expenses, management expenses and other portfolio charges) to investors) as dividends. While this is always a problem with publicly traded company stock, investors in conventional shares get a claim on the cash balance which may compensate (at least partially) for the unpaid dividends. There is no such compensating claim with tracking stock. 

5. Investment Risk
If you are an investor who decides to buy Arian Foster tracking stock, there is one final risk that has to come into the picture. Since there is no ready market (yet) for these shares, it may be difficult and expensive to liquidate these investments. In valuation, that is generally a reason for either charging a “illiquidity premium” in your discount rate (increasing the discount rate) or attaching an “illiquidity discount” to the value. The extent of the effect will depend upon how much you value liquidity as an investor and how easy/difficult it is to trade these shares. 
Arian Foster tracking stock: Since this is the first set of tracking stock, I will assume that there is substantial illiquidity risk. That risk may decline over time as more athletes get listed and the Fantex trading market becomes more liquid, but neither is a reality yet. 

Valuing the Fantex Claim 
To value the claim on Arian Foster's earnings, I began by forecasting aggregate earnings to Arian Foster. In making these forecasts, I assumed that:
  1. Expected playing time: I will assume that Foster will play for nine more years, until the age of 36, at which point both his contract income and his endorsement income will end.
  2. Current contract: The current contract would deliver on the remaining $23.5 million due between 2013 and 2016. On average, that works out to $5.875 million a year. During the current contract period, I will also assume that he will earn approximately $2 million in bonuses each year, approximately a third of his overall potential bonus payments.
  3. Contract renewal: At the end of the current contract period, I am assuming that Arian Foster will get resigned to a new contract for the rest of his, worth $4 million a year, assuming that his age (31) and the production decline that comes with age with affect his earning power. I will also assume a step down in bonus income to $1 million a year for the rest of his career.
  4. Player fines/penalties: Given Foster's clean history and the position he plays, I will assume no dollar penalties will be imposed on his during his lifetime.
  5. Endorsement Income: Arian Foster's endorsement income in 2013 was $687,750 (though some of it is contingent on performance). I will assume that there is substantial growth potential (10% annual growth rate) in this income.
To value the cash flows, I have to make assumptions about player and default risk. For player risk, I will assume that there is a 5% probability of a career ending injury each year, resulting in cumulative probabilities that will increase over time (to 37% by the last year). For default risk, I will assume that Arian Foster's history & desire for commercial success will keep default risk low (a default spread of 1.50% and a discount rate of 4.1%). will be added to the risk free rate. For endorsement earnings, I will assume that there is low exposure to macroeconomic risk, resulting in an equity risk premium of 3% (and a discount rate of 5.60%). The table below captures the cash flows, discounted value and the value today (with the link to the spreadsheet).

The value of the claim on Foster's earnings to Fantex, based on these assumptions, is $10.06 million (before accounting for expenses and injury probabilities).  Fantex paid $10 million to get these claims, this looks like a break even deal for both sides of the transaction, with Arian Foster having the slight edge.

Valuing the Tracking Stock
To value the tracking stock, I have to factor in the drains on the cash flows from management expenses and branding investment, as well as the additional risks from not getting a direct claim on the earnings. For the first, I will assume that management expenses will consume 5% of the flow through earnings (as specified in the S-1) and branding investments will account for 15%, leaving 80% of the earnings as residual earnings. While I will assume that all of the residual earnings will be paid out as dividends, Fantex has no history (good or bad) in this respect and I will add an extra 3% to my discount rates to capture my absence of any corporate governance power (over either expenses or dividends). Finally, I will incorporate an additional premium of 3% in my discount rate for illiquidity, since it is unclear to me how I would exit this investment, without bearing significant costs. The value of my claim is illustrated below (with the link to the spreadsheet):

Specifically, I will be willing to pay $6.11/share for the Adrian Foster tracking shares, with my assumptions. There is a conversion feature on these shares, but it can be exercised only by the company to convert these tracking shares into Fantex platform shares; that option will make my claim less valuable, not more so. Consequently, I would not be a buyer at the $10 share price that Fantex has tentatively tagged the shares as worth in the S-1 filing.

Update: In both the Fantex and tracking stock claim valuations above, I did not incorporate the injury probabilities. Since I have an estimated probability that Foster will be playing in future years, I decided to incorporate that probability into the value and not surprisingly, it brings both numbers down:
Note that there is only a 63% chance that Foster will be playing in year 9 and the value of the Fantex claim drops to $8.2 million, giving Foster the clear edge on the deal, and the value per claim drops to $5.07.