Friday, May 20, 2011

Dual share structure: The Google model spreads

Google rewrote the book for initial public offerings in two ways. One is that they bypassed the traditional investment banking syndicate for an auction (which is a good development) and the other is that they were unapologetic about the fact that they had two classes of shares and that the founders would hold on to the shares with the disproportionately large voting rights. While shares with different voting rights are par for the course in many parts of the world (Latin America, for instance), their use in the United States was limited to a few sectors; publishing and media companies such as the New York Times and the Washington Post have used the structure to allow the founding families to control these companies, with relatively small percentages of the overall equity.

Two factors played a role in containing dual class shares: the first was that, for decades, the New York Stock Exchange barred shares with different voting rights from getting listed on the exchange and the second was the fear of an adverse reaction from investors. Google was unfazed by either concern. It listed on the NASDAQ and institutional investors were so eager to hold the stock that they seemed to overlook the voting share structure (or at least not price it in).

So, what's the big deal with voting rights? Voting rights matter because they allow stockholders to have a say in who runs the company and how it is run. It is true that most stockholders don't use these rights and prefer to vote with their feet, but the voting power does come into use, especially at badly managed companies, where a challenge is mounted on management either from within (activist stockholders) or from without (hostile acquisitions). The argument I have heard from institutional investors for their benign neglect of different voting share classes at Google is that the company is well managed and that control is therefore worth little or nothing. There is a kernel of truth to their statement: the expected value of control (and voting rights) is greater in badly managed companies than in well managed ones. However, if you are an investor for the long term, you have to worry about whether managers who are perceived as good managers today could be perceived otherwise in a few years. (A decade ago, Cisco would have been ranked among the best managed companies in the world. Today, its management is under assault after ten years of bad acquisitions and under performance).

How does this play out in valuation? Once you have valued the aggregate equity in a company, you have to estimate the value of equity per share. When shares all have the same voting & dividend rights, you can divide by the total number of shares outstanding. When they don't, though, you may have to allocate the equity value differently to different share classes. Generally speaking, voting shares should trade at a premium over non-voting shares, but that premium should be larger in poorly managed firms than in well-managed firms. How much larger? I have a paper on the topic that does try to come up with a specific premium for voting shares.

The trigger for this post was the Linkedin valuation that I did yesterday. I valued the equity of the company at approximately $ 2 billion, but I was unforgivably sloppy about getting the per share value. I used the 43.31 million shares that Yahoo! Finance listed as shares outstanding and I should have known better. Checking the prospectus for Linkedin, here is what I see:
* 7.8 million class A shares (all of the shares offered in the IPO are class A shares)
* 86.7 million class B shares (which have ten times the voting rights of class A shares)
Dividing the value of equity by 94.5 million shares yields a value per share of $21.51/share, but even that may be an over estimate. If we assume that the voting shares trade at a premium of 5% over the non-voting shares (the 5% is the average premium for voting over non-voting shares in US companies), the value per share for the non-voting shares drops $ 20.57:
Value per non-voting share = $2,033 million (7.8 + 1.05*86.7) = $20.57
Reading the prospectus, though, things get worse. Linked in notes that it has options outstanding on roughly 17 million shares, with exercise prices ranging from $6 to $23. Needless to say, all those options are deep in-the-money now and while I don't have information on vesting, it behooves us to act as if these options will be exercised. Using an average exercise price of $15, the value per share drops further to about $20.

Bottom line: Getting from value of equity to value per share gets progressively more difficult as you add shares with different voting rights and outstanding options to the mix. 

15 comments:

Immortal said...
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Immortal said...
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Immortal said...

Prof,

Correct me if i am wrong..but u have attached 5% premium to class B shares which actually increases the outstanding shares and thus lowers the per share value...Is the calculation valid?

Aswath Damodaran said...

Yes. That is because I am trying to compute the value of the class A shares that are the non-voting shares..

Mike said...

Prof, thank you for looking further into Linkedin share price. I expect the price to fall to less than $50 in a few weeks.

Gaurav Mehta said...

i am not sure if the price would fall to below $50.... the reason being... internet based stocks are in their own momentum and its only when results start to disappoint its then that share prices get a reality check... not even sure when that would happen just for the reaosn maybe the company might be able to susatin ~ 100% growth for a year....

On the same topic of different voting right shares ... Tata Motor DVR shares trade close to 40-45% discount to their actual share price... is it a bargain to buy those. since the discount is way too large on the DVR shares? This discount has only widened from 35% last year...

Gaurav Mehta said...

Not sure what the future holds for Linked.... but for a company like Facebook to sustain for another 5 years they will have do keep doing something out of the ordinary... people change social habits as a new better platform is available... Hi Five, MSN Messenger, Yahoo.. are good examples of the same... Linked being more of a corporate platform has a great chance to sustain and grow... Google is more like microsoft Operating Systems... has too much of a monopoly and technological advantage with regards to Searching.

Mike said...

Gaurav,

As pointed out by a reader in a previous post, check this out:
http://blogs.wsj.com/marketbeat/2011/05/19/linkedin-helped-by-lack-of-shorting-put-options/

This gives an indication that lkdn price is likely to fall sharply when shorts and puts start.

Gaurav Mehta said...

Mike.. thx for the link.allowing shorting would bring down the share but i am still no convinced about as low as 50...in this bullish internet market....unless there is a good correction in US equities overall..

I wouls suggest looking at the ADR of Baidu.com, Inc (BIDU)... its risen from <10 in 2008 to 134 currently..

Krishnan said...

Prof.
Thanks; I used to add a premium (for such issues) to the discount rate; This is a lot more clinical
Best
Krish

Mike said...

Krishnan,

Interesting... you can go ahead with your method and then compare your numbers to prof's number.

The trick is to find the proper premium..

Aswath Damodaran said...

Discount rates are blunt instruments and not designed for augmentation. Analysts tend to add all types of premiums to discount rate, for small market capitalization, for illiquidity or for the presence of options. For the most part, these premiums are arbitrary and often end up miscounting or double counting risk.

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I am trying to compute the value of the class A shares that are the non-voting shares..xlpharmacy

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Anonymous said...

Professor Damodaran,

I'd like to know more about the 5% premium. Do you have any resources on how this number is derived? Is this a valid rule of thumb when valuing company with the dual share structure?