By Stephen Bryan, Lee-Seok Hwang, and Steven Lilien
Illuminating Analysts’ Valuations
In the wake of the recent market run-up, acting SEC Chairman Laura Unger identified the SEC’s concern over the unregulated activities of sell-side analysts that pump target price information into the capital markets. While financial statements filed by companies with the SEC are prepared according to a set of regulated financial accounting standards, the models used by analysts to determine their pricing recommendations are not subject to a similar set of rational requirements. The authors use the case of MicroStrategy, Inc., to illustrate a method to determine from a buyer’s perspective whether the target price for a stock is reasonable. They advocate an analysis of the implicit assumptions necessary to support a specific price in the context of widely accepted pricing models. Their advice when assumptions are unreasonable: “Buyer beware!”
Between January 1999 and January 2000, Micro- Strategy, Inc.’s stock price rose from $29 to $295. The stock split 2:1 and rose to an intraday high of $333 on March 10, 2000. Ten days later, Micro- Strategy issued a press release to inform of a downward restatement of revenues (by approximately 25%) for fiscal years 1998 and 1999. MicroStrategy closed down $140, or 60%, on the day of the announcement. Since then, MicroStrategy’s CEO, COO, and former CFO, without admitting or denying charges, entered into consent decrees with the SEC and agreed to pay $350,000 fines each. Furthermore, the company agreed to disgorge $10,000,000 in stock and to implement meaningful corporate governance and compliance reforms. The SEC’s complaint alleged that premature revenue recognition led to overstated revenues and earnings during the periods in question. The restatements related to the timing of revenue recognition; notably, cash flows remain unchanged. For a full description of the case, see SEC Accounting and Auditing Enforcement Release 1350, December 14, 2000 (www.sec.gov).
Because the announcement of the restatement coincided with the dramatic drop in the firm’s market capitalization, many in the business press laid the blame at the door of the accounting profession. MicroStrategy’s auditor, PricewaterhouseCoopers LLP, recently settled a class-action shareholder lawsuit for $51 million. Nevertheless, analysts’ “target prices” for MicroStrategy and the models used to set them may be at least as appropriate an avenue of investigation as the accounting problems. Sell-side analysts continuously set target prices for MicroStrategy’s shares that are hard to justify analytically.
The Residual Income (RI) model can be used to standalize and benchmark analysts’ assumptions. The reasonableness of the assumptions should shed light on the reasonableness of the target prices. A template for the RI model (downloadable from www.cpajournal.com) can be used to test the reasonableness of observed stock prices, of analysts’ target prices, and the assumptions underlying these prices.
Reliance on Revenue-based Valuation Models
Traditional cash-flow or earnings-based valuation models perform poorly in estimating the equity value for many technology companies, because these metrics are frequently negative and cannot render a theoretical valuation. Furthermore, even positive metrics are so small that the valuation multiples derived from them fall outside a normal range. For example, a March 6, 2000, Forbes article noted that MicroStrategy was trading at “a meaningless 590 times 1999 net, fully diluted.” Anecdotes and criticism from the business press suggested that analysts began using other performance metrics, such as revenues and even website hits or “eyeballs.” Not only did these metrics have little theoretical foundation, they also yielded huge multiples. For example, MicroStrategy was not only trading at 590 times earnings, it was also trading at 65 times revenues. Robert A. Olstein, a mutual fund analyst, offered the following criticism:
Instead of providing investors with the kind of analysis that would have kept them from marching over the cliff, analysts prodded them forward by inventing new valuation criteria for stocks that had no basis in reality and no standards of good practice. (Morgenson, December 31, 2000)
Aside from theoretical issues, a focus on revenues aroused the suspicion that management would abuse revenue recognition standards in order to inflate revenues and revenue growth. Most of these concerns, however, were related to premature revenue recognition, which has no cash flow effects, nor does it necessarily affect the total revenue to be recognized.
A potentially more serious issue is revenue “quality.” There are numerous examples of Internet companies engaging in two-way revenue recognition (swapping revenues). In some instances no cash is exchanged (a pure barter), as when two Internet firms swap advertising space on their websites. In others, cash is exchanged, often in equal amounts, yielding a similar result. In both cases, expenses nearly or exactly offset revenues.
At a given price-to-revenue multiple, an increase in revenue (even of low quality) would increase (target) market value. Thus, even barter transactions can lead to higher stock prices. The same is not true of an earnings-based multiple, which would be less able to reach to the same earnings multiple.
Revenue Quality at MicroStrategy
In November 1999, the Center for Financial Research and Analysis, Inc. (CFRA) issued a warning about Micro-
Strategy’s revenue quality. MicroStrategy and NCR had agreed to swap revenues and cash flows in a transaction announced a few days after the close of the September 1999 quarter. A portion of the cash flows was recognized as revenue during the previous quarter. In a similar report dated January 24, 2000, CFRA issued a statement of concern about revenue quality in another swap announced several days after the quarter had ended, this time with Exchange Applications, Inc. (EXAP).
Analyst Reliance on Multiples
The Investext database (part of the Gale Group; www.galegroup.com) contains 97 analysts’ reports on Micro- Strategy, written by 12 research firms from July 1998 to February 2001. Of the 97 reports, 26 (27%) give target stock prices and most of the reports identify the model (usually a multiple of revenues or earnings) upon which the target price is based. The target prices and models are shown in Exhibit 1, along with the dates of the analysts’ reports and the price of MicroStrategy stock on the dates that the reports were written. The long-term growth rates in earnings per share (EPS) that are implied by the target prices using the Residual Income (RI) model also appear.
Of the 26 reports shown in Exhibit 1, 18 were issued during the period from July 1998 through March 2000 (the month of the restatement) and 8 in the post-restatement period. In the 18 reports in the pre-restatement period, the target prices range from $28 to $450. These 18 reports are from 7 different brokerage firms and include 11 target price changes. One analyst, Firm D, made 5 target price changes (6 different target prices: $29, $40, $50, $100, $300, $450) over a 9-month period (from May 14, 1999, to January 28, 2000).
The target prices are usually based on multiples of either sales or earnings, depending upon analysts’ opinions on the revenue (or earnings) multiple and revenue (or earnings) forecast. For example, Firm D’s upgrade to $50 (from $40) on July 13, 1999, was made as the analyst reclassified MicroStrategy from a “decision support systems” vendor to an “Internet software” vendor, thus meriting a higher multiple, in the analyst’s opinion. Alternatively, on July 22, 1999, C cited a growing customer base that included new deals with blue chip customers, which increased its revenue forecast and formed the basis for a revising its target price from $28 to $47.
Revenue quality issues at MicroStrategy did not derail the reliance on revenue multiples. In response to the first CFRA report on revenue quality, D responded with an updated report that reaffirmed the strong buy on MicroStrategy, specifically taking issue with the CFRA report:
We believe MicroStrategy (MSTR) was under pressure Friday primarily due to the release of a CFRA report that was negative on MSTR and offers an excellent buying opportunity. We have not seen the CFRA report yet but believe it highlighted three concerns, none of which, in our opinion, are conclusions supported by a sound analysis of the facts.
Less than one month later, on December 9, 1999, Firm D upped its target for MicroStrategy from $100 to $300. The basis for the change was a new multiple of 45 times forecast revenue:
A MC/R (market capitalization / revenue) valuation is necessary to compare MSTR to other companies in the e-business community. Our 12 to 18-month target price for MSTR of $300 is based on a market capitalization of 45 times our estimate of fiscal year 2000 revenue, which is a 20% discount to e-business software leader BSVN, trading at 56.5 times revised estimates for fiscal year 2000.
Based upon a higher-than-expected revenue result, D raised the target price again on January 28, 2000, to $450 (or $225 on a split basis). Similarly, on the same date, C noted that “the stock now trades at 40 times 2000 revenue, a well deserved premium.”
On the day that MicroStrategy announced the restatement—March 20, 2000—Firm A, among others, noted that cash flows remained unchanged and that only the timing of revenue recognition changed. This was not enough to support MicroStrategy’s stock price, however, which fell that day over 60% (from $226.75 to $86.75). A reduced its rating to “accumulate.” By comparison, B wrote:
We think the unknown future financial impact of these changes, skepticism with respect to the strength and quality of the business (highlighted in a March 6, 2000, Forbes article) and valuation concerns will continue to put downward pressure on the stock in the short term. As a result, we are reducing our rating to 2 buy (long-term buy) from 1 buy. For those investors who missed out on MSTR the first time around, this is the ideal time to be buying.
Five weeks later (April 27, 2000) B added the following:
Based on current valuation levels (2000 price-to-sales ratio of 10), we think the stock is properly valued, especially in light of recent events. We do not feel comfortable recommending the stock to investors at this time and are reducing our rating to 3 hold (neutral) from 2 buy (long-term).
The return to buy ratings began with Firm H, which, on May 30, 2000, initiated coverage “with a buy rating and a 12-month price target of $75 or 23.2 times our revenue forecast of $254.9 million.” This was followed by Firm I which, on July 14, 2000, gave a buy rating and a 6-month price target of $67. Two weeks later, however, Firm I lowered its target to $45 and changed its revenue multiple:
The company is trading at a market cap to revenues multiple of 7.3 … the multiple for comparable firms is 20. [W]e would assign a 50% discount to the comparables group to arrive at a $45 target price, down from our previously published $67 target level.
Two of the analysts that had issued strong buy opinions on the stock in the pre-restatement period reappeared with new brokerage firms. Firm B’s analyst went to J, which initiated its coverage of MicroStrategy on October 2, 2000, with a recommendation of “accumulate” target price of $47, using a combination of a 10-year discounted cash flow model and revenue multiples (the DCF model parameters were not given in the report).
Firm D’s analyst moved to K and issued a report on October 27, 2000, that set a target price for MicroStrategy of $60 based upon a revenue multiple of 10. The analyst justified the multiple by citing the median multiple for e-business intelligence application vendors (8.9 times revenues) and arguing that MicroStrategy’s products and growth prospects warranted a premium. By comparison, this analyst’s target price before the fall was $450 (pre-split price), based upon a 45 times revenue multiple.
The Search for Reasonableness
The above cases illustrate a range of analysts’ target prices: from $28 (May 1999) to $450 (January 2000). They also illustrate a range of revenue multiples: from 4 times to 45 times forecasted revenues. The ratcheting up of multiples in the pre-restatement period appeared to be justified by the higher observed multiples for the chosen comparables.
Aside from the theoretical concerns about using multiples, the reasonableness of the multiples chosen for Micro-
Strategy is also questionable. Were the multiples inappropriate or unreasonable? If so, was it due to the analysts’ choosing inappropriate comparables or to the comparables themselves having inappropriate multiples? These questions can neither be answered directly nor without the bias of hindsight. The residual income (RI) model is useful in addressing these issues. It provides a relatively simple yet theoretically based means of computing a fundamental value of a publicly-traded company based on observed values of book value, return on equity, and the cost of equity capital.
The RI model calculates a theoretical value to share prices that can then be compared to actual share prices. Alternatively, the assumptions about the cost of capital, forecasted EPS, and forecasted long-term growth rate that are required to yield the observed price can be calculated. In either case, the model allows individual users to assess the reasonableness of observed stock prices or the reasonableness of the assumptions needed to yield the observed price, based upon the user’s own standards. Sell-side firms, buy-side investment firms, and private corporations all use the RI model, including CS First Boston, Goldman Sachs, Morgan Stanley Dean Witter, CREF, Oppenheimer, Putnam, ADC Telecom, Coca-Cola Company, Eli Lilly, Monsanto, Sprint, Whirlpool, and BankAmerica.
A major attractive feature of the RI model is its simplicity. The model requires easily obtained data inputs:
The forecasted inputs, particularly EPS and long-term growth rates, receive enormous analyst attention and are readily available from web-based data sources, such as Value Line, Zacks, Primark, and CNBC. Various assumptions about the dividend payout ratio can be made by adjusting past dividend payout ratios for current information. The book value is obtained from the firm’s balance sheet.
Exhibit 1 includes the growth rates implied by the analysts’ multiples, assuming all revenues were of high quality and the timing of their recognition had been correct. Using the RI model, even the low-end price targets of $30 implied a 80% annual EPS growth rate, compounded, for the next five years. The highest target price of $450 implied a 203% annual growth rate, compounded over five years. From another perspective, if Micro-
Strategy’s revenues did actually grow at the rate of 203% (assuming a constant profit margin), they would total more than $54 billion in five years. By comparison, Microsoft’s1999 revenues were only $19.7 billion. Revenues of $54 billion would make MicroStrategy the 23rd largest company in the United States, by revenue.
Sustaining growth of such magnitude requires tremendous human resources and financing capital, consequences rarely disclosed or discussed in analysts’ reports. Never is a complete, pro forma “picture” of the firm disclosed— one that includes all three financial statements with an extended horizon.
The observed valuations for Micro- Strategy just before the restatement announcement were used to calculate the implied growth rate and the other implied estimates for the model, given the observed price. Exhibit 2 shows three cases that illustrate the assumptions necessary to arrive at the pre-restatement price of $226. The fourth case shows the results of using a normal assumption about the cost of capital, along with consensus estimates of the other variables, to arrive at a theoretical pre-announcement price.
The consensus forecasts for Micro- Strategy’s earnings, before the restatement announcement, were $0.32 and $0.48 per share for 1999 and 2000 respectively. The consensus long-term earnings growth for a five-year forecast horizon was 50%. Assuming that all revenues were of high quality and the timing of their recognition was correct, a yearly growth rate of 163% would be required to arrive at a pre-announcement price of $226 under the RI model (case 1). Alternatively, the cost of capital would have to be 1.5% (case 2), or, finally, the forecast EPS for year 2000 would have to be $7.95 (case 3). Finally, case 4, using more routine assumptions, yields a theoretical price of $13.47, or 94% less than the actual price of $226. MicroStrategy was recently priced at $4.76 (May 2001).
Consider All Information Sources
The steep price decline of MicroStrategy cannot and should not be attributed solely to aggressive accounting. Timing differences were of relatively short periods, and, more important, the associated cash flows were unaffected. Whether any price run-ups emanate from a form of “irrational exuberance” or departure from reasonable expectations of analysts can be ascertained only by a better understanding of the processes used by analysts in making their recommendations.
The analyst community should exercise increased care in its assessment of a company’s prospects. An expanded analysis may provide a more complete pro forma picture of the firm that fully incorporates all explicit projections and thereby uncovers any implicit assumptions.
Increased diligence by internal management, outside auditors, and the analyst community will ease what often appear to be, in hindsight, cases of irrational exuberance. Better fundamental analysis may even benefit from outside scrutiny of, and attestation to, the processes used by analysts in developing their reports and forecasts. Attestation of the actual analyst’s forecast is of less importance; rather, sound methodology and diligence in research will increase investor confidence.
The Association for Investment Management and Research (AIMR) publishes standards of professional conduct that all AIMR members are expected to follow. One applicable standard (Standard IV, “Relationships with and Responsibilities to Clients and Prospects”) requires AIMR members to do the following:
A reasonableness standard is found in many court decisions and the conceptual framework for setting financial accounting standards. The various professional organizations representing the analyst community should provide guidance that specifies reasonableness or at least advances a requirement for a full set of pro forma financial statements that would allow users to determine whether the analysts have upheld the reasonableness standards. In the absence of such disclosure, users of analysts’ reports and target prices should employ a screening mechanism such as the RI model to expose the underlying assumptions and assess reasonableness.
In the case of MicroStrategy, even if the revenues had been properly recognized and had been of high quality, the extreme assumptions appear to stretch the limits of reasonableness. It is incumbent upon the firm, the external auditor, the SEC, and the analyst community to ascertain the lessons of cases like MicroStrategy.
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