A Casual Conversation on Tech Valuations

“The Bubble Question” is the title of a recent Fred Wilson blog and the frequently asked question: “Are we in an stock market and/or technology company valuation bubble?”

Fred Wilson is a managing partner at Union Square Ventures, prolific venture capital blogger, and (from what I’ve gathered reading his blog for years) a pretty smart guy. Given his position, he gets asked the aforementioned question quite often and laid out his current conclusive response via blog. The gist of his explanation for the bubble is:

“valuations are at extreme levels because you cannot get a decent return on your money doing anything else…. really just one factor (cheap money/low rates)… is the root cause of the valuation environment we are in. And the answer to when/if it will end comes down to when/if the global economy starts growing more rapidly and sucking up the excess liquidity and policy makers start tightening up the easy money regime. I have no idea when and if that will happen. But until it does, I believe we will continue to see eye popping EBITDA multiples for high growth tech companies…. It’s been a good time to be in the VC and startup business and I think it will continue to be as long as the global economy is weak and rates are low.”

After having read Fred’s blog and my recent analysis of Castlight Health, my good friend and old Heyzap coworker Micah Facebook asked me for my thoughts on the tech bubble discussion. With his permission, I’ve posted the transcript from our April 24th conversation which contains my simplified explanation of the outrageous tech company valuations we are currently seeing and other thoughts on the internet industry.

Note: After the transcript I’ve included some further references related to points in the discussion. I also realize some comments in the conversations are over-simplified, but my friends/readership fall all along the spectrum of economics knowledge, so I usually opt for over-simplifying and clarifying details for those who ask. Any comments, critiques, or elaborations are welcome at loganfrederick@gmail.com.

Part One: Shortly Before Leaving Work, Micah Asks Me a Question

4/24, 5:10pm – Micah Fivecoate: So, does Fred’s post explain Castlight?

4/24, 5:10pm – Logan Frederick: I haven’t read through his post yet
But Just from the comments
It is a big part of it
I will respond tonight
After I read his article

4/24, 5:10pm – Micah Fivecoate: I don’t understand yet how it’s tech-specific

4/24, 5:10pm – Logan Frederick: Basically the simplified chain is
Fed lowers interest rates -> Means it’s really cheap to borrow money -> So everyone starts borrowing money -> That money is expected to be put to work to earn a return -> But given the economy now, a lot of industries and assets do not look that appealing -> Tech/internet sector looked pretty strong coming out of financial crisis with increased usage and actual revenues/profits from the giants -> Investors with cheap cash view that as the best place to get a return -> All the money goes into tech

4/24, 5:13pm – Micah Fivecoate: Ah, okay

4/24, 5:13pm – Logan Frederick: Even more basic, it’s just two factors: Tech companies look like the biggest growth opportunity compared to all other asset class, and the Federal Reserve policy makes it very easy for investors to get money to invest in tech

4/24, 5:13pm – Micah Fivecoate: So, it’s a combo of free money + tech looking good

4/24, 5:13pm – Logan Frederick: Yeah
That’s really it
If/when Fed rates rise
It will surely hurt tech company valuations
Even as some commenters said it would be a signal the economy is stronger or inflation is higher
But regardless, less money would be available for investment
So some companies might do better with higher interest rates, but overall valuations will be lower in real terms

4/24, 5:15pm – Micah Fivecoate: Wonder what would do better with higher interest rates
I guess any co with lots of cash
or that facilitates loans

4/24, 5:16pm – Logan Frederick: Well assuming rates go higher because of a strong economy, you could reasonably expect that the large tech companies would be doing well

4/24, 5:16pm – Micah Fivecoate: Oh

4/24, 5:16pm – Logan Frederick: The fed interest rate moves
Are more a trailing indicator
“Oh, economy is strong? Then we raise rates”
But your point was right as well to a degree, a company with a lot of cash can weather a rate increase better because it does not need to borrow

4/24, 5:18pm – Micah Fivecoate: So, is the effect to slow change when things are strong, and accelerate change when the economy is weak?

4/24, 5:18pm – Logan Frederick: Yep
That’s the basis of Monetary Policy

4/24, 5:18pm – Micah Fivecoate: cool

4/24, 5:19pm – Logan Frederick: You can continue down the rabbit hole of Monetary Policy theory, but all the research and debates are about what is the best mechanism for maintaining/finding the right equilibrium of economic strength or growth in relation to interest rates
The libertarian/anti-Fed Reserve crowd’s argument boils down to: The Fed does more to deviate us from the right equilibrium than help
In the pre-modern Federal Reserve era (pre-1917 if I have the year right)
Individual banks set their interest rates
I could go on and on, but I am packing up at work
Will respond more after reading Fred’s blog

4/24, 5:22pm – Micah Fivecoate: Cool, I’ll read up a bit on monetary policy in the meantime

4/24, 5:22pm – Logan Frederick: lol Good deal, see ya in an hour

4/24, 5:22pm – Micah Fivecoate: later

Part Two: An hour later with a glass of wine and dinner at Logan Bar and Grill

4/24, 6:16pm – Logan Frederick: I did not realize that this blog post
Was the same one posted a month ago

4/24, 6:17pm – Micah Fivecoate: Oh

4/24, 6:17pm – Logan Frederick: I didn’t fully read it then either
Halfway through, don’t see anything I disagree with and is pretty simple finance
I like Fred
It’s pretty simple finance but his readership is tech folk
So it’s good to post this kind of analysis
So Finished his post
Agree with it all, but it’s only half the story
Which is disappointing

4/24, 6:20pm – Micah Fivecoate: Yeah, it wasn’t clear from his post why the money would be going in to tech

4/24, 6:21pm – Logan Frederick: Well that’s not what I meant by half the story

4/24, 6:21pm – Micah Fivecoate: oh

4/24, 6:21pm – Logan Frederick
But that’s also true
But I filled in that part for you
That you can draw, from his post

4/24, 6:21pm – Micah Fivecoate: yeah
4/24, 6:21pm – Logan Frederick:
If you judge things by growth rate
Tech offers the best right now
And always, really
I don’t like “tech” as a sector term
I prefer “software” or “internet”

4/24, 6:22pm – Micah Fivecoate: oh, makes sense
“tech” isn’t necessarily the same sort of low-marginal cost business

4/24, 6:23pm – Logan Frederick: Well I just mean it as tech is too vague a term
In a recent copy of Intelligent Investor, editor Jason Zweig overlays one of the tech stocks of the 80s (IBM I think) on top of General Motors in the 1920s and it’s the exact same. Because General Motors was the “tech” of that era

4/24, 6:23pm – Micah Fivecoate: hah, yeah

4/24, 6:23pm – Logan Frederick: But that’s semantics

4/24, 6:24pm – Micah Fivecoate: barnes and noble isn’t doing too well with their printing press tech

4/24, 6:24pm – Logan Frederick: Your point is valid too, in that different “tech” companies have different business models
Barnes and Noble has a lot of issues and I should look again at shorting them maybe
It’s scary now that they keep decreasing in market cap, someone will take them over before they go bankrupt (possibly)
Hard to short in that situation

4/24, 6:25pm – Micah Fivecoate: Oh, yeah

4/24, 6:25pm – Logan Frederick: I can guarantee some PE firm has run numbers on them
If it’s a takeover candidate or not

4/24, 6:26pm – Micah Fivecoate: Yea, it’s pretty high-profile

4/24, 6:26pm – Logan Frederick: High profile, really the only monopoly in the space left, even if it is a shitty industry of bookstores
But that’s the job of a PE guy, run the numbers of what their debts are, do they own their real estate locations? What’s the value there?
How many costs can be cut?
If we can get them for $100 or $200 million, can we reconfigure them to spit out enough free cash flow to cover whatever debt they have/we add AND give us a private equity level return?

4/24, 6:35pm – Logan Frederick: I should turn this into a blog post
And write a blog post in response to Fred’s
I did not elaborate on what I meant as “the other half of the story”, which is what happens when interest rates rise again to the levels he suggests in the post

4/24, 6:36pm – Micah Fivecoate: Oh, yeah

4/24, 6:36pm – Logan Frederick: And that’s the sound of the bubble popping
The high valuations will end either when the Fed decides to raise interest rates (by their indications 2016 I think?) or when companies with high valuations fully realize that they can not earn returns on their investments
Whichever comes first

4/24, 6:37pm -Micah Fivecoate: the giant sucking sound of all the money leaving SV

4/24, 6:37pm – Logan Frederick: At least some of it, yes
I’m still a big believer in tech and think software still has a lot of room to run

4/24, 6:38pm – Micah Fivecoate: Oh, are they planning to raise rates in 2016?
looks like
maybe going to 2%ish in 2016?

4/24, 6:42pm – Logan Frederick: But I think people forget that software is meant to improve things and that largely means taking process which cost $100 using humans to cost $10 using machines, but that generally speaking means a lot of software companies don’t need to be as big as companies of old
Paul Graham says as much in one of his essays
The goal should be maximizing profit per employee. Can you have a billion dollar company with only 10 people?
Software shouldn’t require a business to need to be valued at $100 billion
You can replace General Motors with new high tech cars…at a lower valuation
I’m kind of shooting ideas from the hip, but you could vet them out and qualify them where need be, but the general point stands I think

4/24, 6:43pm – Micah Fivecoate: What principle does the rev/employee metric maximize?

4/24, 6:44pm – Logan Frederick: Well from the PG essay he was just talking about software leveraging human talent, that was his point there
I’m sort of adding on that you could make the link that PG’s point implies valuations don’t need to be as big to have as significant an impact/be as disruptive
A five person, $10 million company could hypothetically replace a 10,000, $10 billion company
Craigslist versus the newspapers as an example

4/24, 6:45pm – Micah Fivecoate: Yeah, i guess it’s how you define disruptive

4/24, 6:45pm – Logan Frederick: So then why, taking it a step further, are investors and tech entrepreneurs *seeking* valuations larger than the company is intrinsically worth

4/24, 6:45pm – Micah Fivecoate: Oh, and the profits of the $10B company just dissipate into the market at large

4/24, 6:45pm – Logan Frederick: Intrinsically judged by how much money they actually make over a future time span

4/24, 6:46pm – Micah Fivecoate
Shouldn’t the smaller company be able to keep profits as high?
like, costs could go down
maybe the profits would fall because the competition could implement the same software, and there wouldn’t be as much room for differentiation
or just it’s harder to justify to customers such a large profit margin
or is valuation tied in some way to gross revenue rather than net

4/24, 6:49pm – Logan Frederick: If a new software startup has costs of revenue (cost of providing the service) much lower than an old non-software company in the industry, the company won’t keep their price point at the same as old company because their customer’s substitution costs wouldn’t be affected. Their disruption will lower the costs to customers, and then depending on the industry, competition could drive those lower over time
Yeah, I typed that as you typed, but basically you as a new disruptive company would have higher profit margins, but lower prices than your old incumbent

4/24, 6:50pm – Micah Fivecoate: yeah
So you can initially keep the same profit, but lower price due to lower costs
but then other people start competing with you with software
and that’s what takes the valuation down

4/24, 6:52pm – Logan Frederick: Well valuation goes down even before your second step of competition

4/24, 6:52pm – Micah Fivecoate: because they know it’s coming?

4/24, 6:52pm – Logan Frederick: Well no, I take my last statement back
This would be an empirical question, but I would guess most software that very directly replaces an old manual task
Does not have gross profits greater than the old manual business
That’s hard to test empirically I think because most software replaces a cost of an old manual task
So you’d have to say, what were people spending on process A that was replaced with software product B
And cost of B is probably less than A
So in terms of valuation
It’s odd to word it this way
But what was the “valuation” of the dollars spent on A versus the valuation of company B
But I would guess if you did that kind of test
B is significantly lower
And that’s my point of valuation being naturally lower

4/24, 6:55pm – Micah Fivecoate: Weird
It seems like if one company can provide the same service at a lower cost
they should have a higher valuation
Might be running in to some sort of efficient-market fallacy

4/24, 6:56pm – Logan Frederick: I always view valuation in terms of return on investment
If the cost and price are lower
You can have a high ROI and still come up with a valuation number lower than the old incumbent
And then like you said earlier
If the ROI is *that* good
Then competition comes in and keeps everything in check like prices, cost, valuation

4/24, 6:58pm – Micah Fivecoate: Yeah
I guess, I’m thinking if the incumbent charges $100 for a product that costs them $90 to produce
and the disruptor charges $90 for $10 cost
then disruptor should have a higher valuation

4/24, 6:59pm – Logan Frederick: That is true

4/24, 6:59pm – Micah Fivecoate: but it probably just rarely works out so well
and then competition

4/24, 7:00pm – Logan Frederick: And that’s where it’s a case by case basis and where I think the tech industry screws up
I agree with your statement
Maybe half of software companies are like that
And another half, the bad ones, think they are doing that but are really only charging $20 at a $10 cost or charging $90 at an $80 cost, and so shouldn’t have a higher valuation
But because they are “tech” they and others think they should have the same multiples

4/24, 7:01pm – Micah Fivecoate: Hah, yeah

4/24, 7:01pm – Logan Frederick: And that’s part of why you get bubbles
Businesses thinking they can achieve a level of profitability and margins that similar-ish companies have
But really the business is not the same
And they don’t achieve it
And I guess my larger point would be
There is nothing wrong with *not* having the best margins
You just have to accept your okay margins and profits and accept that your valuation will be okay
But in a bubbly environment, every company thinks they will have the best margins, profits, and a valuation that their real margins and profits do not justify

4/24, 7:04pm – Micah Fivecoate:
Makes sense
So, is that purely because there’s too much money that wants in on this market

4/24, 7:06pm – Logan Frederick:
Yeah, so companies raising money can get away with it
If there wasn’t as much money available, investors would be more picky

4/24, 7:07pm – Micah Fivecoate: Doesn’t seem like the risk tolerance would shift with the amount of $ available
maybe it does though

4/24, 7:08pm – Logan Frederick: I could be wrong, but I think it does, although long-term it has been trending toward high valuations and more entrepreneur control, specifically in the computer software and hardware industries. Over decades that may continue.
But I say the risk tolerance does shift
Because VCs, the main drivers of these valuations, have investors themselves
And in weaker economic climates
There is a real possibility of VC investors, the big funds, saying they won’t do as much VC investing
And if VCs are worried about bad returns
They will get more choosey when it comes to investing

4/24, 7:09pm – Micah Fivecoate: Oh, interesting

4/24, 7:09pm – Logan Frederick: I can think of some counterarguments on both the high and low end though
On the high end, you could argue that VCs will still pay whatever it takes to get into the clear winners, the “next Google”
And on the low end, the dollar amounts are so low it doesn’t hurt them to continue this
And that leads into what people have been saying about Series A and B crunches
Companies in the middle of these two places who haven’t proved their worth to VCs that they can earn big returns but need more money than seed rounds can provide
I dunno how valid the Series A or B crunch is based on a few articles I’ve read, but that logic I just laid out would explain why it exists
VCs are just increasingly worried about investments in those stages

4/24, 7:11pm – Micah Fivecoate: Yeah

4/24, 7:11pm – Logan Frederick: Series D is safe
Seed is safe
By VC math

4/24, 7:11pm – Micah Fivecoate: right

4/24, 7:12pm – Logan Frederick: Any other thoughts/questions for me?
That I can come up with half-assed, on the spot answers for


  1. Regarding my comment about wanting to maximize revenue per employee from Paul Graham, I tried finding the exact PG comment I had in mind. My memory of it may have been off. His essay “How to Start a Startup” has the closest passage to what I was thinking that I could find quickly:

    “If hiring unnecessary people is expensive and slows you down, why do nearly all companies do it? I think the main reason is that people like the idea of having a lot of people working for them. This weakness often extends right up to the CEO. If you ever end up running a company, you’ll find the most common question people ask is how many employees you have. This is their way of weighing you. It’s not just random people who ask this; even reporters do. And they’re going to be a lot more impressed if the answer is a thousand than if it’s ten.

    This is ridiculous, really. If two companies have the same revenues, it’s the one with fewer employees that’s more impressive.”

  2. My comments at the end about Seed funding and late stage funding being safe for venture capitalists is based on discussion in the past six months on what the media called the “Series A” and “B” crunches. There was debate on whether there was a trend in venture capital of increasing investments in really young or really old companies, but a lack of investment for companies in the middle. Google “Series A Crunch” or “Series B Crunch” for more details.

Castlight Health Casts Bright Light on Market Bubble

Disclaimer: I shorted (bet against) Castlight Health on April 1 at $23.21 and held this position until Friday, April 11 when I exited at $16.99. I exited to lock in my winnings, but as this essay explains, Castlight is still overvalued and I may short them again. Any reader unfamiliar with “short selling” stocks should reference Investopedia’s introduction to short selling.

Additionally, it’s hard to complete these writeups in my evenings in a timely manner while the market continues to move. I began writing a week and a half ago when I shorted Castlight and had a number of friends, such as Andrew Virata, Reece Arthur, Ben Gilbert and others, aware of Castlight. This note is here to add credibility so it doesn’t look like I’m writing the analysis after the stock has already moved in my favor. Additionally, I have uploaded a zip folder where you can download Castlight’s income statement, balance sheet, and cash flow statements in Excel format and the PDF of their public FORM 424B4 filing from which most the research was derived.

“We expect to continue to incur operating losses for the foreseeable future and may never become profitable on a quarterly or annual basis, or if we do, we may not be able to sustain profitability in subsequent periods. As a result of these factors, we may need to raise additional capital through debt or equity financings in order to fund our operations, and such capital may not be available on reasonable terms, if at all. “ – Castlight Health, Page 13 of Form 424B4.

Castlight Health is an internet business which went public on March 17, selling 11.1 million shares at $16 per share, raising approximately $161.2 million for the company ($177.6 million from the public stock sale, but a $12.4 million fee for the bankers). On the first day of trading, the stock rocketed 149% to $40 per share, valuing Castlight at over $4 billion.

In 2013, this business lost $62 million on sales of $13 million. Since it went public a month ago, the stock has dropped over 50%. This is where I start my analysis of what Yahoo has deemed “the most overpriced IPO of the century.” I do not disagree.

What is Castlight Health? It is a web app for enabling employers and employees to easily view and manage their health care and insurance plans. It’s leading application is called Castlight Medical which they say, “simplifies health care decision making for employees and their families by providing highly relevant, personalized information for medical services that enable informed choices before, during and after receiving health care,” and “enables employees and their families to intuitively search for robust and comprehensive information about medical providers, including personalized out-of-pocket cost estimates, clinical quality, user experience and provider demographic information.”

Castlight App Screenshot

How does one lose $62 million in one year building a website for health data? And how is it still in business?

Castlight’s Income Statement

“I would say there is no one here who can understand some new internet company. I said at the annual meeting this year that, if I were teaching a class in business school, on the final exam I would pass out the information on an internet company and ask each student to value it and anybody who gave me an answer I’d flunk.” – Warren Buffett’s Q&A at the University of Florida in 1998

When I first noticed Castlight and it passed my eyeball test as a terrible stock, I wanted to see if I could possibly value the company. I quickly relented.

Castlight filed its Form 424B4 paperwork to the SEC on March 14 which includes all the required information for a company selling public stock. This document contains the company’s historical performance going back to 2011. Typically a financial analyst will use these SEC filings to do a Discounted Cash Flow analysis (link to my introductory tutorial on the subject), but with a company burning through as much cash as Castlight (and many other internet businesses) the DCF analysis quickly breaks. The primary problem is that, unlike a more mature company, or even a barely profitable one, you can’t even begin to predict the company’s future with any degree of confidence or reliability. The two sub-problems when making those future predictions are projecting future revenue increases and cost decreases. In looking at Castlight, I realized I had few ideas on how either of those line items would look over the next five years.

Here is their slightly organized income statement (numbers are in millions):

Castlight Income Statement

The last row, Castlight’s earnings, paints a pretty grim picture of not just three consecutive years of losses, but increasingly large losses. While revenue (row three) has grown substantially, costs (rows five and nine) have grown faster.

Castlight is an enterprise software company, so initial development and sales expenses are likely to be higher than mainstream consumer software. Yet after three years, these numbers clearly show a company that’s been lighting dollar bills on fire with matches in front of large customers for a pittance.

Castlight’s Customers

Page 82 of Castlight’s filing lists its top customers: Wal-Mart, Microsoft, Eaton, Indiana University, Microsoft, Mondelez, Purdue, Safeway, Honeywell and others. While this is a seemingly impressive group, they only totaled $13 million in revenue. If you can’t become profitable with Wal-Mart and Microsoft as your customers (two firms with a large number of employees), how many customers and how large do your future orders need to be? By Castlight’s own admission, Wal-Mart accounted for about $2 million of the $13 million in revenue under a contract which expires in 2015. Are there potential customers bigger than Wal-Mart who are willing to pay more than $2 million? With $58 million in selling and administrative expenses, it’s unclear if Castlight has figured out how to sell services at a higher price than it costs to do the selling (I could have phrased this much less glowingly).

In Castlight’s defense, they dedicate page 83 to “Customer Case Studies”, examples of their application saving companies or their employees money on health insurance. For Honeywell, “employees who used Castlight to shop for laboratory services paid 14% less than those who did not search (February 2012 through September 2013).” This would be more impressive if it weren’t preceded by: “Castlight developed a health care management platform that connected Honeywell health care vendors in a single integrated solution and offered employees a consistent user experience and message.“

Although Castlight Medical is a web application, their business model is not entirely Software-as-a-Service. A large component of their revenues is from “professional services”.

Professional Services

Professional Services is their consulting business of customizing its software suite for each client, which they say typically takes three to twelve months. While there are highly successful consulting businesses, the profit margins on such an employee-heavy business model are typically worse than a pure software business.

In its own documentation, Castlight almost creates a paradox. On page 50 under the section “Key Factors Affecting Our Performance”, the company says about its Professional Services business:

“We believe our professional services capabilities support the adoption of our subscription offerings. As a result, our sales efforts have been focused primarily on our subscription offering, rather than the profitability of our professional services business. Our professional services are generally priced on a fixed-fee basis and the costs incurred to complete these services, which consist mainly of personnel-related costs, have been greater than the amount charged to the customer…. These factors contributed to our gross loss percentage from professional services of (249)%, (596)% and (739)% in 2011, 2012 and 2013, respectively. The increase in gross loss percentage in 2012 was due to non-recurring professional services fees. The increase in gross loss percentage in 2013 was a result of an increase in the number of customers and complexity of our customer implementations. We expect to continue to generate gross losses on professional services for the foreseeable future as we focus on adoption of our subscription offerings.”

That can be summarized as: Professional Services loses money. We have no intention of it directly making money, but using it to up-sell our customers into profitable subscriptions.

That’s not so bad a proposal, until page 51’s “Costs and Operating Expenses”:

“Cost of professional services consists primarily of employee-related expenses associated with these services, the cost of subcontractors and travel costs. The time and costs of our customer implementations vary based on the source and condition of the data we receive from third parties, the configurations that we agree to provide and the size of the customer. Our cost associated with providing implementation services has been significantly higher as a percentage of revenue than our cost of providing subscriptions due to the labor associated with providing implementation services…. We expect to continue to generate negative gross margin on our professional services for the foreseeable future. As our implementation processes and technologies mature and our use of automation increases, we expect our gross margin on our professional services to improve.”

And back on page 50 under the “Revenues” section: “We expect professional services revenue to constitute a significant portion of our total revenue in the future.“

This reads to me as, “Professional services is going to generate a lot of our revenue, but because it’s so personally customized at big upfront costs for each client, it’ll create even greater losses, even if our margins improve.”


Speaking of margins, they are usually easier to improve when you’re not in a competitive industry.

Page 22 highlights the industry’s competitive landscape:

“While the enterprise health care cloud market is in an early stage of development, the market is competitive and we expect it to attract increased competition, which could make it hard for us to succeed. We currently face competition for sub-components of our offering from a range of companies….These competitors include Truven Health Analytics Inc., ClearCost Health, Change Healthcare Corporation, Healthcare Blue Book and HealthSparq, Inc. In addition, large, well-financed health plans, with whom we cooperate and on whom we depend in order to obtain the pricing and claims data we need to deliver our offering to customers, have in some cases developed their own cost and quality estimation tools and provide these solutions to their customers at discounted prices or often for free. These health plans include Aetna Inc., Cigna Corporation, UnitedHealth Group, Inc. and WellPoint, Inc. Competition from specialized software and solution providers, health plans and other parties will result in continued pricing pressures, which is likely to lead to price decline in certain product segments, which could negatively impact our sales, profitability and market share.”

The fundamental premise behind Castlight is valid; web applications that allow companies and their employees to more easily manage their health insurance and doctor relationships will be the future. This is not an original concept to the industry’s existing players or other startups, which they clearly admit here.

Also dangerous is that there is little stopping health insurance providers from cutting off their data supply to Castlight if they deem it a competitor to their business or cutting into their revenues from companies/end users. Castlight already acknowledges this: “If health plans perceive continued cooperation with us as a threat to their business interests, they may take steps that impair our access to pricing and claims data, or that otherwise make it more difficult or costly for us to deliver our offering to customers. “ It’s possible for the insurance companies to offer this service themselves. An agnostic third-party application is a good idea, but the clear competition and clear stranglehold the data providers have on them makes it a tough business that could have its valuation multiples suppressed.

The Backlog

There is one potential positive to support Castlight’s valuation: Its “backlog” of customer contract agreements to be fulfilled in the future. My reading of their filings points to the backlog information as one of the few indicators of potential revenue.

Castlight explains what constitutes its backlog on page 60: “At any point in the contract term, there can be amounts that we have not yet been contractually able to invoice. Until such time as these amounts are invoiced, they are not recorded in revenue, deferred revenue or elsewhere in our consolidated financial statements and are considered by us to be backlog.”

Potential future deals that haven’t been recognized in their numbers seems promising. The actual backlog size is , as of December 30, 2013, $108.7 million for the “total backlog”, but only half of it, $50.9 million is non-cancellable. Perhaps they give the $108.7 million number to give people a reason to be optimistic, but it seems near-meaningless to me. The $50.9 number is interesting as its a lot larger than last year’s $13 million in revenue and could indicate huge growth for Castlight.

Except Castlight says they do not “expect to fulfill our non-cancellable backlog as of December 31, 2013 over a period of approximately four years, with the substantial majority expected to be fulfilled after 2014.” $50.9 million spread over four years, with most of it in the last three, does not indicate much, if any, growth. Castlight admits as much: “Accordingly, we believe that fluctuations in our backlog may not be a reliable indicator of our future revenue.”

I was hoping the backlog might help them out, but it seems pretty useless except for Castlight to say that some potential customers are kinda sorta considering paying them between $50 million and $100 million over the next four years. And who knows how much it’ll actually cost Castlight in Selling and General Administration expenses to service those contracts.

Possible Valuations?

After having highlighted many of Castlight’s numerous negatives, one may be tempted to try and bet against them (as I am). Despite Buffett’s statement, it could still be worth a back-of-the-napkin valuation so as to have an idea of when the stock may stop its decline.

Since Castlight lacks any significant cash flows to discount, our best guess would be to compare it to similar companies and see if Castlight is overvalued relative to them. The two I will use are BenefitFocus and athenaHealth. Warning that for the purposes of this essay, these valuations are very rough and guaranteed to be inaccurate. I don’t worry too much about the inaccuracy of these valuations considering the company doesn’t make any money.

BenefitFocus is a web application “that enables its employer and insurance carrier customers to more efficiently shop, enroll, manage, and exchange benefits information.” The company went public last September. They are valued at about $1 billion with 2013 revenue of $104 million and $-30.36 million in net income. Still not profitable, but large revenues and valued at about ten-times those revenues. Castlight has $13 million in revenue with -$62 million in net income, so about a tenth of BenefitFocus’s revenue with twice as many losses at three times the market valuation for the company. By using the same 10x revenue multiple as BenefitFocus, Castlight would be valued at about $130 million. In fairness to Castlight, their revenues have been growing at a faster rate the past few years than BenefitFocus, so we’ll double that multiple to 20x revenue and the valuation to $260 million. The stock price would be about $1.60 at a market capitalization of $260 million. The price is currently $18.09.

Now we’ll use athenaHealth, a health care and health insurance software company which offers, “cloud-based services are packaged as four integrated offerings: athenaCollector for revenue cycle management, athenaClinicals for clinical cycle management, athenaCommunicator for patient cycle management, and athenaCoordinator for referral cycle management.” athenaHealth went public in 2007 and is profitable with a mere $2.59 million in net income last year but $18.73 million in 2012. athenaHealth deserves its own research, as it’s currently trading at a price-to-earnings multiple of 8,000-plus. Using the same revenue multiple approach used with BenefitFocus, athenaHealth trades at about 9.2-times its annual revenue ($595 million in revenue and current market value at $5.47 billion). This 9.2x is pretty close to BenefitFocus’s and should arguably be higher considering athenaHealth is profitable and has grown revenues by about $100 million every year for the past five years.

Castlight is currently valued at over 225 times its annual revenue. From a Yahoo! Finance interview: “Jay Ritter, a professor at the University of Florida and my go-to source on IPOs for the past few decades, tells me that Castlight’s insane level of valuation – 107 times revenue (not profits, as they had huge losses last year) – of the original IPO pricing hasn’t been seen for a tech deal since the year 2000, the twilight of the 20th century. Of the prior 13 deals priced at 100 times revenue or more and sales of at least $10 million, the average 3-year return was -92%.”

I’ll reiterate that you can refine these multiples all you’d like or use other metrics, but you can’t refine Castlight’s revenue. Professor Ritter’s stat is the most damning evidence against Castlight’s stock: The average three-year return of companies as overvalued as Castlight going back a decade is -92%.

Venture Capitalists Cover Castlight’s Losses

If Castlight hasn’t made any profits and lost over $100 million over the past three years, how has it stayed in business? With the help of $177 million in investor funding from 2009 to 2012, of which there was only $67 million left going into last year. Crunchbase includes a quick list of its investors and the size of each investment round. Prior to IPO, but at the end of 2013, Castlight had $67.17 million in cash and short term investments that could be liquidated into cash. Their losses for 2013 were $62 million, so they had about one year’s worth of cash left. The IPO raised an additional $161.2 million for the company, so they have about $166 million in cash now, minus whatever they’ve spent in 2014. This is also probably off by plus or minus $20 million, but it should be in the ballpark.

The investors have primarily been Venrock (the largest shareholder and a large Silicon Valley venture capital group), Oak Investment Partners, Maverick Capital, Fidelity Investments, The Wellcome Trust (a British charity endowment specializing in healthcare funding), T Rowe Price, and Morgan Stanley (also one of the investment banks who helped take Castlight public).

Given their history of increasing expenses more than they increase revenue, we can reasonably expect Castlight to spend somewhere in the range of $60 to $100 million this year. Their current cash reserves should last them two years before they will have to raise even more money, either through a secondary stock offering, sell bonds, or a credit lines with a bank. I guess they could accomplish that through increased sales too, but I’ll reiterate that for Castlight increased sales means increased costs.

Castlight’s Two-Class Ownership Structure and Management Compensation

With all these big investors, who owns Castlight?

Pages 113 and 114 list the major owners of the company and their total voting power for company decisions following the IPO:

  • Venrock and affiliates own 20.6% of the class A shares and 18% of the voting power.
  • Oak Investment Partners owns 15.8% of the class A shares and 13.8% of the voting rights.
  • Maverick Capital owns 10.2% of the class A shares and 8.9% of the votes.
  • Fidelity Investments owns 9.8% of the A shares and 8.6% of the votes.
  • The Wellcome Trust owns 8.7% of the A shares and 7.6% of the voting rights.
  • CEO Giovanni Colella owns 8.2% of the A shares and 7.2% of the votes.
  • Chief Operating Officer Randall Womack owns 1.7% of the A shares and 1.4% of the votes.

Combined, these majors shareholders control 75% of the A shares and 65.5% of the management votes.

What do I mean by “Class A” shares? Well, the public offering is of “Class B” shares. Castlight has two types of shareholders: “Class A” a.k.a “Those with lots of power” and “Class B” a.k.a “Those with little power”. Public investors are Class B.

What’s the difference? Right on the very first page of Castlight’s SEC filing, they explain: “We have two classes of common stock, Class A common stock and Class B common stock. The rights of the holders of our Class A common stock and Class B common stock are identical, except with respect to voting and conversion rights…. Immediately following the completion of this offering, outstanding shares of our Class A common stock will represent approximately 98.6% of the voting power of our outstanding capital stock.”

I’m pretty sure voting rights are an important right and the legalese here, in context of everything I’ve already shown, comes across as flippant.

Pages 9 and 116 elaborates on the rights of these different classes. Class A shareholders have the majority vote on the sale or merger of the company, the sale or lease of property and assets, the dissolution of the company, changes to the certificate of incorporation, or “every matter” if an outside individual or investment group has or announces intent to buy 30% of the Class A and B stock combined. Even outside of these issues, one Class A share counts for 10 times as many votes as a Class B share. There are only 11.1 million B shares compared to 75,469,707 Class A shares.

I have to note that this setup is actually relatively common with public companies (where there are two or more types of stock with certain investors having more control than others). It just looks a lot worse for those Class A people when the company doesn’t look healthy.

The list of investors and executives above control the decision making of the company. But if they’re making good ones for the business, the class B public investors could be okay with the setup.

Or the Class A investors could just let management, some of them former employees at the investment firms, pay themselves large sums of money, as shown in this chart from page 100:

Castlight Exec Comp

That’s right. In the last year, the top five executives were paid $965,156 in salary and total compensation of $6,183,012. This is during a year when the company lost $62 million and only had sales of $13 million.

The reasonable argument is that there is a job market for executives and, given their resumes, the Castlight team could get similar or better offers elsewhere. But these individuals are surely already rich given their previous jobs as venture capitalists for Greylock, having sold previous health care companies, and worked in executive capacity for other billion dollar public companies (page 92 lists the biographies of these five executives). I do make an exception for Head of Product Dena Bravata, who has been a practicing doctor and I assume has made good, but not outlandish sums of money prior to Castlight.

But view the situation from a different perspective: What kind of system pays people hundreds of thousands of dollars for losing tens of millions? Only a venture capital funded business could operate this way. They would presumably argue that sometimes you will need to take losses for a while in the early stages to grow the business. I retort that once you have a multi-billion dollar valuation, you are not in the early stages, even if the industry itself (healthcare IT) is not yet fully mature.

Amazon is the common exception people cite for the burn-money-for-years-to-dominate-an-industry, but Amazon’s stock was abysmal for years, going from above $100 in 1999 to $5 in 2001, and 2001 is when you should have bought their stock. Don’t buy Castlight while it’s expensive. If you believe in them, buy them after their stock collapses and they show some signs of success.


Having hopefully made the case that Castlight is a horrifically overvalued company that has offered no prospects for investors to earn a return on their investment (other than for the investment banks and their hand-picked clients who received the initial stock), who is responsible for the inevitable shareholder losses?

I don’t blame Castlight’s management. I am giving them the benefit of the doubt that they believe they have the solution to health care management for employers and employees, and the public investment markets are willing to invest in them, they are incentivized, if not obligated, to raise more money while they can.

The reality is much more grey with blame to be partially owned by everyone. I’m at best an armchair philosopher, but surely there is a moral/ethical argument to be made against Castlight’s management taking public money at multi-billion dollar valuations to pay executive salaries and stock options which put them in the top 1% of earners while losing tens of millions annually just because they can. Someday I will have better philosophical expertise to make a more foolproof assertion.

More blame falls next to the IPO underwriters and brokers: Goldman Sachs, Morgan Stanley, Allan and Company, Stifel, Canaccord Genuity, and Raymond James. In our post-SOX, IPO starved world, investment banks are starting to sell whatever they can now that investors have cash they’re willing to put to work, stock market returns looking more promising than any other asset class, and distance from the original dot-com bubble. Companies come to them with the willingness to be taken public. Bankers compete for the opportunity to support the company’s public offering and get their cut of the deal. Taking companies public is their job. Yet it seems short-sighted of them to sell obviously overpriced companies to public investors. The public has no chance of earning a return on its investment, but the banks and their closest clients get the public’s money. Over time, these kinds of offerings degrade the public’s trust in markets, as we saw in the dot-com boom and bust. The Goldmans of the world claim to have standards that separate them from the scams such as the one depicted in The Wolf of Wall Street. But when the public markets want to invest in stocks and new businesses, the big banks lower their standards to create supply to meet the demand. All this does is put public money into businesses that fail, losing even more money for everyone involved except bankers and executives.

Lastly, the public and the institutions which represent them. Why do we let companies, venture capitalists, and banks get away with making money from selling us stock in companies that lose money? I suspect it’s for two primary reasons: People do not take the time to learn how the financial industry and markets work and they put too much trust in the institutions managing their money without knowing what they are doing either. There is probably academic research measuring those two points. For the institutions like mutual funds, pension funds, and insurance companies, they are looking to make money from investing their cash from the public. New stocks may hold the potential to grow into the next Microsoft, Exxon, or Walmart. Both the institutions and the individuals they represent want to believe this is still possible, and invest accordingly in new stocks with their cash and hope.

That’s the real root of Castlight, the current market boom, and most investment bubbles. We all want to believe the future is brighter, regardless of the present conditions. And it’s usually true that technology will continue to, paraphrasing Gordon Gekko, “mark the upward surge of mankind.” What is lost is that the future is brighter because of today’s work. Though they may help, no amount of high finance or VC funding replaces the work that goes into sustainable solutions to hard problems. That’s what a healthy economy is: sustainable. Currently, Castlight and many internet companies of its kind are not.

If you have any questions, feel free to email me at loganfrederick@gmail.com.

UPDATE: Monday, April 14, 2013:
Jim Cramer directly addresses technology IPO oversupply in 2014 and lists Castlight Health as an example of a disappointing IPO harmful to the market. Maybe he reads my blog.

Books Read in the Second Half of 2013

My reviews of books read during my first year in Chicago was my most popular post yet (as measured by email responses from friends). So I’ve decided to make it a semi-annual tradition.

Once again, the books are sorted from worst-to-best on a one-to-five scale, with my highest rated book given special recognition at the end.

Note: The books marked with an asterisk are ones I read in the previous time period but forgot to include in the last post because they were e-books.

Two Stars:

Lean In by Sheryl Sandberg: Yes, we get that you were able to attend Harvard and were lucky enough to work for Larry Summers *and* your husband also runs a multi-hundred million dollar business. And I don’t hold any of that against Sandberg personally, but the book reads as, “Let me show you what my life, as a successful woman, is like,” instead of, “Here is how any woman can achieve her goals.” Any lessons for women are reworded cliches with “Lean In” being a 21st century brush up of “Speak Up More” which teachers have been telling the shy kid in class for decades. Men will get the most out of it. It’s a good reminder of our cognitive biases and weaknesses when dealing with women. You can get the same effect from older feminist writings.

The Games That Changed the Game by Ron Jaworski: I only give this a two star rating because its for a very specific niche and I don’t feel it even nails its topic. Jaworski’s book is, like his ESPN commentary, a breakdown of the game film from the seven most influential games in NFL history (in his opinion). Even if you’re a football junkie, you will question his choices for the first and last chapter (a Sid Gilman game all about the rushing attack and the 2001 Patriots-Rams Super Bowl focusing on defending Marshall Faulk). I did enjoy the exclusive interviews with players from these games across many generations and Jaworski’s individual play analysis, it’s only a portion of a book aimed for diehard football fans.

Three Stars:

*The Return of the Great Depression by Theodore “Vox Day” Beale: Beale is an economic crank, but that doesn’t mean he’s without good points (as tends to be the case with cranks). His most convincing chapters debunk a Paul Krugman article nearly line-by-line and establish how the Federal Reserve has failed to reduce bank failures and financial crises. He hurts his Austrian arguments with his poorly thought out sexist policy recommendations and over-referencing of the inaccurate ShadowStats site.

Catching The Wolf of Wall Street by Jordan Belfort: Considering I had read the first book sophomore year of college (I suspect I was one of the few students in 2010 who did) and the Scorcese movie was being released, I felt it appropriate to read the sequel. Belfort maintained the outrageous writing, both in style and substance, that was present in the first book and displayed in the movie. It’s not a book about finance, it’s about one man’s descent into madness in some of the most destructive, off-the-charts ways possible, and the FBI’s attempts to pin him.

Confessions of an Economic Hitman by John Perkins: In this memoir, Perkins explains his life as an “Economic Hitman”, a consultant hired by governments and corporations to convince third-world nations to borrow money from the first-world at indenturing terms. Given the premise, I was hoping for a real expose. Sadly, Perkins is light both on technical economic details and gritty drama. This does leave the book as a quick, thin read. It pairs well with Naomi Klein’s “The Shock Doctrine” which I previously reviewed.

The Defining Decade by Meg Jay: I’d been hearing from friends and media outlets alike that this book was a must-read for young adults in my generation (whatever that means). Given the attention the book got upon release and Dr. Jay’s credentials, I was expecting something more substantive. Defining Decade still contains useful, relatable anecdotes for those in their 20s who are searching for happiness and meaning. I’m just disappointed most of the science was absent.

Four Stars:

*The Launchpad: Inside Y Combinator by Randall Stross: New York Times journalist Stross was able to get exclusive access to the inner workings of Y Combinator, the revolutionary startup investment firm, as it led one of its famed startup “batches” through a summer. The book is a quick read as Stross jumps through the all the startup stages in his three months in Mountain View. It’s length is a great strength, as every page brings the wisdom of Paul Graham and company to readers considering starting a company of their own.

*Effective Programming: More Than Writing Code by Jeff Atwood: A collection of essays by the creator of the Coding Horror, Atwood covers a wide breadth of technology topics including software testing, programmer hiring, project management, and application security. Given his years of enterprise experience, co-founding Stack Overflow, and still maintaining his popular blog, every essay in this book is worth digesting and re-reading.

Without Their Permission by Alexis Ohanian: Written by the cofounder of Reddit, Without Their Permission is a half biography/half pep talk about the origins of Reddit and the modern internet ecosystem. Alexis writes with a sense of humor, a clear understanding of how lucky he is, and explains the work he put in to be in that position. While anyone who is familiar with Reddit’s history will find the first half a bit redundant (or anyone familiar with SOPA will feel the same way about the second half), Without Their Permission covers enough varied material that any reader will get something new out of it while enjoying Alexis’s storytelling.

The Undercover Economist by Tim Harford: This introduction to economic thinking meanders aimlessly from topic to topic, but doesn’t feel aimless. Despite not providing much depth for those with a pre-existing background in economics and seemingly disorganized chapter structure, I would recommend this book as a primer on practical applications of economics to those unfamiliar with the field.

The Smart Swarm by Peter Miller: This high level explanation of the research into animal group behaviors is readable, understandable, and educational. Miller accomplishes the tough task of simplifying complex flocking and biomimicry research, presenting its real-world applications, and keeping a steady pace for the casual reader.

The Bed of Procrustes by Nassim Taleb: It seems kind of narcissistic to write a collection of your own one-liners and publish it. Since most people aren’t as insightful as Taleb, he gets away with it. It’s cheap, takes an hour to read, and the most wisdom you can get in that time for that price.

The Blind Side by Michael Lewis: Lewis’s second sports work after Moneyball and a popular movie starring Sandra Bullock, he continues to tell the stories of unsung heroes with outsized impact on their fields (in this case, a literal one). What the movie left out of Lewis’s book is the entire half dedicated to explaining why Michael Oher’s position at left tackle became so valuable in the NFL. The Blind Side reminds one that everyone has potential, especially those with the most unappreciated skills in the most overlooked places.

Average Is Over by Tyler Cowen: Cowen, one of my favorite economists and author of “The Great Stagnation”, presents his latest thesis: The future of the American economy is a class divide driven by an individual’s aptitude for complementing computers. Programmers and those with fantastic soft skills which are difficult to quantify will be at the top of the income scale, leaving everyone else competing for minimum wage service work. The book meanders while making its point in the middle chapter and goes increasingly off-topic. It is saved by the final chapter “The New Social Contract” which takes his thesis to its practical societal conclusions. Cowen has said he hopes it reads like a history book of the future and I hope more social scientists attempt this presentation style.

The Score Takes Care of Itself by Bill Walsh: Recommended by Twitter creator Jack Dorsey as his manual for leadership, this posthumously published guidebook lays bare the thoughts of a football legend. Walsh led the San Francisco 49ers to three Super Bowls and two more under his self-appointed successor during the 80s and early 90s. His core philosophy of teaching his employees/players to rise to his “Standard of Performance” can transfer into any workplace. Although the book is just a tad repetitive, the central thesis mixed with Walsh’s personal stories from coaching one of the NFL’s greatest and longest dynasties makes it recommended reading.

Currency Wars: The Making of the Next Global Crisis by James Rickards: The book for understanding how currencies work and the dangers of mismanaging them on a global scale. The book is split into two parts: First, a history of the past 100 years of fiat currencies; Second, Rickards’s projections on the future of international monetary policy. These discussions are centered around the concern that countries are increasingly using currency manipulation as economic warfare. This should be read by everyone in a position of political and economic power who decides these very issues.

Five Stars:

The Count of Monte Cristo by Alexandre Dumas, translated by Lowell Bair: The 2002 Kevin Reynolds film rendition of this classic is one of my favorite movies. I was concerned that seeing the movie first would spoil my view of the book. Luckily, major plot lines are significantly different enough to keep the two separate in my mind. Monte Cristo is the definitive revenge story. I am not surprised it has survived for centuries.

*Bubble Logic: Or How I Learned to Stop Worrying and Learned to Love the Bull by Cliff Asness: Billionaire founder of AQR Capital Management wrote this unpublished-book-turned-long-academic-paper in August 2000 as the dot-com bubble was crashing. Asness eviscerates the Internet bulls using simple financial mathematics. As someone who is a believer in the potential of internet companies, Asness provides the logical, sobering truth to the Silicon Valley-ites who misunderstand market realities. A must-read for value investors or anyone who wants a deeper understanding of the stock market.

Fate of the States by Meredith Whitney: I’ve already written another blog post based on the information in this book. Whitney and her research team have compiled damning evidence on the widespread mismanagement of state and municipal governments on both coasts of this country. While her calls against these municipalities might be criticized for early timing, her broader points can not and should not be ignored by politicians and the broader citizenry.

Best Book Read in the Second Half of 2013:

Fooling Some of the People All of the Time by David Einhorn: While Fate of the States, my runner-up for this position, is an easier and more relevant read for most, Fooling All of the People was too memorable to not have the top spot. Hedge fund manager Einhorn documents his multi-year fight against the fraudulent Allied Capital. Einhorn clearly walks through how white-collar criminals, Wall Street banks, Harvard professors, government agencies, and shady accountants conspired to steal hundreds of millions of dollars from taxpayers and individual investors. Compared to writings about the 2008 financial crisis, Fooling All of the People is a personal tale of a small group of individuals investigating the very corrupt corporate systems that preceded the crisis and have really existed throughout history. This is a book that will leave you a less naive person. That feeling alone is worth the price of the paperback.

Is Gamestop Overvalued? – Conclusion

We’ve come to the end of this tutorial on Discounted Cash Flow analysis. Using Gamestop’s publicly available data, we have determined that Gamestop’s stock is worth $23.78 (I have used “we” throughout this tutorial, but of course you are welcome to get different results by modifying the model). Considering the stock at the time of the research as evidenced by the Introduction page was $50.29, it seems like a good investment to bet against Gamestop’s stock, or at least avoid buying it.

I’ll also reiterate that all the data and spreadsheets used for this tutorial are available for download so that you can tinker with it and read more information about Gamestop’s operations.

If you have any questions or comments, your emails to loganfrederick [at] gmail.com are welcome.

Is Gamestop Overvalued? – Extending the Research

The following aspects of Gamestop’s business were not thoroughly researched for this paper and should be to complete the analysis:

Leasing versus Ownership:

Gamestop uses a combination of leasing and owning for its retail locations and distribution centers. It is possible that the renewing leases could help or hurt Gamestop in some significant way or that the financing environment might affect how these leases are paid. Lease accounting is discussed in the 10K on page 35 and page 49.

Tax Rates:

The model uses a standard 35% corporate tax rate. Gamestop has some tax credits that can be used in the future to potentially help its earnings, but has also had some historical years with effective tax rates above 35%. These were not used in the model and should be to get a more accurate price.

Choosing a Different WACC:

After attempting to use comparable companies to Gamestop to select the model’s Weighted Average Cost of Capital, I set this value to 8% as it seemed the most reasonable. A more rigorous model for selecting the WACC involving different comparison companies or industry information could be used.

Better Methods for Modeling Future Sales

Despite all the discussion about what might affect Gamestop’s sales in the future, the model uses a simple method for growing and declining sales. The first couple projected years grow based on previous sales growth rates due to the launch of new game hardware. Then the last few years show steady sales decline based on the reasons given in the thesis.

A better, potentially more accurate method for estimating future revenue would include factors such as projected consumer spending patterns, more precise adjustments for the potential hardware and software sales with a new gaming generation (which could be determined using patterns from past generation launches), and other sector and economic factors.

Investigate the Increase in Selling, General, and Administrative Expenses:

Why has SG&A increased by $400 million in five years? This is the primary question which came to mind when building the model.

On page 38, Gamestop notes: “Selling, general and administrative expenses decreased by $6.2 million, or 0.3%, from $1,842.1 million in fiscal 2011 to $1,835.9 million in fiscal 2012. This decrease was primarily due to changes in foreign exchange rates which had the effect of decreasing expenses by $26.7 million when compared to fiscal 2011 offset partially by expenses for the 53rd week in fiscal 2012. Selling, general and administrative expenses as a percentage of sales increased from 19.3% in the fiscal 2011 to 20.7% in fiscal 2012. The increase in selling, general and administrative expenses as a percentage of net sales was primarily due to deleveraging of fixed costs as a result of the decrease in comparable store sales. Included in selling, general and administrative expenses are $19.6 million and $18.8 million in stock-­based compensation expense for fiscal 2012 and fiscal 2011, respectively.“

This does not explain the $400 million increase from 2008 to 2011. Although sales grew by approximately $700 million from 2008 to 2011, sales dropped in fiscal 2012 back to 2008 levels, while SG&A remained stagnant, presumably for the fixed cost/same-­store sales decrease reasons listed above. If revenue remains around the 2008 levels, it would be worth investigating if Gamestop could bring its SG&A costs down as well.

Next: Conclusion
Previous: Valuing The Stock

Is Gamestop Overvalued? – Valuing the Stock

In the Introduction, I mentioned that future estimates of a company’s profitability are inherently inaccurate because nobody truly knows what will happen in the future. Additionally, the farther into the future you try to guess, the less accurate your guesses will generally be. To compensate for this, financial analysts use the previously noted Time Value of Money principle to “discount” future Free Cash Flow (which we found in the last section). Discounting means that if we want to use future profits to determine the company’s value today, we have to make those profits less valuable because there is a chance the company won’t actually earn those profits in the future.

So the next question is: How much less should future cash flow be worth?

The common technique in finance is to apply a “Discount Factor” or “Discount Rate” to decrease the future cash flows.

The Discount Rate is an annual interest rate, except instead of going forward in time, you’re going backward in time from the future to the present (also known as the Present Value formula). The Present Value formula is:

Present Value Formula

In our Gamestop model below, we find the Present Value for every year into the future we have found Free Cash Flow (“Present Value of FCF” in the spreadsheet). “N” is how many years into the future.

What do we use as the discount rate (“r” in the equation)? This is where we use the Weighted Average Cost of Capital (WACC). A longer definition is in the Glossary, but the WACC represents the minimum expected rate of return an investor in the company would expect the company to earn with the investor’s money. Therefore, discounting by the investor’s minimum expected investment return turns future profits into their present value based on investor expectations.

How do we determine what the WACC should be?

There are some different ways to determine the WACC. In my case, I tried initially to find Gamestop’s WACC using data from similar companies, but the value this produced was too low. You can see this work if you download the Excel workbook and view the “WACC” spreadsheet. The lower the WACC, the higher the stock price, since you are discounting or decreasing the cash flows by this rate. So I manually set the WACC at 8% in the model, which seemed realistically fair.

Applying the Present Value formula onto each future year’s FCF gives us the “Present Value of Free Cash Flow” row in the Excel model.

Free Cash Flow

Finding Enterprise Value:

With the knowledge of what the company’s future profits are worth to us today, we can determine how much the company is worth. The company’s value is called the “Enterprise Value”. Again, a longer definition of Enterprise Value is in the Glossary. Here we can define the Enterprise Value as the sum of the Present Value of Free Cash Flows (in the spreadsheet as “Cumulative Present Value of FCF”) plus the Terminal Value.

The Terminal Value represents the value of the company for all the years beyond our model combined into one amount. This can be determined in different ways. In my model I chose to use the “Perpetuity Growth Method.” Simply put, this takes the last year’s Free Cash Flow in the model and grows it at a small rate indefinitely into the future and then discounting it back to its present value. The Terminal Value requires choosing a “perpetual growth rate”, also known as the rate at which the company will grow forever into the future. This percentage should be low as it’s impossible for company to grow faster than the entire economy forever. For Gamestop, I chose a one percent perpetual growth rate. Based on the Thesis and Supporting Arguments, I do not believe the company will grow very fast in the future, but I did not choose zero growth to keep my model a little more conservative and assume that Gamestop will not go completely bankrupt.

Adding the Cumulative Present Value of FCF and the Terminal Value gives us the Enterprise Value. Congratulations, you have now found the value for the entire company! In my model, I determined that the entire Gamestop company is worth approximately $2.357 billion.

The Final Steps – Finding the Stock Price:

Next we will take the value of the company and determine how much each share of stock gets of that value. Adding the Enterprise Value plus the company’s cash gives us the Equity Value, which is the value of the company which belongs to the shareholders. Gamestop has $635 million of cash in the bank, so added onto the Enterprise Value gives Gamestop an Equity Value of $3.006 billion.

The formula for the stock price is:

Stock Price=Equity Value/Fully Diluted Shares Outstanding

Fully Diluted Shares Outstanding is the number of all the company’s stock. To reiterate in English, the stock price is the total value of the company and its cash divided by the total number of shares of stock that exist. FDSO is the “Shares Outstanding” (shares available in the market) plus new shares of stock that can be created by stock options in owned by the company and its employees.

Gamestop has 126.4 million shares of stock.

Take Gamestop’s $3.006 billion in Equity Value divided by its 126.4 million shares and you find that every share of stock is worth $23.78.

Next: Extending the Research
Previous: The Future

Is Gamestop Overvalued? – The Future

Now that we’ve discussed the business, potential problems, and historical financial performance of Gamestop, we can attempt to predict the future to determine if the stock is under-, over-, or correctly valued in the stock market.

Below is the second half of the DCF Excel spreadsheet with the future projections for Gamestop’s financials and projected Free Cash Flow, followed by an explanation of how these numbers were found.

GME Future

Future Sales: In your typical DCF model, you can just grow sales every year into the future using the average growth rate I list in cell G3 in the above spreadsheet. In reality, business rarely have revenue every year change by the same amount. Specifically with Gamestop, I chose to have temporary high growth in the near future because of all the new video game consoles being released in 2013 and the pent up videogame demand saved up for this occasion. However, for all the reasons listed in my “Supporting Arguments”, I decrease the company’s revenue in the future. For the specific percentages, I used Gamestop’s best and worst annual growth rates in the past five years.

Cost of Revenue and SG&A Projections: To find Gamestop’s future Earnings Before Taxes, Interest, Depreciation and Amortization, we need to subtract out its future Cost of Revenue and SG&A costs. To predict those costs, at the bottom of the spreadsheet I have included some extra information: The Cost of Revenue growth rate taken from the CAGR column and SG&A as a percentage of Revenue. SG&A as a percentage of Revenue is based on the average ratio of SG&A to Revenue from past years and using that average ratio in the future.

GME Other Variables and Ratios

Depreciation and Amortization: Future D&A was set at 2% of future revenue. This is another standard number that you could try and modify if you see major changes in these expenses, but I did not see such reasons. If you compare the future projections of D&A using this “2% of future revenue metric”, you will see it is relatively close to the past values and thus seems like a reasonable assumption.

Capital Expenditures: Future Capex was set at 1.85% of future revenue, which was the average Capex over the previous five years.

Increase in Net Working Capital: This is the most complex part of the Free Cash Flow equation, so I have dedicated a separate post to explaining the details on how to project future changes in Net Working Capital.

The equation for Free Cash Flow is:

+ D&A
– Capex
– Increase in Net Working Capital
=Free Cash Flow.

The reason this works to find the company’s available cash flow:

EBIAT represents the company’s earnings that could be used to pay off any debts in the event of a liquidation (hence why “Interest” is not taken out, interest comes from those debts).

Capex is subtracted because it is a use of the company’s cash. Even though it can be considered cash spent wisely to improve the business, it is still less cash available to the owners (the stock holders).

The Increase in Net Working Capital is subtracted because an increase in NWC, like Capex, means cash has been used to either increase the company’s assets or decrease its liabilities. Both of these are not strictly good nor bad, but they are uses of cash that are not available for the investors to pocket.

However, the remaining cash is available for investors.

Using the steps and descriptions above for each row in the Excel spreadsheet model and every column representing the next five year’s of the company’s operations, we can use the simple math explained above and in the past to estimate future Free Cash Flow.

With our guesses for the company’s future profits, we can now determine what the stock price should be.

Next: The Future
Previous: Net Working Capital

Is Gamestop Overvalued? – Net Working Capital

Increase in Net Working Capital: Increase in Net Working Capital is the most complicated of our future projections. This is because to properly find future NWC, you have to predict future Current Assets and future Current Liabilities.

To accomplish this, I added a “NWC” spreadsheet to my Excel workbook:

GME Net Working Capital

All of the numbers in the 2008 through 2012 columns were taken from the 2008 through 2012 Gamestop Balance Sheets. The projections for the 2013-2017 values are found by taking the average growth rates or most recent value for the assets and liabilities and using those values or rates in future years.

The spreadsheet provides a visual for what makes up Current Assets and Current Liabilities. In English, they are:

Current Assets:

Accounts Receivables: Amounts owed to the company for products or services it has given on credit to other business or individuals.

Inventories: Inventories are the company’s raw materials and products made or in the process of being made.

Prepaid Expenses: These are expenses paid by the company before receiving the products or services for which it has paid. An example of a prepaid expense is an insurance premium which is paid completely upfront but covers a company or person for some amount of time such as a year. The insurance is a prepaid expense which initially is an asset that will get used over the course of the year, decreasing the asset over that time.

Cash and Cash Equivalents: The company’s cash and assets that can almost immediately be turned into cash, such as commercial paper and Treasury Bills.

Other Current Assets: Assets that do not fall into the above categories but are still assets that can be turned into cash within a year. These kinds of assets are typically non-recurring or not large enough to require their own category on the balance sheet. Some examples of this could be cash paid in advance to suppliers or employees that is accounted separately from the rest of the company’s cash or small investments in other companies or assets the company has made.

Current Liabilities:

Accounts Payable: Payments owed to the company for products or services already provided to a customer. This can be thought of in non-accounting terms as customers’ unpaid bills.

Accrued Liabilities: Expenses such as salaries, rent, interest, and taxes that the company owes but has not yet paid.

Other Current Liabilities: Other types of liabilities that don’t fit into one of the other categories, possibly don’t occur very often, and are due to be paid or worked off within a year.


Day Sales Outstanding (DSO): DSO tells you how a company is managing its Account Receivables. The lower the number, the faster the company is getting paid by its customers. The equation for DSO is: (AR/Sales) * 365.

Days Inventory Held (DHI): DHI tells you how a company is managing its Inventory. The lower the number, the faster the company is selling or getting rid of its old product inventory. The equation for DHI is: (Inventory/Cost of Revenue) * 365.

Prepaids and Other Current Assets as a Percentage of Sales: This percentage is used to project the Prepaid and Other Current Assets into the future by setting them to a percentage of the future Revenue.

Days Payable Outstanding (DPO): DPO tells you how long it takes a company to pay its suppliers. The larger this number, the longer amount of time the company is taking to pay its suppliers. A larger number is good because it means the company is not rushed to pay its bills and has time to invest its cash into other parts of the business before having to pay bills. The equation for DPO is: (Accounts Payable/Cost of Revenue) * 365.

Accrued Liabilities as as Percentage of Sales: This percentage is used to project the Accrued Liabilities into the future by setting them to a percentage of the future Revenue.

Other Current Liabilities as a Percentage of Sales: This percentage is used to project the Other Current Liabilities as a percentage of the future Revenue.

Is Gamestop Overvalued? – Starting the DCF Model

Now that we’ve highlighted the important vocabulary used in Discounted Cash Flow modeling, we can build a model for Gamestop.

The goal of the DCF is to find the value of the company based on its future profit discounted at some rate to factor in the uncertainty of those profits. This “value” is called “intrinsic value”, which is different from the “market value” of the company. In the marketplace, anyone can buy the company or its stock for whatever someone is willing to sell to them at a “market price”. This can be unrelated to how much money the business actually makes.

The key points to remember are that although the market value can be unrelated to the health of a business, it can be easily seen in the market. The intrinsic value is how much a company is actually worth based on how much money it will make, but predicting the future is harder to see.

Given the information that companies are required by law to publish about themselves (the accounting statements in SEC filings), how can we divine the intrinsic value of a company?

This is done by taking the company’s revenues and removing all of the expenses that affect its cash until you are left with the Free Cash Flow. Finding how much cash a company makes is vital to its intrinsic value.

To get the actual numbers to plug into the DCF, we pull from the publicly published accounting statements.

In arithmetical terms along with the accounting statements where the data can be found, the DCF formula is:

Revenue (*Income Statement*)
-Cost of Revenue (*Income Statement*)
=Gross Profit
-SG&A (*Income Statement*)
-D&A (*Income Statement*)
-Taxes (*Your Choice or Income Statement*)
+D&A (*Income Statement*)
-Capex (*Cash Flow Statement*)
-Increase in NWC (*Balance Sheet*)
=Free Cash Flow

The DCF model is generally built using annual data, so taking these data points from one year’s SEC filings will give you one year’s Free Cash Flow.

But the company’s intrinsic value isn’t really determined by what happened in the past! What we want to know is how a business will do in the future after we’ve invested our money. As I pointed out in the introduction, we obviously don’t know the future, so the best we can do is use past performance, along with our educated guesses (hence the thesis and researched supporting arguments), to predict the future.

In a typical DCF model, you will want to run the above Free Cash Flow formula on multiple previous years, taking your data from those years’ publicly available financial paperwork. I have done this for Gamestop using the years 2008-2012 (the numbers are measured in millions):

GME DCF Past Data

Some things to point out from this historical data:

  • While revenue growth between 2008 to 2012 was almost flat (rising until 2011 then falling dramatically in 2012, possibly due to consumers waiting for the new gaming systems), SG&A expenses rose by $400 million over this period.
  • EBIAT has decreased from 2008 to 2012.
  • Capital Expenditures decreased from 2008 to 2012, which helped free up cash for the shareholders but could also signal decreased investment back into the business.
  • Despite the increase in SG&A and flat Earnings metrics, Free Cash Flow has more than doubled over the past five years, a good sign for stockholders.

On the far right I have included a column with the Compound Annual Growth Rate (CAGR) of the various financial data to show how these parts of the Gamestop business have grown over the past five years. We can use these growth rates to attempt to predict into the future, along with our own modifications based on our beliefs in the future of the business.

Next: Net Working Capital
Previous: DCF Glossary

Is Gamestop Overvalued? – DCF Glossary

Before walking through the model, here is a glossary of common accounting and finance terms that will be used throughout this blog series:

Sales/Revenue: Sales or Revenue is the total dollar amount a company has “realized” (received) through the sales of its products and services during a given time period.

Cost of Goods Sold/Cost of Revenue: These are the costs directly associated with producing the company’s products or services, which include the cost of materials used and the labor of making the product or doing the service.

Gross Profit: The profit earned by a company after subtracting the costs directly related to producing its products or services. This can be used as an indicator of the company’s efficiency and for determining gross profit margins.

Selling, General, and Administrative Expenses: These are expenses a company incurs that are required to run the business but not to directly make an individual product or service. Basic examples of this are building rents, utilities, and administrative and sales employee salaries.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): A common metric for operating cash flow since it reflects the company’s total cash operating costs for producing its products or services. It is also important for comparing companies in the same industry against each other because EBITDA is free from the differences companies have in the “capital structure” (whether a company is funded by stock investment or debt, and the interest expenses that come with debt) or tax rates. If this is not given by the company, it is calculated by taking the company’s reported “EBIT” number and adding back in Depreciation and Amortization. These are added because they are not cash expenses (cash was spent at some point in time, but not on a continuing basis). This is a non-Generally Accepted Accounting Principle measure, but is commonly used by companies and financial analysts.

Depreciation and Amortization: These are two methods for decreasing the value of an asset because it has been partially used. The layperson example of depreciation is of an individual’s car losing value after buying and driving it because the car has been used and is therefore older and potentially more “worn down”. Companies have assets which they depreciate in a similar manner. Amortization is reducing the value of an “intangible asset”. An layperson’s example of this is an “amortizing home loan”, where the loan’s principal value decreases steadily with each mortgage payment. While the house might be an asset, the loan is what is being paid, and financial instruments like loans can be considered “intangible”.

Earnings Before Interest and Taxes (EBIT, also known as Operating Income, Operating Profit, or Operating Earnings): The reason EBIT is also called Operating Income because it is the measure of a company’s profit after all its operational expenses (the SG&A, Depreciation, Amortization, and Cost of Goods Sold) that are part of earning its revenue are subtracted from its revenue. The only expenses left are interest on debt and taxes, which do not directly affect the business’s operations except as final expenses.

Taxes: The taxes applied on a company’s earnings. Typically for basic modeling purposes analysts will use 35% to 45% tax rates, but companies will give more detailed tax expenses or credits in their public filings.

Earnings Before Interest After Taxes (EBIAT): Earnings after taxes is sometimes used as a metric for comparing companies, but less so compared to EBITDA. Taxes are taken out because they are an expense that company’s have little influence on compared to the rest of their business and so are considered not highly relevant when trying to figure out how healthy a business is.

Capital Expenditures (CAPEX): A capital expenditure is an expense used to acquire or improve a company’s assets, such as building new factories and buying equipment. These expenses are made with the intent of growing the business. This is found in a company’s Cash Flow statement.

Current Assets: Current Assets are non-cash assets that can be used or turned into cash within a year, such as Accounts Receivable (payments due from customers to the company) and Inventory. This is found on the Balance Sheet.

Current Liabilities: Current Liabilities are liabilities that need to be paid or settled within a year. This is found on the Balance Sheet.

Net Working Capital (NWC): This is a company’s “Current Assets” minus “Current Liabilities”. This shows how much cash and other liquid assets a company uses to run its operations. One important point is that an increase in NWC is a use of or decrease in available cash because the cash is being turned into assets like inventory used to grow the business. A decrease in NWC is either caused by assets being used up to generate cash or liabilities decreasing, and is therefore an increase or source of cash.

Free Cash Flow (FCF): This is the cash left over after all the expenses of running the business have been removed from revenues. Free Cash Flow is what companies use to grow the business, save for a rainy day, or give money back to shareholders.

Weighted Average Cost of Capital (WACC): Companies are funded by some mix of equity (stock ownership) and debt. Investors who either buy the stock or give the company loans expect some return on their investment. The “cost of capital” is financial jargon for an investor’s expected return. Because stock and debt are have different legal and financial arrangements between the company and investors, they have different costs. A lot of public companies use a combination of stock and debt, so you have to find an average between the cost of stock and the cost of debt to the company. The equation for the Weighted Average Cost of Capital is:

WACC Equation

Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
T = corporate tax rate

Tangible Book Value (Per Share) (TBV): Tangible Book Value is the value of the company if it had to sell off all its tangible assets at the value of those assets in its accounting books. “Intangible” assets like trademarks and brand recognition are not included because, in a situation like bankruptcy where a company has to sell all its assets, intangible assets would have no or unpredictable value. If a company supplies its TBV data (which they typically do), it will appear on the Balance Sheet. TBV per share is the company’s TBV divided by the number of shares of stock, telling each shareholder how much of the company’s value his stock is worth.

Terminal Value: The value of the company as an ongoing business. In the context of a DCF model, it’s the value of all the potential future profits outside of the immediate years in your model.

Perpetuity Growth Rate: The annual rate at which the company’s terminal value will grow indefinitely into the future. This is a way to factor into your model the expectation that the company will continue to grow and this growth should be considered when valuing the business. This percentage is rarely more than 3% per year, which is the target for annual growth of the USA economy as a whole.

Enterprise Value: The value for the entire company. The equation for Enterprise Value is: Value of all the common stock (called “market capitalization”) + value of preferred stock (often given to special investors or founders/managers of a company) + value of debts + Minority Interests in Other Business – Cash and cash-like assets.

Next: Starting the DCF Model
Previous: Supporting Arguments