At Goldman Sachs, Chinese Tech Companies Apparently Have the Same Risk As U.S. Ones

24 Jun

I’ve been analyzing (YOKU) for the past three weeks, and as I said most recently, I can’t possibly see how the stock could be worth more than about $21/share, using what I think are pretty optimistic assumptions.  I read Goldman Sachs’ – YOKU’s lead cheerleader underwriter – report before I published, and I’m still going through it and finding data, figures, conclusions and other “analysis” I find very puzzling, to put it nicely.  I’d made a note to myself during my first read-through to go back and check GS’s WACC calculation, since their Cost of Capital was only 12%, which seemed pretty low to me considering we’re trying to value a high-growth, relatively high-risk company in China.

Today, I finally went back and checked GS’ work, and what I found is at the very least EXTREMELY confusing, and at worst, deeply, deeply troubling.

Here’s why:

GS is using 6.5% as the Equity Risk Premium for a high-growth, high-risk company with all of its operations an emerging market economy (at least recently) plagued by poor internal controls/accounting/audits, shoddy corporate governance, and downright fraud?  In what alternate reality does that make sense?

Why would we use the U.S. ERP (6.5%, which may even be a low estimate depending on whose research you use. Last I checked, Ibbotson’s ERP is >100bps higher) for a such a company?  I can’t come up with a good reason, although I can come up with several bad excuses.  Does Goldman think YOKU should be worth SUBSTANTIALLY more (less) simply because its listed in the U.S. instead of China?  Huh???

Zhu & Zhu (2010, pdf) estimate Risk Free (Rf) and Equity Risk Premia for Shanghai, Shenzen, and Hong Kong stocks at 11.23%, 14.04%, and 8.19%, respectively.  Using my beta and these rates (along with Zhu & Zhu’s “adjusted ERP’s” which are significantly lower), we get the following values for YOKU’s Equity Cost of Capital using CAPM:

Because the adjustments account for factors I don’t think are relevant here (e.g. limited investment opportunities faced by mainland Chinese investors, etc), I prefer to use the unadjusted numbers.  So doing indicates Goldman’s Equity Cost of Capital is anywhere from ~22%-42% too low, which has a profound effect on the ultimate company valuation.  To give you an idea of just HOW profound the effect is without replicating Goldman’s numbers, if I change the Cost of Equity in my model from 15% to 12%, the valuation changes from $21.37 to $38.31, an 80% increase!  If Goldman had used an appropriate Cost of Equity in their valuation, their target price would be MUCH lower than $55, likely around the stock’s current price of ~$30.  After reading a fair amount of research, I just can’t imagine any way GS can defend using 6.5% as the Cost of Equity, at minimum, that number is ~150bps too low.

I’m not a huge fan of using Beta to estimate the Equity Cost of Capital (there are other, slightly less “scientific” ways of so doing), but what I think this exercise shows is that Goldman’s analysts have SEVERELY underestimated YOKU’s risk as measured by its Cost of Capital, which results in a SEVERELY inflated valuation.

For what its worth, I’m also not sure where Goldman got 1.2 for Beta, as my calculations using the NASDAQ for the Rp show it to be 1.31 (~8.5% higher) , even if we assume they only included prices up until the day before the report was dated.  I suppose they could have used a different index’s returns for Rp, or used weekly instead of daily returns, or something.  Why Goldman used 6.5% for the Cost of Debt is also a total mystery to me, though, as the footnotes to the firm’s SEC filings (pg F-24 in the 5/2011 prospectus) state the rate is 12%.  These is (slightly) less of an issue than the grossly understated ERP, so I’ll let it slide for now.

If I’m feeling adventurous, I might just contact Goldman and ask them to explain (defend?) their numbers.  I’m not going to lie, absent some fantastically surprising explanation, it looks like Goldman just did a goal-seek on the Equity Cost of Capital to get to the price they thought the stock is “worth,” which is a MAJOR screw-up the likes of which a summer intern wouldn’t even make!

I think no matter how you look at this, it looks bad for Goldman.  Its one thing to claim revenue will grow or margins will expand faster than other (less biased) market participants think to get your target price a few dollars higher.  Its another thing altogether to use such indefensible and wrong numbers to jack up your valuation like this.

At a minimum, Goldman has produced a report with an inappropriate Cost of Capital by “accident,” and didn’t update it for country (etc) risk, causing The Market to assign (insofar as GS reports are relied upon) a SEVERELY inflated value to the stock.  At worst, we’re looking at a gross, intentional, and possibly systematic abuse of valuation techniques in a report for a stock Goldman underwrote, a situation which if true, I’m sure the SEC and oodles of securities lawyers would LOVE to hear about…


7 Responses to “At Goldman Sachs, Chinese Tech Companies Apparently Have the Same Risk As U.S. Ones”

  1. Junior IBank Boy June 24, 2011 at 9:13 am #

    First lesson in IBanking, obtain the target prices you NEED first then work the model to fit it. Any target price can be reached with enough tweaking.

    • The Analyst June 24, 2011 at 9:15 am #

      Ha, of course the practice is nothing new, but the way they’ve gone about doing it is. Its easy to just estimate above-reasonable revenue/margin growth to goal seek to your target price, and much easier to defend vs using the wrong cost of capital. No excuse for that.

  2. Tony S June 24, 2011 at 9:17 am #

    I was going to contact goldman for their thoughts on this article. However, when I briefly searched their page I found no emails. Anyone happen to have an Exec email at goldman? My intention is not harassment or anything negative. I will be including my name, number and personal email. I just want their feedback on this article and others like it.

    • The Analyst June 24, 2011 at 9:24 am #

      The only contact info I have is for the analysts who wrote the report, sorry.

      • Tony S June 24, 2011 at 10:14 am #

        It is very strange, they have a feedback link:

        But usually companies of this size list more than just a general feedback. I guess when I contacted them in the past I knew who I wanted to touch base with. So was never forced to check their homepage.

        I found some contacts through Zoominfo, & linked in. Now, it is just trying to figure out which one of these fellows would be the best receipt. I’ve mentioned this in the past. But it lends great credibility (and much more) to your site & information that you actually interact with posters and respond to emails in a timely fashion.

        StoneStreet Fan,
        (Tony Schwartz)

  3. Tony S June 24, 2011 at 1:43 pm #

    I won’t hold my breathe or throw temper tantrums if I do not get a timely response to this one. But, I was curious to see if I could get feelings from people possibly more informed than myself… I am of the opinion many of the people @ GS should be in jail for their treason against the US economy and “working class”. CTFC and other watchdog groups seem to agree with me? I know there are congressmen and women who agree with me too. But, my congress is so full of people who put profits above people on both the republican & democratic side I find myself almost always torn who to believe. Before someone tries to sue me for defamation of character, I am just repeating what I heard in the news, from my congress and others. As far as I am aware while they might technically disagree with reasons or exact details people like: Krugman,Rogers, Schiff, Keiser also recognize many at GS as criminals. Dom from IMF also seemed to share in this opinion. I have even heard the word financial terrorist used. It seems like so quickly we are heading back to old ways. The Fed recently suggested no more bailouts(QE3) but it seems like we are back to same ole same ole. My opinion is if you are rich or poor… You should suffer for the intentional or unintended crimes that were a result of your actions, ignorance or neglect. Possibly I am reading and misunderstanding this?

    The Analyst & Ron Paul 2012!

    StoneStreet Fan
    (Tony Schwartz)

    • The Analyst June 24, 2011 at 1:46 pm #

      Most of the people who say that individuals at GS (or any other banks) should be in jail don’t have any idea what they’re talking about. Barry Ritholtz (lawyer) has made some statements along those lines, and while I don’t necessarily agree with some of what he says, at least he has the legal background, as opposed to the other pitchfork & torch crowd stokers you mention.

      If ignorance were a crime, the majority of the country would be in jail.

      Do yourself a favor and stop getting your finance coverage from the main stream media and fringe websites.

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