I’ve been analyzing YouKu.com (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.
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…