A company that is probably as far away from value investing as you can get right now is recently listed Zoom Video Communications Inc. (ZM, Financial). This business, which provides, almost exclusively, video communication tools, went public at the beginning of April and has since seen its share price appreciate by 170%.
After this gain, the company has an enterprise value of $26 billion, a colossal sum and completely nonsensical. Last year, the company made just $9.7 million in free cash flow and the current enterprise value is equivalent to 62 times its forward revenue.
Investors seem to be willing to pay this high price because the company is one of the fastest-growing software as a service businesses on the market right now.
Its current enterprise value, however, makes little sense because even the company itself expects the total value of the video communications market to be worth $43.1 billion by 2022. On this basis, at its current valuation, Zoom's enterprise value implies that the company will be worth 60% of the total market by 2022.
What's the company worth?
I will admit, I have used Zoom in the past. I think it is worlds away from other alternatives out there, so I am a fan of the business. Compared to alternatives such as Microsoft Skype, it is miles ahead of the competition. That being said, I cannot envisage any world where the company makes up more than 60% of its market. I wanted to use this as a case study for Warren Buffett (Trades, Portfolio)'s favorite method of valuing businesses, the method he attributes the fabulist Aesop with creating in 600 B.C.:
"Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn't smart enough to know it was 600 B.C.).
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was 'a bird in the hand is worth two in the bush.' To flesh out this principle, you must answer only three questions:
How certain are you that there are indeed birds in the bush?Â
When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)?If you can answer these three questions, you will know the maximum value of the bush and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars."
So, how does this apply to Zoom?
In trying to find an answer, we run into a problem almost immediately. It is difficult to tell precisely how much money this company will ever make from video conferencing.
The only comparable we have is Skype, which Microsoft (MSFT, Financial) bought for $8.5 billion in cash in May 2011. The company doesn't break out revenue figures, but, more to the point, most of the services Skype offers are free. You also have FaceTime, which comes with every Apple (AAPL, Financial) iPhone and video calling on WhatsApp. All of these services are free. So when Zoom says that its total addressable market could be worth $43 billion, there's no way of proving it.
Further, other estimates on the size of the global video conferencing market differ significantly from the company's own numbers. One estimate claims the market will be worth just $20 billion by 2024. On this basis, Zoom's current enterprise value is 50% bigger than what the market might be worth in five years.
In reality, we don't know how big the market will be in five years and what the future holds for Zoom. It could come to dominate the world of video calling. At this point, it is challenging to see that happening because we don't know how big the market is and if the business can ever make a substantial profit. In other words, we don't know when the birds will ever emerge from the bush, if they do at all.
Disclosure: The author owns no stocks mentioned.
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