What's going on with Twitter?

By special request, I am going to discuss my thoughts on Twitter and the volatility of its share price.

As anyone that reads my writing will know, I believe that markets are efficient.  The price of a security reflects all available information.  Practically, the price of a security is governed by the bid-ask spread that develops when people buy and sell it.  The collective knowledge of the people buying and selling securities is what makes markets efficient.  With that in mind, why is Twitter's share price so volatile, and why has its price appreciated so much since its IPO if it hasn't turned a profit?

To answer this, I would first like to discuss where share value comes from.  The value of any asset stems from the cash flows generated by the asset, the lifespan of the asset, the expected growth in the cash flows, and the risk associated with the cash flows.  In the case of Twitter, we are really only concerned with the expected growth rate in cash flows.  If we say that the price of a stock rises based on the feelings of investors, it is really rising because investors feel that cash flows will see significant growth in the future.

Based on the preceding information, the answer to the question regarding Twitter's volatility is obvious; the price is based on the opinions and ideas that a bunch of analysts, traders, and fund managers have regarding the company's expected growth in future cash flows, and their consensus is subject to change.  If Twitter had years of stable financial information that could be used to forecast future cash flows, these people would likely arrive at a stable price consensus because less imagination would be involved.  As for why its price has shot up so much, I would call it speculation.  There are two types of people involved; people thinking that the company will become profitable and the share price will appreciate, and people thinking that they will buy the stock today and a greater fool will buy it for more tomorrow.  The firm has not changed, it is the excitement around the firm's potential to generate cash flows in the future that has changed.  This excitement around future cash flows is what makes investing in companies like this such a poor bet.

I previously wrote about a paper that discusses the idea of investing in growth companies.  It is a dangerous game when many people are speculating on growth due to the effects that speculation has on the P/E ratio.  Even if this company increases its earnings dramatically and becomes a stable performer, the price has to increase relatively with the earnings to make this a good investment based on growth potential.  As actual earnings increase, it is not likely that the P/E will increase with them; the price will remain stagnant or grow at a fraction of the rate of the company because those future earnings are already priced in today.

To summarize, I think that it is possible that Goldman and friends had lower earnings growth built into their valuation model than what the market was willing to accept, I missed the IPO, and I would be hard pressed to believe this stock will be a sure bet.  Its price is not based on the growth of real cash flows, it is based on the guesses and estimates of the collective body of information that makes up the market.