#80: Valuing The TradeDesk Is Two Sides of Coin
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Revised Thinking on How to Value The Trade Desk
Valuing a business is not a difficult exercise: Start by studying the historical performance and then identify what should boil down to a few performance drivers (e.g. revenue growth, operating profits, and investments in invested capital) to get a picture of future free cash flow. The rest will fall into place. You’ll end up with a valuation estimate and compare it to the current stock price to see if the company is undervalued, overvalued, or trading around your fair value estimate.
When it comes to valuing The TradeDesk it’s not so straightforward. TTD is trading at a ~$46 billion market cap today or ~$95/share. However, coming up with a sound model and fair forecast of future cash flows will not get you there. Not even close.
Yet at the same time, The TradeDesk is perhaps the most interesting and compelling company in advertising today with an outstanding management team and a strong company culture. That’s precisely why trying to value TTD is a story about two sides of a coin.
On one side (heads) you have your classic discounted cash flow (DCF) valuation model that considers all the material drivers of value creation in the future. On the other side (tails), you have gut instinct compelling you to believe that a major event that is going to happen at some point in the future and TTD will be a major benefactor of that event. Let’s examine both sides of this fascinating coin.
TTD Valuation Model: Paid subscribers can check out our simplied DCF model at the end of this post.
Heads = Valuation
Revenue: The historical performance for TTD is one of the best in adtech. Revenue growth continues to impress investors with every passing quarter. TTD recently reported 1Q24 on May 9 with 28.3% YoY revenue growth. Full-year results in FY23 (reported in February) showed strong revenue growth at 23.3%. TTD routinely beats digital and display ad market growth by over 2x according to eMarketer’s estimates which means it’s taking share from other players. Who else is doing that in AdTech Land? Not many.
Operating profits are a different story: Unadjusted EBIT margins maxed out in FY20 at 17.2% and were 10.3% in FY23. There is no rational way for a forecast model to get you to a $46B valuation on 10% EBIT margins. It’s simple not in the realm of probability.
Something has to change to get there. Like many other companies, we expect to see EBIT margin expansion manifest through AI-driven productivity gains (e.g. fewer people getting way more done thus bringing data processing and operating costs downward). But even if you assume stellar 30% EBIT margins in the future, it’s still does not generate enough operating profits to justify $46 billion. Something much bigger is needed.
Invested Capital: The next thing we examine is invested capital which is working capital plus capital expenditure on tangibles and intangibles. Importantly, before we calculate invested capital, we need to make an important adjustment to R&D expense which is favorable to TTD’s profit margins and valuation.
Philosophy: Quo Vadis takes Damodaran’s view on capitalizing all R&D expenses for valuation purposes, especially for “tech” companies. 100% of research and development expenses should be treated as tax-deductible capital expenditures not just the software development expenses as GAAP.
So, for The Trade Desk, we capitalize all R&D expenses on a 5-year schedule creating a $246 million adjustment to operating profits (EBIT) in FY23 bringing EBIT margins up from 10.3% to 22.9%. In other words, the amortized R&D expense is much less than the actual R&D expense recorded by the accountants.
Turning back to invested capital, that means $893 million of capitalized R&D is added to TTD’s invested capital bringing it from $1.1 billion to $2.0 billion and giving us a normized view of return of invested capital (ROIC).
Bottom Line: Ultimately, the only thing we really care about when valuing any company is its ability to create ROIC above its cost of capital. The bigger the spread, the more true free cash flow you’re generating for investors.
TTD Historical Financial Summary
Next, we turn to NOPAT or Net operating profits after cash taxes: Our model shows two approaches. The first approach adjusts reported taxes into an estimate of cash taxes by removing tax shield on net interest expense/income and reconciling deferred taxes.
The second approach assumes that any company will always pay a ~20% cash tax rate past, present, and future. Importantly, our 20% cash rate assumption is favorable considering the standard academic assumption which assumes a 27% marginal tax rate for federal, state, and local taxes. For instance, FY23 trued-up adjusted taxes were $152 million but the 20% cash tax rule is much lower at $89 million resulting in $357 million of NOPAT instead of $294 million with the standard approach.
With these adjustments in place, we see a business generating 18% Return on Invested Capital (ROIC) which beats TTD’s cost of capital by 6% deliverying a healthy 17% fundamental growth rate.
Free cash flow: With $357M in NOPAT and $340 in net investment which incorporates the change in operating working capital, depreciation and capex, TTD generated $17.4 million in actual “purified” free cash flow in FY23.
10-Year Forecast
With our sound historical view in place, we look to various profit-generating drivers to forecast future free cash flow.
Let’s start with revenue growth: As you can see in the model, TTD’s natural growth decay will take revenue growth from 23.3% in FY23 to 7.5% growth rates ten years down the line. That means revenue ten years from now will be $6.8 billion on gross ad spend of $34 billion (3x current gross ad spend) assuming take rates remain constant at 20%.
Forward EBIT Assumption: Next, we come to a really big assumption. We assume EBIT margins (adjusted for capitalized R&D) will grow from 23% to 30% over the next ten years.
On one hand, that’s rarified territory for any business. Average EBIT margins across the S&P 500 over the last 20 years are 14.5%. On the other, we would not be surprised in the slightest if TTD pushed operating margins up to 30%.
Cash outflows: TTD’s invested capital grew by 20% from FY22 to FY23. Importantly, the more a company invests back into the business, the more cash outflows are taken from free cash flow. It’s a management balancing act.
Going forward in our 10-year forecast, we assume at 10% YoY growth in invested capital on a constant basis which is admittedly a bit light and therefore favorable to valuation. You always have to keep in mind that big revenue growth assumptions need to tempered with a comensurate investment rate back into the business.
Base Valuation: After we subtract the value of all the stock options and restricted stock units, add back excess cash (e.g. cash not needed for working capital), and then subtract the only material debt equivalent on TTD’s books (operating lease liability), we get a value of $11/share.
Yes, we know. That’s a difficult output to believe given TTD’s statue at the top of the adtech foodchain trading $95/share. However, if you believe in the time value of money approach and discounted cash flows as the best way to estimate fair value (it works well for Warren Buffett, Bill Ackman, and many other value investors) then it is what is, as they say.
Upgraded Assumptions: Needless to say, that’s a really wide gap to fill. So, instead of believing revenue growth will decay over time, let’s assume it grows 20% YoY at a constant rate for the next ten years. That’s unlikely, but we’ll do it anyway which takes us to $29/share.
With that kind of revenue growth and 20% constant takes rates TTD will control $80 billion of media dollars by FY33, but we’re still not where we need to be to justify TTD’s current $46 billion valuation.
Going Huge: Let’s completely juice the model with a toggle switch we call “Huge.” Huge assumes $200 billion of gross ad spend in ten years time at 20% constant take rates while growing to 30% EBIT margins. A huge future gets you close to ~$95/share.
Total global ad spend in FY23 is estimated at $900 billion. Take
’s work at and assume 5% annual growth over the next ten years and global media spending will be $1.5 trillion with a “T.” If our “Huge” scenario plays out for TTD, they’ll control 13% of global media spending vs ~1% today.Here’s the main thing: Getting to 1% market share is practically impossible and yet TTD got there. That raises a simple question: If you can get to 1%, then can you get to 13% and play ball with market share leaders like Google, Meta, Amazon and share-taking stars like TikTok?
Tails = Big Black Swan Event
Forget about all the aforementioned numbers. If you try to value The TradeDesk with numbers, you won’t get there. The reason why is very simple. TTD’s valuation is pegged to a big event that is going to happen in the future. A black swan kind of event.
Nobody can predict it. Quo Vadis cannot predict it. You can’t predict it. Not even AdTechGod(s) can predict what the event is or when it will happen. But it’s going to happen. And when it does happen, TTD is going to be a big benefactor. And that, in a nutshell, is the bet investors are placing on TTD.
Unfair Advantage: The TradeDesk has one huge advantage when the big event comes. They don’t just have one of the very best CEOs in adtech, they have one of the best CEOs full stop.
For Quo Vadis, what we find most interesting about Jeff Green is not what he’s accomplished in the advertising space. That’s rarified territory. The bigger question is what he could accomplish next that is completely outside of advertising. It could be anything he sets his mind too.
We saw an indication of this future big event last week with the Netflix announcement about its ad tech platform. One analyst estimates that the deal will generate an incremental $500M in gross ad spend. That’s a drop in the bucket compared to $200 billion, but it’s a sign nonetheless. That’s not the big event we are talking about here. Not even close.
Only two questions remain for Quo Vadis readers:
What is this big event?
Will you be surprised that The Trade Desk benefits from it?
Valuation Model Tutorial
Paid subscribers can request access to our simplified model.
The model allows for a handful of input assumptions that you can change to study different scenarios.
You can choose the three different revenue growth scenarios discussed above.
Since many research analysts wrongly add back stock-based compensation expense to EBIDTA as if it never occurred as an expense, the model also allows you to do just that to juice the valuation. Doing so creates a material value lift, but you still can’t get to a $46 billion valuation. Our approach to SBC relies on the wisdom of Damodaran which is to count SBC as an expense and then adjust the company’s valuation for outstanding options and RSUs using Black-Scholes.
Enjoy! Feel free to share your thoughts.
Disclaimer: This post, and any other post from Quo Vadis, should not be considered investment advice. This content is for informational purposes only. You should not construe this information, or any other material from Quo Vadis, as investment, financial, or any other form of advice.