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Owner's Manual

Owner's Manual

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The role of an investor is to constantly look out for capital allocators who are better than them and wear a learning hat. In today’s market, with liquidity abound and markets hitting new highs, there are everyday articles around valuations, PE and other metrics which are used as a barometer to define the relative value of a business.

At Itus, we believe that the value of a business is derived by its ability to generate cash flows. This cash flows growing gives the CEO the ability to reinvest the capital and when done well creates significant wealth creation for the minority shareholder. While valuations are important, we believe that they come lower down the pecking order in the way we view businesses.

With this as the background, I take you through one of the most contentious acquisitions made by a CEO to understand the thought process behind the investment when it happened. Through this, I aim to take the reader through the decision-making process, capital allocation decision, synergies seen to the business around how the Investment decision was made. This was touted by the analyst community as the worst investment decision made in the history of Corporate America but the rest is history.

The conversation (in Image 1) happened between Mark Zuckerberg (the CEO of Facebook) and David Ebersman (the CFO). To set the context, Facebook was a desktop application back then and was poor on mobile from a User experience. The decision was around how Facebook could fix a gap they had while acquiring users (on mobile) in the form of a network in an adjacent space.

Image 1 (Mark Zuckerber’s first email to his CFO on looking at acquiring a mobile app company)

Investing Pyschology

David’s response (the CFO) was along typical lines as most M&As typically result in failure. There were three big takeaways from David’s response. M&As fail with a high probability as they are done for one of the below

  1. Need for the CEO to show action in the business
  2. Neutralize a potential competitor
  3. Acquiring Talent

All three are very expensive reasons to do mergers as they can cost the business a lot. It is important to realize that the acquiree in question (Instagram) was a loss-making business that was young and Mark wanted to pay a significant premium for the deal.

Image 2: CFOs Response to Mark’s email looking at the failure rates of mergers to understand why Facebook needed to think of this

Investing Pyschology1

Mark’s response to David’s email highlights his thought process. He understood that it would take time for Facebook to bring its network into mobile and he did not want to lose time. Acquiring a mobile first product, would give him two aspects to his business – a growing network on a platform Facebook did not have and the ability to integrate the acquiree company’s products into their own. He thought of the acquisition from a different lens to most, which makes him one of the best capital allocators till today.

Image 3 & 4: Response of Mark which highlights how he thought of the merger and the synergies

Investing Pyschology2

 

Investing Pyschology3

It was the sequence of these emails that give us a rare insight into the decision-making process of the founder. Do note that there was no talk of PE, PB, EV/ Ebitda, the usual valuation metrics used to decide the investment process of ‘sophisticated investors’.

In fact, he was talking about paying an excessive premium to acquire the company of interest.  The analyst community called this one of the worst capital allocation decisions by a CEO (Reference: Facebook buys Instagram for $1bn and everyone hates it already)

Today, Instagram generates quarterly profits to the tune of the same number Facebook paid to buy the company.

There are multiple lessons to learn for an investor through this eye-opening journey of the mind of the founder of Facebook around capital allocation and investing decisions. While it would require 3 years to understand if the decision was a well-thought-out one, the framing of the thought process around the business and keeping valuations down the pecking order was one of the biggest takeaways we wanted to ride home.