Sports betting company DraftKings (NASDAQ:DKNG) has been one of the hottest stocks of 2020, soaring about 68% (as of Monday's close) since it formally went public through a special purpose acquisition company (SPAC) in late April.
However, investors should be aware that the company's valuation may be more expensive than it first appears due to the creation of additional shares that will soon add to the share count and dilute shareholders. Inappropriately calculating the number of shares outstanding throws off the math on total market capitalization and leads to errors in valuation -- investors may want to sharpen their pencils!
What is DraftKings' market cap?
Market capitalization measures how much a company's equity is worth, and it is defined by multiplying the stock price by the number of shares outstanding. Market cap seems like a straightforward calculation, but it is often obscured by share-based compensation, mergers, accounting, or other issues.
When DraftKings went public in April 2020, it indicated that it had roughly 336 million shares outstanding. The company's stock price was around $20 at the time of the SPAC IPO. Therefore, the market cap was $6.5 billion (336 million shares multiplied by the $19.35 share price).
Things changed quickly. DraftKings issued more shares in a follow-on offering in June after the stock doubled in price to over $40 per share. The company issued an additional 16 million shares in the follow-on offering, bringing the total share count to 352 million (16 million plus 336 million). This brought DraftKings' market cap to $14.0 billion ($40 share price multiplied by 352 million shares).
The stock has declined to $30 per share as of this writing, implying a $10.6 billion market cap, but the share count hasn't changed since the last offering. Beware that many popular websites currently misquote the company's market cap because they haven't yet updated their databases for the recent follow-on share offering.
But wait, there's more (share dilution)
It is factually correct to quote DraftKings as having 352 million shares outstanding, but more shares are expected to be issued in the near and not-so-distant future due to complicating factors. The additional shares will have the effect of increasing the market cap and diluting current shareholders.
First, as a quirk of the way DraftKings became a public company, there are 35 million warrants outstanding. Warrants are a type of financial derivative that can be exercised to acquire stock (similar to call options). The warrants DraftKings issued are in the process of being converted into common shares. That process is expected to result in the issuance of 16.3 million additional shares of stock later this year.
There are also shares that may be issued in the future contingent on the company's financial performance. DraftKings has reserved 6 million shares for SBTech as part of its acquisition of the gaming technology company earlier this year. If the company hits certain performance milestones, those 6 million shares will be granted. The company has also reserved 13.1 million shares for employee stock compensation. The employee shares will vest based on performance metrics and assuming the employees remain with the company.
To be clear, these shares totaling 35.4 million (16.3 + 6.0 + 13.1) have not yet been issued and are not technically included in shares outstanding -- they are future shares which are referred to as dilutive shares. Adding 35.4 million shares would increase the company's share count (and therefore its market cap) by roughly 10%, making the stock that much more expensive for investors.
It is up to investors how they would like to calculate market cap regarding the dilutive shares. The warrant shares are expected to hit the share count this year and should probably be included, but the shares contingent on performance metrics could theoretically never be issued.
How should investors value DraftKings?
Valuing DraftKings stock is difficult for a number of reasons. Starting with share count, if investors can't accurately calculate market capitalization, it makes the job of determining whether the stock is over- or undervalued more difficult.
Even more confounding is that DraftKings is not a profitable company. Therefore, most traditional valuation metrics like the price-to-earnings ratio are not relevant. That doesn't mean DraftKings isn't a valuable business; it just means investors need to look to other metrics.
The most relevant metric for valuing DraftKings would probably be the total addressable market (TAM). DraftKings has noted that it expects the TAM for U.S. online gambling to eventually be as high as $40 billion! Hypothetically, if the company can take 20% market share of that future TAM, that would translate into $8 billion of revenue. Many internet and e-commerce stocks trade at revenue multiples of five times or higher. If DraftKings earns a high revenue multiple on that hypothetical future revenue, it would imply a market valuation in the tens of billions. This type of math and speculation requires believing in the company as well as the industry's potential which may or may not shake out.
Bottom line: DraftKings is a growth stock expected to generate healthy profits if and when the U.S. sports gambling market matures. The important questions investors need to ask are: How big could the U.S. sports gambling industry become, and how large a slice will DraftKings take? Only by putting the current market capitalization into the context of DraftKings' future prospects will investors be able to determine if the stock is a good buy today. And of course, knowing the actual market cap of the company today informs investors of what they would need to pay today against that future value.