'Valuing Internet stocks: It can be done'...
<<By Abhishek Gami
Special to the Tribune
August 3, 1999
It seems everyone has an opinion about the value of Internet stocks. Many are valid, but one very dangerous school of thought has emerged: The value of Internet stocks can't be assessed because of their nearly limitless opportunities.
Such thinking leaves little room for determining stock values that reflect a reasonable balance between risk and reward, and it fails to take into account the market opportunity as well as whether an Internet company has the right stuff to sustain a long-term franchise.
Traditionally, valuations are determined by taking a company's profits or earnings and multiplying the figure by a number that the stock is believed to be worth. In the Internet world, however, business models shift rapidly as new market opportunities are uncovered and confidence in a particular company might swing in response to various events. This can change stock values more rapidly than in a more mature industry and makes it difficult to apply traditional valuation parameters. Although we can't ignore these traditional methods, it's hard to apply them to companies that aren't making money yet and don't have established revenue or earnings.
Internet companies spend a lot of money to win market share. Because their marketing expenses are so high, they often fail to turn a profit, even while increasing revenue and market penetration. In the long term, market share is an invaluable asset, so it isn't fair to look at a company's decreased earnings and profit and declare, "This is bad." Quite the contrary, so far Internet companies that can spend the money to gain market share have drawn investors.
The challenge analysts face is to find new ways to determine the value of Internet stocks. The commercial Internet market is less than five years old, and therefore revenue or sales is the best indicator of whether a company is succeeding. This can be applied both to companies that are ready for prime time and those that are still in a preproduction or evangelist state and therefore generate more publicity than financial returns.
By using revenue to calculate value, there is no penalty for companies implementing aggressive and often expensive marketing activities that could lead to near-term losses and decreased profitability. At the same time, indiscriminate spending should not be rewarded either. Therefore, investors must assess the validity of a company's spending and whether it, and the organization's long-term strategy to maximize profitability from that spending, make sense.
To make sense of this seemingly mad market and calculate the value of Internet stocks, analysts need to know quantitative data (forecasted growth rates, margin and revenue estimates) as well as qualitative information (an assessment of management's capabilities, the company's market opportunity and an analysis of current company fundamentals). While the quantitative details will produce a targeted price, it's meaningless unless the qualitative aspects of the company pass muster.
At issue is how far out can one project the quantitative data and still feel comfortable. For the sake of argument, consider "Company X," which has a large market opportunity, 10 different products to sell and millions of customers already signed on and using those products. For a company such as this one, we feel comfortable with forecasted figures as far out as four years.
Now, consider Company Y, which has 10 large customers today, a large market opportunity, but only two products that are ready for shipment. Although the executive management of Company Y seems just as intelligent and demonstrates as much confidence as that of Company X, we should be less confident of Company Y because of its limited product line.
Because Company Y has just two products and only 10 customers, the loss of a customer could cause severe financial damage, so we might have confidence in estimates that are only two years out. Based on the fast growth of the Internet market, the further out you are willing to believe the projections, the more you should be willing to pay for that company's stock today. Ultimately, it comes down to comfort with a company's fundamentals. In this scenario, because Company X has a strong revenue history and a series of cutting-edge products that will have a ready audience for at least the next few years, we should be willing to pay more today to own that stock.
Market leaders are afforded significant premiums in the valuation game. While this is logical, in some cases those premiums reach levels that imply investors might be expecting more than a company ever could deliver. We sometimes find that investors are looking five or more years out to arrive at their price objective. There is nothing wrong with this if the company continues to perform at a high level, but it represents an enormous amount of risk. Consider biotech companies like Amgen, and even software giant Microsoft, which soared in their early years and then spent a couple years or more trading sideways and downwards because their stock prices got ahead of their fundamentals.
While the actual calculations are relatively simple, the most important part of the equation is the qualitative information--the strength of a company's management. The Internet moves quickly, so errors in judgment and faulty execution can cripple a company and leave little hope for recovery. A common investing blunder is placing too much faith in management and business models because of strong near-term industry growth. Additionally, investors should take care to investigate a company's true earning capacities.
If investors pay heed to these fundamental principles to identify the true value of a company's stock, they will find it easier to participate in the sector, which can be much more interesting and than avoiding it altogether. If an Internet stock is trading at a level far in excess of what our methodology indicates is the appropriate risk or reward level, we recommend that investors look elsewhere instead of chasing a "hot stock."
Abhishek Gami is a research analyst for Chicago-based William Blair & Co., an investment banking firm specializing in investment advisory services. E-mail him at net@wmblair.com. >> |
