Interesting article
Worth Online
"YAHOO AND YEE-HAA!"
By Robert X. Cringely
03/24/99
Why does it seem the old rules don't apply when it comes to valuing internet companies? Because they don't. Accept that now, or regret it later.
For most of this longest of bull markets they've been with us, the Internet initial public offerings. From Netscape Communications in 1995 right up through whatever little tech company goes public this afternoon, we've had this phenomenon of spectacular early price rises that seem to have no fundamental economic support whatsoever. Sometimes gravity reasserts itself, but sometimes it doesn't, leaving us with a few companies with market capitalizations almost beyond understanding. How the heck did Yahoo get to be worth twice as much as Sears?
Something has clearly changed. A market driven for decades by price-to-earn rations appears to no longer require an "e" in p/e. The old technique of building a profitable little company, tuning earnings for a few quarters, then going public to finance the next big growth spurt is over. Now high-tech companies are born, introduce a product, then go public. It's as though all it takes to get money coming in from the capital markets is to have a product--almost anything--going out the door. And of course there are market fundamentalists who see this as a death trend, the end of market life as we have known it. But those fundamentalists are wrong. Yahoo really is worth all that money.
It started not with Internet stocks but with biotechnology. From Genetech in the 1980s on, the market embraced the concept of buying into a stock that not only had no earnings to support the price but often had no sales. Somehow in biotech, with the FDA-enforced long time to market, it made sense. It was easy to see a potential bonanza slowly working its way through the product-development pipe. The biotech companies found they could turn to the public for their last round or two of what otherwise would have been venture capital. Though going public is a pain in the butt, regular investors consistently support higher valuations than do jaded venture capitalists, so the entrepreneurs get even richer.
And when the companies turn to the public for venture capital, the real VCs are freed to spread their money across an even larger swath of companies. Since they are often playing the odds, more companies means more innovation, more successes. And more growth. Early IPOs have thus turbocharged the whole wealth-generation apparatus. It's possible to argue that this has been a major factor in extending the bull market.
So we have all become venture capitalists. And in the case of Internet stocks, our rationalization for doing so is provided by the holy trinity of Microsoft, Cisco and Dell. Of course, these companies aren't at all like today's Internet start-ups. Each of them had a good old-fashioned IPO complete with sustained earnings growth. But it is the results of those IPOs that got our attention. If you'd invested $100 in Microsoft in 1986, you'd have $42,000 today. If you'd put $100 into Cisco in 1990, you'd have $53,000. A $100 stake in Dell in 1988 would be worth more than $53,000 now.
That's why investors are willing to jump earlier than ever on what they believe to be the gravy train, even before their dream company is profitable. All it takes is a consensus that the product area qualifies as the next big thing. The last big thing was the personal computer, and the next big thing, everyone seems to agree, is the Internet. Internet IPOs are hot.
A question investors often ask is "How can these share prices be sustained without earnings?"; The answer is they are sustained because we sustain them. The market no longer seems to require earnings from certain types of companies. And if the market doesn't require earnings to support a good stock price, then it would be foolish for these companies to have earnings. It is much smarter for the companies to fold right back into growth what might otherwise be booked as profit. Why pay taxes? Could amazon.com be consistently profitable? Yes. Could Amazon.com be consistently profitable and still prevail in its death struggle with Barnes & Noble? Probably not.
For Internet companies, it is grow or die, and we as investors seem to have bought into that concept. We all seem pretty confident that the Internet will eventually revolutionize communications and entertainment. So we're happy with the industry. It's choosing the right company that's the hard part.
Which brings us to Yahoo. This is the quintessential Internet portal, the single most valuable property in cyberspace, yet it is also a company that owns no technology. You could build your own Yahoo from off-the-shelf parts. The founders were a pair of slacker Stanford Ph.D. candidates (not as much of an oxymoron as you think) who started the company as a distraction from writing their dissertations. Jerry Yang and David Filo are billionaires today. But they aren't Yahoo. True, Filo's title is Chief Yahoo, he lives in the same grotty apartment has always has, he drives the same grotty car, and he can usually be found in his bare feet when at work. But Yang and Filo are figureheads. Yahoo is like Disney's Frontierland, a rustic fa‡ade under which you'll find a high-tech machine with a Michael Eisner type at the very bottom, scooping money into a bucket.
Yahoo is a franchise, and that's exactly what you want to look for in an Internet investment. Does this company define a category? Does it lead that category? Does the company have staying power? Yahoo and its very professional management have bedeviled competitors from the beginning. Ten years from now, when the Internet as a financial engine is a hundred times as big as it is today, Yahoo will be there, and that's what makes it a good investment. Yes, Yahoo is worth $30 billion.
The same basic principles can apply on a smaller level. Here's an example from my own admittedly quirky portfolio. I am an investor in an Internet mortgage broker called E-LOAN (www.eloan.com). E-LOAN is not yet a public company, so mine was a private investment. In fact, it was more like a panic investment, because the company was unable to make its payroll. I literally covered the payroll for a week in exchange for stock. Start-ups are always running out of money.
So how did I justify my investment in E-LOAN? It satisfied my five criteria for a great Internet investment: 1) I could afford to make the investment; 2) the niche E-LOAN chose ? the Internet mortgage brokerage ? was a no-brainer. The Internet is perfect for selling any product that can be delivered as electrons and for which the Net can be used to eliminate middlemen; 3) E-LOAN was an early player in this niche; 4) the founders were experienced mortgage brokers who added technology, not nerds trying to learn the mortgage industry; and 5) it just seemed obvious that E-LOAN would either be a long-term player in this niche or would be acquired at a premium. As long as it could make the next few payrolls, I assumed my investment was secure.
But what if it wasn't secure? What if E-LOAN went down the tubes? I could afford to lose the money. This is the first and last key point to Internet investing: Invest only money you won't miss. It's not that you expect to lose the money, but investing from this position makes it much easier to take a calculated risk. Some experts advise investing in a basket of high-tech companies, hoping for one big score. All this technique does is drag down your return. Instead, take that money you were holding in Krugerrands and bet on what you believe will be the next franchise company.
"All great companies almost always look expensive," says Michael Moritz of Sequoia Capital, Yahoo's original and very happy VC. "Microsoft has almost always been considered expensive. Cisco has almost always been considered expensive. The only thing that is more expensive than becoming an investor in one of these franchise companies is not being an investor." |
