And this.
September 11, 1998
How to Pinpoint the Next Recession
Waiting for Yahoo! to Get Cheaper
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IS THE PARTY
over for Internet
stocks? We'd
like to think so.
But just when it
seems the
insanely high
valuations of
these issues
have come down
to earth (or close
to it), their
resiliency
astounds us. As
the Dow
dropped 249.48
points Thursday,
Yahoo!
(YHOO) closed
down a mere 1/8 of a point. Excite (XCIT) actually gained
8.4% to close at 28 1/4 on news of a deal with online movie
retailer Reel.com. Only investors in Amazon.com (AMZN)
seriously embraced the selling spirit, driving down shares of
the online bookseller 5 points or 5.7% to 79. But the selloff
manifested itself only after a spate of articles suddenly
discovered that Amazon is in a notoriously low-margin
business and has scant hope of turning a profit until well into
the next millenium.
The absence of earnings may be one reason to avoid Internet
stocks, but it isn't the right one. Amazon and Yahoo are both
well-managed companies with promising futures, and may
well turn out to be the next Microsoft (MSFT) or Dell
Computer (DELL) -- in other words, the next great tech
stocks. The real trouble is, despite the recent fall from their
Everest-like highs (Yahoo is down 23% from its July 21 high
of 103, Amazon down 46% from its high of 147 on that date),
these stocks are still too expensive.
In fact, their prices are out of all proportion with the great
tech stocks everyone wishes they had bet on years ago but
didn't. As our chart above shows, Microsoft and Dell, for
example, have classically traded at P/E's of roughly 32 and 27
times trailing earnings, respectively, according to
SmartMoney's own research. Back in 1986, when Microsoft
went public, a year in which observers ranted about
speculative excess and unreasonable premiums, the
company's stock was considered expensive. But even then
you could have bought in at less than double the P/E of the
S&P 500, which has averaged 18.9 over the past 12 years.
Dell was even cheaper.
INTERNET STOCKS: WHERE WE'D LIKE TO SEE THEM
COMPANY
CURRENT
PRICE
FORWARD
P/E*
PRICE WE'D
LIKE TO SEE
TODAY
FORWARD P/E*
WE'D LIKE TO SEE
TODAY**
Amazon.com
(AMZN)
$75.75
244
$18
57
Doubleclick
( DCLK)
$21.19
177
$5
42
Excite
( XCIT)
$26.63
38
$24
35
Lycos
( LCOS)
$24.94
75
$12
35
Yahoo
( YHOO )
$78.38
114
$27
38.5
*Based on year 2000 EPS estimate
**P/E reflects a 30% discount to the stock's secular growth rate
They were expensive, yes, but they received nothing like the
premium Yahoo! has enjoyed: At Thursday's close of 79,
Yahoo trades at a multiple of 247 times this year's projected
earnings of 32 cents a share, a pretty hefty premium to the
company's projected earnings growth rate of 50% per year,
whatever financial model you're using.
Some of the other Internet valuations are equally ridiculous.
Should you really be paying 75 times Lycos's (LCOS)
expected year 2000 profit of 33 cents per share? At today's
price of 25 and with losses last year of 12 cents, you're paying
a lot for what you might get out of Lycos two years down the
road. With a loss of 23 cents expected this year, Excite's
multiple of 68 times next year's projected earnings of 38 cents
per share is cheaper, but it's still rather gross.
There are plenty of reasons stocks enjoy a premium. Inflation
is at a 35-year low, and consequently, all stocks have enjoyed
some premium in the last year. Microsoft and Dell have been
trading at 50 and 33 times trailing earnings in the past 12
months, higher than their historical average, in other words.
Some Wall Street analysts will of course tell you the Internet
stocks are not enjoying a premium, or not much of one,
anyway. To present the case that stocks with little or no
profits are cheap, they have constructed detailed models of
what earnings might be several years out, and they argue that
present valuation reflects a generous discount on the price of
those future earnings. But all that is really a justification for
speculation.
The real reason for the premium is more closely tied to the
way the shares trade versus the way other stocks trade.
According to CDA/Spectrum, about a third of Yahoo!'s 46
million shares outstanding is in the hands of institutions. In the
case of Amazon, 23% is held by institutions. It's a very small
amount of institutional ownership, relatively speaking, leaving
a lot of shares in the hands of founders like Yahoo!'s Jerry
Yang and David Filo, and Amazon's Jeff Bezos. What Bezos
and Yang and Filo don't trade is fought over in the retail
market. Roger McNamee, a general partner with investment
firm Integral Capital Partners, echoed the fears of most
cautious retail investors during his turn on CNBC Thursday
afternoon, when he referred to the "uncertainty" resulting
from all those retail investors fighting over the crumbs
Yahoo!'s founders drop from the table.
And here supply and demand play a large role. Individual
investors in love with the Internet stocks realize that not only
are there few shares to go around, but there are very few
so-called "pure play" Internet stocks to invest in, such as
Yahoo! and Amazon. That affects supply and demand, too.
It's pretty clear, though, that the party is going to end sooner
rather than later. The supply of Internet stocks is not going to
drop off drastically. Though the current economic mood has
put a damper on the market for public offerings, there's still
billions in venture capital money pouring into the market for
Internet startups. Many of those companies may not go public,
but many others will. In time, the flood of new opportunities
will be a tsunami sweeping over the Internet leaders,
tarnishing their luster as investors' love affair with the entire
sector dims.
We have little doubt that the best of these companies, Yahoo!
among them, will be able to rise above this onslaught. Those
like Yahoo! that have staked out their claims early in
cyberspace will reap the rewards of the Net's exponential
growth -- and will likely play a major role in shaping the Net's
development over the next several years. Jupiter
Communications, a New York-based market research firm
that tallies numbers on Internet trends, says that dollars spent
in online shopping by U.S. consumers alone should reach
about $37 billion by the year 2002 -- a drop in the bucket in a
$30 trillion economy, but nonetheless proof that a substantial
amount of consumer shopping will take place in cyberspace
over the next few years. That's not even counting auto sales
or plane tickets, increasingly popular online purchase items.
It is, perhaps, that awesome promise that has seduced many
investors into paying amazing prices for Internet stocks. Or
maybe it's just speculative greed. You can't stop speculation,
of course. These days it's a natural expression of a robust
economy and higher consumer confidence. Many retail
investors who might go out to a movie or splurge on expensive
vacations are instead logging onto their online brokers to play
the equivalent of Internet Lotto.
But with the challenges facing young companies like Yahoo!,
the notion that supply and demand will sustain these stocks'
present valuations is more a sucker's bet than a gamble. Retail
buyers know only that there's a fifty-fifty chance the euphoria
will continue, and a fifty-fifty chance these stocks will meet
the wild expectations held for them over the next three to five
years.
The earnest technology investor, on the other hand, likes to
have some fundamentals on his or her side when gambling. If
Yahoo! has the prospect of 50% secular growth for the next
several years, maybe a premium of double that growth rate is
fair. That would give the company a forward PE of 100, or a
price of less than half of what it's trading at now. Now that
the party may finally be over, we hope we'll see a buying
opportunity like that in the near future.
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