Internet Stocks, Whats their real worth?
Also from BW.
< Look at Amazon.com. At the recent price of 214, the market is implying that Amazon's revenues will increase 59.6% a year over the next 10 years (table). That's the conclusion of veteran securities analyst Charles R. Wolf of Warburg Dillon Read.
To come to that conclusion, Wolf uses a valuation method built on Economic Value Added (EVA), a concept developed by Stern Stewart & Co., a management consulting firm. The idea behind EVA is that in the long run, it's not accounting profits--taking in one more dollar than you put out--but economic profits that matter. And simply put, a company earns an economic profit only if it has earned more than its cost of capital, which is not found on an income statement. EVA was originally designed as a management tool, not for investing. But some, including Steve O'Byrne, a former Stern Stewart consultant who now has his own firm, and Wolf have adapted EVA principles for investment analyses.
COMMON SENSE COUNTS. The idea in EVA analysis is that the market value--the stock price times number of shares--has two components. One, the Current Operations Value (COV), is a measure of the worth of the company as it now operates. The second, Future Growth Value (FGV), measures the company's expected growth. Once you determine the COV--and that's the easier of the two--you can figure out the implied future growth value. And once you know that, you can determine the implied revenue growth rate. Then you can make a judgment as to whether that growth rate is achievable.
Critical to the analysis is the cost of capital. For Amazon.com, Wolf estimates a cost-of-capital charge of 15%, a figure derived from such variables as the risk-free rate of return, the extra return that equities historically return over bonds, and Amazon's ''beta,'' or price volatility as compared with the stock market.
Can Amazon.com achieve a nearly 60% average annual revenue growth rate over 10 years? That's where investors must turn to industry fundamentals and old-fashioned common sense. For instance, using Wolf's calculations, Amazon should reach sales of $63 billion in 10 years. Is that realistic?
Not by a long shot. U.S. retail book sales in 1997 were $11.8 billion, and they're not expected to be much higher in 1998. Even if the book market expanded at 3% a year, it would be only around $16 billion 10 years out. True, Amazon is selling recorded music, but that market is no larger than books, with growth prospects no better. ''Amazon has to sell a lot more than books, CDs, and videos if it's ever going to reach the revenue growth implied in the price,'' says Wolf. True, that's in the company's plans. But as it changes from a bookstore to a mass marketer, it will run up against competitors. Says Wolf: ''Barriers to entry are low, and others can easily underprice them.''
The Internet is probably the most sweeping and potentially powerful medium to come along since television. There's no question that enormous growth is there, but how much should investors pay for that potential? Whether you're weighing revenue projections for Amazon or any other Net stock, it might be useful to note that at Microsoft Corp., perhaps the most successful company in recent history, revenue growth averaged 43% a year since it went public in 1986. Keep that in mind when you're tempted to buy a Net stock that reQuires a 60% growth rate to justify its price.
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