The Metrics For Evaluating Internet Companies
Valuations. Why COOL is a bargain:
By Steve Harmon
Senior Investment Analyst
Internet.com
"Where Wall Street Meets The Web"
Pundits supposedly in the know regularly decry valuations of Internet stocks. They have a well-worn lexicon handy with
thumbed pages that include "bubble," "overvalued," "hype." But in 1994 when the first pundit jumped up and said the Internet
was a fad and a bubble because the price-to-earnings (P/E) of AOL at that time was off the charts according to the industrial
era P/E ratios I had to delve deeper into the emerging phenomenon called the Internet.
What I found was I needed real tools, real metrics to evaluate really new ways of doing business. And many didn't exist.
What resulted in the following five years since then has been a toolbox of metrics, some of which I had to invent, to properly
evaluate these new animals called "Web" or "Internet" companies. Because this new fangled thing was unlike anything that had
plopped on the planet before.
First an analogy. Think for a second of the emergence of the automobile and you begin to see how the old ways of thinking
cloud the new. When "cars" first were invented they replaced the "horse and buggy carriage," hence how "cars" came to be
called "cars" (from carriage).
Another term introduced to describe a car was "horse power." Anyone who drives a car or talks to a car salesperson today
hears how much "horse power" the car has.
Yet the term is empty. How many car buyers today know what one horse's power is?
How many have ever ridden a horse? Is it meaningful to gauge a car with expressions such as "it has 250 horse power?" 250
horses cannot be ridden at once so why use it as a term to describe an entirely new way of travel? And few know what a
horse's power is anyway today.
Let's cut the horse talk with Internet companies also. We are at a crossroads in the evolution of industry.
The next 100 years will be defined by new views, new ways of evaluating opportunities, by a new lexicon and new set of
metrics thundering up and down Main Street, Wall Street and Web Street.
It's already here and now and has been for quite some time, something I've been opening daily in an effort to understand the
Pandora's box called the Internet.
With a "traditional" non-Internet company the metrics are in place. For example, in a prior life as a media financial analyst I
valued broadcast stocks on a discounted cash flow basis or multiple of EBITDA cash flow. Ditto newspaper stocks.
Or I valued firms in the PC space such as Apple, Sun or IBM on P/E basis. For despite being "technology" firms each is and
was in the business of moving plastic boxes with silicon inside around the planet. Hard goods, hard distribution.
With the Internet there are no walls. The entire telecommunications infrastructure worldwide -- a multi-trillion dollar investment
made in the past 100 years -- is effectively Amazon.com's (NASDAQ:AMZN - news) store. Amazon's cost to use it? next to
zero.
How big can AOL get? Well, there's phone lines everywhere, connecting millions of people who are not connected today in
anyway. Earthlink, Mindspring same thing. The 50 companies in ISDEX all leverage this platform, all are financing their way
into the future (or trying to).
The 50 stocks in ISDEX, by the way, represent 95% of the market capitalization of what I define as the Internet stock
universe. At approximately $400 billion the ISDEX stocks are a blip on the overall ebb and flow of the world's stock
exchanges. Old-line thinking prevents value from being identified, evaluated and realized or perceived.
Why? the world is looking at Internet companies and using old ways of thinking, drubbing up modern-day equivalents of
"horse power" to try and label the shift. Or observers who haven't spent any time really analyzing the Internet call the sector
"hype" or "bubble."
Yes, speculation, hype, confusion, puzzlement, and more all exist in this space. But instead of coming at a new era with old
metrics or your grandfather's diction, I'm sharing with you the set of tools that I have used for five years now to begin to make
sense of the new ways of doing business and ultimately valuing the Internet industry.
The categories are usually self explanatory. Some day they may be standardized across the board and especially on Wall
Street, where ratios matter more than most places. A few of these are popular now but weren't when they debuted in Internet
Stock Report in 1996 (noted by *).
Let me open my toolbox (again, since some of you have seen this but now it's updated) and show how metrics can be applied
to draw out valuations and effienciencies of being an Internet business. (If any of this helps you let me know or pass this along
to a friend):
Steve Harmon's Internet Valuation Metrics
Market capitalization/users*
A reference for comparables and peers, an
indicator of overall value per reach; see
WEBDEX each week for this
Market cap/page views*
Indicates what a basic page view is valued at by
investors
Market cap/ad views*
Page views generating revenue rather than sitting
blank
Private market value
What private deals go for either in merger or in
bidding situation
Customer acquisition cost
What it costs to gain a new subscriber or buyer;
valuable in evaluating ISPs, etailers, auctioneers,
wholesalers, manufacturers that sell on the Web
Valuation/customer acquisition
cost*
Useful when comparing peers to see which may
be valued at a relative discount based on
customer growth efficiencies
Enterprise value
Subtract cash and add debt to market cap to
determine core value of the company; particularly
useful in valuing potential takeover targets
Revenue multiple (or market
cap/revenue)
Primary method for valuing Internet stocks since
most firms are not earnings positive. Or if they
are, the P/E is often off the charts still
EBITDA cash flow multiple
The way mature media companies are valued
such as Time Warner, Disney or TCI. Usually
EBITDA cash flow
Revenue per subscriber
Primary way to value ISPs such as PSINet,
Earthlink, Mindspring or AOL
Lifetime value of an e-buyer*
This is the metric we think will be key very soon
in valuing Internet companies, especially
Amazon.com, CDnow, Egghead, ONSALE and
etailers (and it is!)
Effective deal value
What a deal went for after factoring cash and
debt or other considerations that affect the
outcome of the offer
Market cap/POP*
A ratio for comparing ISPs that have points of
presence
Market cap or PMV to to
potential market share
Helpful in determing future revenue, cash flow
and earnings to see if the firm is under or
overvalued to its potential
Market cap/total Internet
users*
The value of a firm's reach globally per user
Revenue/direct e-marketing*
Shows yield of campaign efficiency, useful for
direct sellers such as Xoom.com
Market cap/Websteader*
Useful for valuing community of free home page
providers such as GeoCities, theglobe.com or
Lycos' Tripod/Angelfire
Revenue/Websteader*
Measures yield on community sites, how effective
Websteads generate revenue for community firms
Price/discounted earnings
Project earnings and discount back to current
stock price; especially useful for firms with losses
today; Netscape's IPO was priced this way at
50x projected EPS two years ahead
Sales/employee
How lean and mean a company operates; 1
engineer to 10 lightbulbs or 10 engineers and 1
lightbulb?
Revenue/bandwidth cost*
Useful to determine how effectively management
deploys its bandwidth to generate revenue;
applies to all Web firms but especially those
involved in selling
Revenue/reach*
How much revenue is generated compared to the
firm's percentage reach points on the Web; divide
by total reach percentage points
* = ratios we invented during the past 5 years of analyzing the emerging Internet as an
investment vehicle
(c) 1999 internet.com LLC www.isdex.com - home of the ISDEX
New issue coming March 2! Harmon's Hotwatch '99 - the 10 stocks to watch in the Internet space - last year's watch group was up more than
300%
for 1999 it's now available as a monthly paid newsletter sent direct to your email box - click here to subscribe now -
Accolades for Internet Stock Report:
"Fresh and provocative" -CBS Marketwatch, who named Steve Harmon one of the top Internet stock analysts and only
independent one honored
"I am a huge fan of Steve Harmon's analysis" -Kleiner Perkins' John Doerr
Blip us with an e-mail to stocktalk@internet.com on what you think about any Internet stock or investment you've seen or
heard about to. Send us your rants, raves or ramblings and they may be included in this column in a special feedback edition
every week. Throughout the trading day be sure to check Internet Stock Report's index of leading Web companies, the
ISDEX, Internet Stock Index, for a roundup of how Internet stocks fare minute to minute.
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