Valuing AOL
By Andrew Greta
Special to TheStreet.com
4/4/99 12:16 AM ET
If there's one thing I've learned about this city so far, it's to
expect the unexpected. Just the other day a guy in coveralls
walked up to my office window, opened it up, hopped out on the
ledge, closed the window behind him and started washing the
panes. No rope, no harness, just a six-inch lip of concrete and
140 feet of blustery air between him and oblivion.
In a way, that's how I feel every week here at Fundamental
Questions. Without a cushy safety net of reader questions to
draw from, I'm liable to pancake on Trinity Place. So keep those
emails coming in to me here. I'm also looking for meaty
subjects to run a few feature articles and break up the Q&A
pace. Enough said. On to the column.
Flunking the Valuation Final with AOL
I would like you to take on America Online (AOL:NYSE) and
the recent rise it has incurred. Do you believe that AOL is
extremely overbought or is the price justifiable? Thanks.
-- Robert Saville
Robert:
I guess it all depends on your definition of "justifiable." I heard
somewhere about Warren Buffett's plan for a teaching an
investment class for budding analysts. For the final exam, he'd
ask each student to value an Internet stock. Those who handed
in a value -- any value -- would automatically flunk the course
and be sent back to remedial studies until deemed fit to rejoin
mainstream society.
So from a strictly fundamental perspective, AOL is insanely
overvalued. According to guidelines set forth by Ben Graham,
the father of stock valuation, you'd need to have your centers of
rational thought lobotomized with a knitting needle to ever
dream of paying hard-earned dollars for a stock sporting a
current price-to-earnings ratio of 656 and a price-to-book of 93
(see my piece Ben Graham's Lucky Seven for more).
Even using more modern valuation methods like Economic
Value Added (see my EVA Primer) yields similar results.
According to my back-of-the-envelope EVA calculations, AOL
would need to lock up and sustain over 1 billion subscribers
right now to justify the future growth rate implied in the current
stock price.
Keep in mind that fundamental analysis is geared toward
wealth builders who want to soberly buy undervalued assets at
bargain prices with the intention of holding them for a long time.
This kind of rational approach is often at direct odds with the
short-term realities of a hysterical market.
After all, over 30 brokerage firms rate AOL a buy and the stock
price continues to march higher. So while the stock may seem
way overpriced, trying to run against the crowd, even if they're
headed for a cliff, could get you trampled in the near term. Or as
I heard one tipsy trader announce loudly in a local Wall Street
watering hole the other night, "don't fight the tape" -- or was it, "I
don't like my date"? Either way, you get the picture.
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