WSJ (editorial page) nuked AOL today. Fallout should cause even more collateral damage:
The Wall Street Journal -- April 19, 1999
Manager's Journal:
Are Internet Stocks Overvalued? Are They Ever
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By Jeremy J. Siegel
Editor's note: Is the gold rush for Internet stocks justified? Will this revolutionary new medium also mean revolutionary profits for high-tech firms whose shares today sell for hundreds of times earnings? Manager's Journal posed the question to two experts. Next week: The case for Internet stocks.
"Investing in Internet stocks is like playing the lotteries," Federal Reserve Chairman Alan Greenspan told Sen. Ron Wyden of Oregon in January. "Some may succeed, but the vast majority will fail." Yet so far, few investors have failed by buying Internet stocks. And buyers of these stocks will continue to make money as long as they convince the next guy that the stock will be worth more tomorrow than it was yesterday.
But no market in history has continued to rise without bound. The Dutch tulip-bulb mania of the 16th century, the Florida land bubble in the 1920s and the speculations in precious metals in the 1980s all came to an end. Eventually the value of all assets must confront the law of economics. This law dictates that the value of any asset must be tied to the future cash returns paid to the owner of the asset. This law does not say that Internet stocks are necessarily overpriced. It does say that we must take a hard look at the valuations of these firms and decide whether their current prices realistically reflect their economic potential.
A case in point is American Online, the current "blue chip" of the Internet stocks and the only pure Internet firm in the Standard & Poor's 500. AOL has a market value approaching $200 billion, putting it at or near the top 10 companies in market value in the U.S. Yet last year AOL was ranked only 311th in profits and 415th in sales against other U.S. firms and did not even make the top 500 in tangible assets. If AOL's ranking in market value matched its ranking in profits or sales, the firm would have a value of about $4.5 billion. Ironically this is very close to the current market value of Apple Computer, a company touted in the 1980s as the pacesetter of the great personal computer revolution.
AOL is currently selling at more than 700 times its earnings for the past 12 months and 450 times its expected 1999 earnings. These are unprecedented valuations for a firm with this market value. Small stocks often sell at high price-to-earnings ratios since their expected future profit potential is large relative to their size. But we know that when firms reach a certain magnitude, their growth rate invariably drops, and their price-earnings ratio deflates. If AOL in its "maturity" sports a P-E ratio of 30 -- and this is a ratio that still anticipates substantial growth -- it will have to generate net profits of about $6.7 billion per year to maintain a $200 billion market value. In 1998 General Electric was the only American firm with profits that high.
One can ask what sales volume will be needed to generate these profits. It depends on the "margin," or the percentage of net earnings that can be generated from a dollar of revenue. Very few large firms are able to achieve 20% or higher margins. Microsoft is an exception, but GE, the profit leader for 1998, generated a margin of less than 10%. The average margin of the top 500 firms in the U.S. was only 6.6% last year. At a 10% profit margin, AOL needs to generate $67 billion in annual sales. Sales of this magnitude were surpassed by only seven U.S. companies in 1998 (General Motors, Ford, Wal-Mart, Exxon, GE, IBM and Citigroup), and the average margin of these firms was only 5.7%.
AOL's current market value is about $15,000 per subscriber, or more than 50 times the annual subscription fee. Clearly the market believes that AOL can capitalize on its audience to sell services and merchandise that will generate far more revenue than the connect fee.
But here's the rub for Internet companies: Merchandising margins are likely to be quite small on the Web. Almost all Web surfers are interested in deeply discounted goods or loss leaders. The whole Web culture thrives on deep markdowns, razor thin margins and the commoditization of goods and services.
Advertisers seeking premium prices by developing brand names will find the Internet unsuitable. Any site that thrusts unwanted advertising on its viewers will be dumped for another site that does not. And one feels no qualms about milking a site for information and then clicking onto a cheaper supplier. It is a relief not to have to look a salesperson in the eye and say "Thanks for all the info, but I don't think I'll buy from you today." The secret of the Web is the very bane of profitable selling -- the ability to switch in an instant to a merchandiser with a cheaper price.
My reluctance to pay 700 times earnings for AOL is not at all because I am a "value investor" seeking low P-E ratios. In my book, "Stocks for the Long Run," I rejected the conventional wisdom that the "Nifty Fifty" of the early 1970s -- those high-flying stocks that carried an average P-E ratio of 40 -- were overvalued. Even from their market peak in December 1972, many of these firms, such as Philip Morris, Pfizer, Bristol-Myers, Gillette, Coca-Cola, Merck, American Home Products and Pepsi, outperformed the S&P 500 over the next 25 years. But none of the firms that outperformed the market had a P-E ratio in excess of 60 in 1972, and even the most deserving stock of this original group, Coca-Cola, would have been overvalued at a P-E ratio of 80.
Even stocks that seemed to have an impregnable hold on future technology did not warrant P-Es in the triple digits. IBM is an example. Although Remington Rand came up with the first computer, Univac, in 1951, IBM soon dominated the field. With its superior research, development and marketing, IBM captured nearly 80% of the computer market in the 1960s and 1970s and its brand became almost synonymous with computers and high technology. IBM reached an unheard-of 65 P-E in 1961.
But despite IBM's spectacular earnings growth (18% a year for more than 15 years), IBM was overpriced at that ratio. Big Blue underperformed the S&P 500 after its market peak in 1961. In fact, none of the technology stocks in the original Nifty Fifty (including Xerox, Digital Equipment, Texas Instruments, Burroughs, Kodak or Polaroid), has managed to outperform the index over the past 25 years.
Many enthusiasts maintain that smaller Internet companies may be overpriced, but AOL and Yahoo! (and perhaps a few others) are the "blue chips" likely to succeed. This is not necessarily so. In fact, the blue chips, eager to prevent competition from eroding their already thin margins, will probably buy out many of these small companies. Give the inflated valuations of the larger Internet firms, buyouts are easy to manage at almost any price. But buying out the competition at astronomical prices cannot persist. The buck must stop somewhere. Eventually the big Internet companies must convert all this Monopoly money into hard earnings, or their prices will collapse.
No one can deny that the Internet is a communications revolution. But the very accessibility that has made it spread like wildfire limits its ability to create premium profits. The Web is democratic and fiercely individualistic; it requires minimal capital to enter. Services must be provided at cost or users will switch to alternative sites.
One of the fundamental tenets of economics is that value is created by scarcity, not by usefulness, need or desire. Water, necessary for the sustenance of life, costs pennies, but diamonds, used solely for adornment, fetch astronomical prices. I have no doubt that the Web will revolutionize the way goods and services are marketed. The Internet will deliver many billions of dollars of savings to consumers. But this in no way guarantees those billions will be handed over to the suppliers of this new form of communication.
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Mr. Siegel is a professor of finance at the Wharton School and author of "Stocks for the Long Run" (McGraw Hill, 1998).
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