To all - WSJ piece by Jeremy Siegel on overpriced Internet stocks.
April 19, 1999
Manager's Journal
Are Internet Stocks
Overvalued? Are They Ever.
By Jeremy J. Siegel, a professor of finance at the Wharton School and author
of "Stocks for the Long Run" (McGraw Hill, 1998).
"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 America 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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