Contents

Introduction The Internet Technology Boom What is all this Internet Hype about? Lessons from the past Internet Industry Overview Notable Players and Events Net Stock Characteristics Forecasts and Trends Valuation of Internet Stocks Method of Comparables and Its Pitfalls For Internet Businesses Discounted Cash-Flows Method (‘Pro-Forma-Analyses’) The Example of eBay: Can the Current Stock Price be Justified by Realistic Projections of Future Cash Flows? Methodology Current market capitalization of eBay Valuation model Arguments to justify valuation Arguments to reject valuation Conclusions Appendix Calculating Future Net Cash Flows Necessary to Justify eBay's Current Valuation

I. Introduction

There is no doubt that the American economy is in the midst of one of the greatest capital-spending and stock market booms in history, propelled by the phenomenal growth of the Internet. As Internet-related stocks and Initial Public Offerings (IPOs) have recently skyrocketed, more and more people raise the same question: are these stocks valued fairly? In this report, we present a brief background on the Internet industry and describe some of the issues that need to be addressed in order to answer such a question. We will then follow with arguments on both sides of the question using objective financial methods.

1. The Internet Technology Boom

From a tiny non-commercial scientific universe as of the early 1990’s, the Net has grown to an international haven of social discourse, advertising, commerce, and much more. Only four years ago, there were a handful of prominent web sites (such as Yahoo!, AltaVista, and WebCrawler) that people knew of and used to access information across the World Wide Web. Since then, as Internet access became more ubiquitous, web sites have turned into services, into companies – Internet-based companies. Recently, things have changed faster than most of us can follow; a real upheaval in the industry has taken place, as these companies continually pop up faster than anything we have ever seen. With search engines evolving into portals, print and broadcast media becoming involved, and mergers and acquisitions hitting fast and furious, Internet stocks have become "the darlings of Wall Street."

2. What is all this Internet Hype about?

The Internet boom stems from the addition of a whole new stratum of industry to the economy. The rush to adapt Internet technology to all sorts of purposes and to create the hardware and software to take the Web everywhere is spurring a tremendous surge in growth, investment and business creation. It is not difficult to explain the frenzy of buying Internet stocks; the idea is actually simple and compelling. The Internet is changing the way we shop, communicate, and do business, and the companies that lead the transformation may well dominate the Web marketplace of the future.

3. Lessons from the past

Perhaps the closest parallel to the net stock excitement in modern times, though not nearly as massive, is the biotechnology boom of the late 1980s and early 90s, when stocks like Genetech and Amgen tore up and down the charts. What we saw there was a bubble of biotech stock mania bursting within a couple of years, after fluctuations from 400% upward to almost as much back down. Experts say that such investment-led expansions that occur when new technologies are emerging will inevitably come to an end, because it is their momentum that drives them, not the certainty of future profitability.

On the other hand, history can also teach a different lesson. Sometimes, when a new technological revolution comes along, if you wait to buy until the outcome is secure and stock prices seem reasonable, you miss the big payday. A good example of that is Microsoft; its first-day 33% jump from $21 to $28 was called "manic enthusiasm", and all along, Microsoft shares were widely considered too expensive compared with others, as based on current earnings. So, even though there was never a ‘right’ day to buy Microsoft, if you waited, you lost. It is interesting to see how all of this applies to Internet companies.

II. Internet Industry Overview

Over the past three years, Net start-ups with no history of earnings have gone public and their founders watched investors bid the stocks up more than 1000% in a single day. Companies that announce ventures having anything to do with the Internet -or simply with a .com in their names- are almost guaranteed a big pop in price. What is so different about the Net stocks in regards to other industries' stocks?

1. Notable Players and Events

The high-profilers in this market include "pure" Internet companies like Amazon.com, eBay, E*Trade and Yahoo!. These companies did not exist before the Internet as their entire business model is built around it, and all their revenues derive from transactions on the Net. All of these companies’ stocks have appreciated magnificently from their levels of a year ago. Since going public in May 1997, Internet retailer Amazon.com has seen its stock fly up more than 2,000%, become the fastest growing Internet brand, and is heralded as a potential "Wal-Mart of the Internet". EBay, an online auction company, has grown to a staggering market capitalization of $26 billion (as of 4/30/99). Other players who have adjusted remarkably to the Internet mania include America Online and IBM. Last year alone, AOL produced a huge 361% gain in stock price.

In 1998, there were a total of 28 Internet-related IPOs. And their performance is leading the bull market. Out of the 25 companies that have gone public since early last year and are now trading at more than 200% above their offer prices, the top 11 are Internet-related. The latest Net darlings include Priceline.com (Nasdaq: PCLN), which recently opened at an offering price of $16 closed at $82.88 a day later; and iVillage Inc. (Nasdaq:IVIL), which on March 19 opened at $24 and closed a week later at $100.50.

2. Net Stock Characteristics

The technology sector, especially the Net market, has proven to be extremely volatile. On January 6, the Dow cracked the 9,500 level as stocks surged 233.78 points -the seventh largest point gain ever. Tech stocks led this charge. A week later, on January 13, the market dropped 125.12 points, due to the devaluation of Brazil's currency. Such hot Internet-related stocks as Amazon.com, Broadcast.com and eBay dropped 8%, 14% and 26%, respectively in one week. As recently as April 19 eBay, AOL, @Home, Amazon, Excite and Inktomi all dropped between 12 and 25% in value in one day while the Nasdaq suffered its second biggest single day loss in history. Yet, less than a week later it was back to setting record highs. Given the young age and the lightning fast pace with which Internet companies are growing, there is no real history investors can follow. What adds to this volatility is a growing segment of the investment base made by amateur "momentum investors" or "day-traders", who have gained increasing access to the trade floor via the now ubiquitous online trading services. Such investors generally have little knowledge of the technology industry and see net stocks as an alternative to lottery.

It is quite interesting that most Internet companies, including leaders like Amazon.com have yet to make a profit. Yet, optimism has not let up on them from investors.

Recently, both the Dow Jones Industrial Average and the Nasdaq Composite Index jumped to close at record highs. Much of those gains stemmed from a pair of industry analyst firms, International Data Corp. and Dataquest, reporting that the PC market is growing faster than expected, with demand for new machines rising as prices continue falling.

Figures released in the past attempting to predict the future size of the Internet market have consistently come short of the actual numbers. Yet, every time we see a new market forecast it is difficult to imagine a growth trend so explosive being perpetuated. For instance, it has been estimated that 57 million Americans logged onto the Internet at home or at work during December 1998, and recent studies predict that close to 100 million Americans will be regularly cruising the Web each month by 2000. Holiday spending on the Web approached $4 billion in 1998, more than triple the 1997 figure. Online sales totaled $13 billion in 1998, and analysts expect this amount could hit $50 billion in 1999.

IV. Valuation of Internet Stocks

1. Method of Comparables and Its Pitfalls For Internet Businesses

Measures such as the price / earnings (P/E), price / sales (P/S) or price / book (P/B) ratios can be used to estimate the value of a company by benchmarking businesses with comparable operations.

Applying this method to Internet stocks gives results that seem out of every proportion: For example, the average price / sales ratio of S&P 500 companies is around 2. The same ratio for some (typical) Internet companies: Excite: 43.7, Yahoo!: 170.3, and eBay: 478.3. P/E ratios, on average around 30 for S&P 500 firms, are sometimes in the thousands for Internet businesses, if there ever is a (positive) E.

The issue here is the comparability of two firms. It may be given for two traditional businesses of the same industry, but it becomes difficult to apply ratios of established, low-growth firms to young, high-growth firms to estimate a valuation. This is the reason why measures of established, older companies, are not meaningful ways for estimating the value of an Internet business. If anything, one wants to use the ratios of other young, high-growth businesses in traditional industries to benchmark against Internet businesses.

Therefore, in our opinion, it is not appropriate to compare the P/E or P/S ratios of Internet companies with those of S&P 500 companies, as is often done when discussing the valuation of Internet businesses.

2. Discounted Cash-Flows Method (‘Pro-Forma-Analyses’)

The second valuation method is that of projecting cash flows that a firm will generate in the future and discounting them back to find the net present value of the firm. Basic financial valuation theory tells us that a business’s "value today always equals future cash flows discounted by the opportunity cost of capital". From the firm value, the value of the shareholders’ equity is found by subtracting the debt. This method of valuation is accurate in that it calculates the exact value of the stock, given the forecasts hold. The difficulty, of course, is to project the future net cash flows, and to find the appropriate cost of capital. However, conceptually, this is the preferred method we will use for the analysis of the valuation of eBay, an Internet auction company, in the next section.

V. The Example of eBay: Can the Current Stock Price be Justified by Realistic Projections of Future Cash Flows?

1. Methodology

In this section, we analyze in depth the valuation of one typical representative of Internet businesses, eBay. We acknowledge that in order to answer the question whether Internet stocks are fairly valued, it is not sufficient to analyze the valuation of one single company alone. However, due to the limited scope of the paper, we cannot do the same valuation for all Internet stocks. With eBay, we use a fairly typical representative, which can be confirmed by benchmarking eBay’s multiples against other Internet stocks. Therefore, our results should hold for other Internet businesses as well.

According to financial valuation theory, eBay’s valuation would be fair (in the sense of the question) if it equals the present value of expected future net cash flows of the company. Of course, neither the market, nor we, know how great these future cash flows will be. So we go the other way: Starting from the market’s valuation of this stock (= the company’s market capitalization), we calculate the net cash flows this company would have to generate in future periods to justify its current valuation (section V.2.).

Then, we discuss whether this scenario (or a scenario with an equivalent NPV ) seems realistic (sections V.3 and V.4.). It would have to be plausible in order to justify the current stock price.

The question of fair valuation ultimately comes down to a judgement about the future profitability of Internet businesses. This is left to the reader. However, we believe this analysis gives him or her an overview of the issues to consider in this judgement, as well as a solid valuation model to capture how these issues need to translate into financial performance.

2. Current Market Capitalization of eBay

As of April 15, 1999, eBay had a market capitalization of $ 21.3 billion. To put this in perspective, this roughly equals or surpasses the valuation of ‘traditional’ businesses, such as Sears Roebuck ($ 17.8B), Dow Chemical ($ 21.4B), J.P. Morgan ($ 22.1B), or Eastman Kodak ($ 21.5B). Comparing the underlying businesses of these stocks with eBay’s, we see a large discrepancy: For example, these traditional businesses have assets in the range of $ 14.7B (Eastman Kodak) to $ 261.1B (J.P. Morgan). Total assets of eBay for the year ended 12/31/98 amount to $ 0.092B (=$ 92M).

3. Valuation Model

We use a standard financial valuation model to find the cash flows eBay would need to generate in the future in order to justify its current market capitalization. The model we use is a discounted free cash flow model. Overall, we are conservative in the assumptions that go into the model. We do not go into details of the valuation here. The valuation is given in the appendix in full.

When we use the model to set the NPV of net cash flows equal to the current valuation, we get the following scenario that would justify the company’s current market value. The company (which in 1998 generated free cash flows of $ – 2.5M), would need to generate a free cash flow of $ + 15M in 1999. This cash surplus would need to grow each year by 294% for five years. After that point in time, the free cash flow would need to grow by 10%, forever. The net present value of these cash flows (using a 27.1% discount rate), minus the debt (negligible), equals approximately the current market capitalization of $ 21.3 B.

Can growth scenarios of this dimension for Internet businesses be realistic? We will discuss this in the next sections.

4. Arguments To Justify Valuation

Today it has become nearly a universal consensus in the developed world that the Internet will become the "wave of the future." The number of new users and web sites has been growing at an extraordinary rate for several years and shows no sign of slowing down. This rapid growth has lead to the astronomic rise in the stock price of nearly every company even remotely connected with the Internet. However, merely being touted the "next great thing," is not, in and of itself, a justification of the remarkable valuations of these young companies.

The main argument in the case against the high prices of Internet stocks is their seemingly outlandish price to earnings and price to sales multiples. While some companies have recently become slightly profitable, most are still in the red. However, it is important to note the maturity level of these companies and the industry in general when comparing their valuation with traditional established companies. The vast majority of all companies lose money in their first few years and nearly all must be expected to do so in such an emerging industry. The characteristics of budding net stocks render these traditional means of valuing a stock almost meaningless.

In section V.3. above, we examined the specific case of eBay's stock using a discounted free cash flow model. This relatively simple model is a powerful way of estimating the value of an investment. The main drawback of this method of evaluating stocks is that one needs to make several difficult estimates regarding future cash flows, discount rates, etc. This is nearly impossible to do, particularly for companies with little history and nontraditional business models. As we will see, the valuation of a stock is extremely sensitive to what assumptions are made in regards to these values. For example if the discount rate used for eBay in section V.3. is changed slightly from 27.1% to 24%, while everything else is kept constant, we find that the net present value jumps from $21.3B to $29.8B. Similarly, if the annual growth rate for the next five years is taken as 325% instead of 294% the NPV rises to $30.9B. This is not meant to imply that these rates can necessarily be expected, but it does point out that given the high level of uncertainly in the projected cash flows and growth rates, assigning a "fair" price is almost entirely arbitrary. In fact, with eBay's 1^st quarter earnings soaring 469% over that same quarter last year, one could just as easily make a case for their stock being undervalued.

Undoubtedly, there will be winners and losers in these Internet companies as the market evolves. We are just at the point now where some of more mature net-based businesses are beginning to return profits. It is important not be so overwhelmed with the rapid growth of the stocks that one forgets the corresponding boom in Internet usage and ignores the truly remarkable growth in e-commerce. Keep in mind that Amazon has done in three years with one website and one warehouse what took Wal-Mart 15 years to do with 78 stores - that is to generate $500 million in revenue. The only way one will ever be able to say with any degree of certainty whether or not today's Internet stocks are fairly valued will be with the benefit of hindsight in the years to come. It is premature to come to concrete conclusions, and it is certainly much too early to declare them overpriced based solely on indicators developed for other industries and on models that seemingly require precise knowledge of future events.

5. Arguments To Reject Valuation

The question of fair valuation ultimately comes down to a judgment about the future profitability of Internet businesses. As we have seen, only substantial positive cash flows going forward would justify the current stock prices. To this end, we want to point out some key characteristics of the industry and the market, and their implications for future profitability.

a) Low barriers to entry: The substantial barrier to entry for Internet businesses is the advertising expenditures needed to attract traffic. Other entry barriers, such as investments in property, plant and equipment, are low, compared to traditional businesses. Sites that already attract traffic face very small barriers to enter new segments. This means that as soon as a company starts to turn out substantial profits, competitors are likely to enter the market to drive the price down to marginal cost, which is almost zero. For example, once a company like eBay becomes very profitable, there is no reason why Yahoo!, Lycos, or AltaVista should not provide exactly the same service, aided by their brand names, at lower price. Therefore, we do not see substantial profit potential in most Internet businesses. In fact, profit margins for most companies are already decreasing, due to competitive pressures. This is the case for eBay, too.

b) Lack of currently profitable business models: Most services provided over the Internet today are free to the consumer. In a typical revenue model, income is generated through sales of advertising space. To this date, most online companies generate losses (Lycos, Excite, Double Click, Onsale, @home). The companies that generate (modest) profits tend to be those that have an actual service to sell that customers are willing to pay for (AOL, eBay, CNet). However, even some of these businesses are unprofitable (Earthlink, Inktomi). All, without exception, are far away from the level of profits to justify their valuations.

These arguments do not mean that these businesses cannot break even at some point in the future. However, for the current valuations of their stock to be fair, they would have to become tremendously profitable, very soon. For example, we have shown above that a way to justify eBay’s stock price would be for the company to turn out a positive net cash flow of $ 15M this year, and to grow this cash flow at an annual rate of 294% going forward over the next five years. That is, a company that has (at least) until 1998 produced negative free cash flows would need to dramatically reverse this trend and turn out tremendous CF-surpluses. In order to do this, the company’s profitability would have to increase sharply.

However, a look at the last three years (1996-1998) shows that the gross profit margin (as a measure of profitability) has actually decreased slightly, due to increased competition (see SEC 10K, Dec. 31, 1999). Moreover, in its financial statements as of Dec. 31, 1998, Ebay states: "…the Company expects competition to intensify in the future. Barriers to entry are relatively low, and current and new competitors can launch new sites at a relatively low cost using commercially available software… We may not maintain profitability." (SEC 10K, Dec. 31, 1998).

Obviously, eBay would be glad if it maintained its current profit margins, which last year were not sufficient to turn out a positive net cash flow. A growth in net cash flows anywhere within the dimensions of 300%, as would be necessary to justify the current market capitalization, seems out of every rational expectation, even of that of the firm’s own management. This leads to the conclusion that the firm will most likely not generate the cash flows to justify its stock price, and that the stock is considerably overpriced. Equivalent arguments hold for most other internet businesses we have looked at. In the comprehensive research we have done for the paper, we have not come across a single academic in finance who has a different opinion.

V. Conclusions

As the parade of successful Internet related initial public offerings marches on, traditional investors are baffled. Even the most indifferent spectator becomes increasingly alarmed at the valuation granted to latest group of IPOs. The paradox of a company like Priceline.com with $35 million in revenue acquiring a market capitalization of $23 billion (as of 4/30/1999) brings the attitudes of both skeptics and believers into sharp relief. At this point, Priceline.com is worth more than Delta Airlines, which supplies most of the tickets it resells. To believers, the market's defiant roar of approval is further evidence that fundamental changes are happening in the way business works. It shows that innovative companies, unencumbered by any baggage from the past and sporting clever Net-centric business ideas, can attract the most ambitious minds of their generation and transform the global economy.

The paper has attempted to take a step back from all this ‘hype’ and focus on the original question that is easy to lose sight of: What determines the value of a stock? Basic financial valuation theory tells us that a stock’s value today always equals future cash flows discounted by the cost of capital. This is not an ‘obsolete’ valuation method; it is also not a rough estimate of the ‘true’ value. It is the definition of ‘value’ in itself. This is therefore the accurate concept to use when valuing internet stocks.

An argument about the valuation of internet stocks therefore has to be an argument about whether these companies can justify their valuations by the future cash flows they will turn out. Euphoric market forecasts, new technologies or even a ‘new economy’ are one thing, but at the bottom line, these still have to translate into cash flows for individual companies. This is the concept of a sound valuation, and the line of thinking we’ve pursued in the paper.

The paper has provided arguments for both sides of the debate whether internet companies can in fact justify their valuations. It has also provided a sound valuation model for an exemplary firm that captures how cash flows translate into value of equity. The final judgement whether these firms are overvalued is left to the reader.

"Calculating Future Net Cash Flows Necessary to Justify eBay's Current Valuation" - EXCEL FILE (20KB)