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Simply blaming Wall Street analysts isn't fair. True, they were a big part of the hype machine that helped to send Internet stocks into the stratosphere between October of last year and March. But a good argument can be made that it wasn't all just smoke and mirrors. "What's going on with technology remains a rare phenomenon," says Michael Mauboussin, chief U.S. investment strategist at Credit Suisse First Boston, who is co-authoring a book about the earnings expectations reflected in current stock prices. Mauboussin is a believer that big productivity gains are inherent in the shift to the New Economy. "There will continue to be huge amounts of wealth creation thanks to the Internet," he maintains. So what went wrong with Net-stock valuations? The most useful lesson to take from the Internet-investing experience so far is that companies in a nascent industry are very difficult to assess. Their growth patterns and the factors that influence their development are not established or clearly understood. And while new valuation methods don't offer much real guidance, neither do the tried-and-true ones used to value traditional companies with long track records. There's no getting away from the fact that new industries are a wildly risky investment proposition, however you value them. USELESS MEASURE. The logic of Net valuations in their heyday 10 months ago was based on the premise that we were -- as we still are -- living through a technological revolution that isn't even half played out. Since we don't know how the technology will eventually mature, we should leave plenty of room for value creation in ways we can't even imagine at this point. Initially, Internet analysts turned their backs on the established discounted-cash flow (DCF) method of valuation that they tend to use for more established industries. Anybody who has taken Corporate Finance 101 knows that the current value of an asset -- read the stock price of a company -- is equal to the future stream of its cash flows discounted back at an appropriate rate of return given the risk. When the Internet took off, there were no historical cashflows on which to base a DCF valuation. Analysts tried instead to value Net companies on revenue growth or unique visitors to a site. But revenue is a pretty useless measuring stick when it comes to predicting cashflow. It ignores all those costs it takes to generate cash. At least in the short term, this overvalued most Net companies and helped lead to the Nasdaq's painful correction. GROWING TO MATURITY. Of course, this isn't the first time Wall Street has had to value the unknown. "I don't think [Internet valuations up until March] were as freaky as everyone thinks," says Lanny Baker, a managing director and online-media research analyst at Salomon Smith Barney. "They were typical of capital formation for a new industry. Some guy spent millions of dollars to build an assembly line for Henry Ford when there wasn't revenue or earnings." More recently, wireless and cable networks were initially valued on a "price-per-pop" basis, adds Baker -- meaning that when a company got the cellular license for a city, the franchise would be valued at some dollar amount times the total population in the franchise area. Biotech companies once were valued per PhD scientist on staff. Eventually, however, new industries mature enough to where measures such as profits and cash flow become relevant again. "At some point...it's no longer about future potential," Baker notes. "When you switch gears from funding growth to assessing value, the valuation methodology changes." On Mar. 10, it seems the market abruptly decided it was time to start assessing value and quit funding growth, he adds. DCF is hardly infallible in valuing new industries. The trick is getting the growth estimates and discount rates right -- which is as much art as science. "We do a classic DCF analysis -- we assume investors are willing to pay up today for a future stream of cash flows," says Sara Farley, e-commerce analyst at PaineWebber. "The biggest thing I've changed are the discount rates [in my DCF analyses of Internet companies]. They were in the mid-to-high teens a year ago. Now, they're 20% to 22%." A higher discount rate means a lower valuation or stock price. Farley also has changed the assumptions about revenue growth in her e-commerce valuation models. Like most analysts, Farley uses Forrester Research's growth estimates for e-commerce, which see the total value of goods sold online rising by 55% annually over the next five years. That means e-commerce will total $185 billion by 2004, vs. $20 billion in 1999. FAIR VALUE? The question is how will that huge pie be cut? Analysts gradually have realized the pure-play Internet companies would only get a slice, albeit perhaps a big one. "It became clear that bricks-and-mortar companies weren't going to stand still," Farley notes. "Wal-Mart did a deal with AOL, and so did Sears. Kmart did one with Yahoo! So even though the overall growth estimates for the industry might have been correct, suddenly it wasn't all going to the e-commerce pure plays. They are going to be sharing it with the bricks-and-mortar retailers." Whether it's because investors have reassessed Net-stock prices' growth potential or are demanding higher returns for their riskiness, these shares are pretty much back to where they were last October, or below. A year ago, Amazon (AMZN) was an $80 stock. At the close of trading on Oct. 4 it was worth 36. Adjusting for an early January two-for-one split, AOL (AOL) began its ascent from the low 50s last October to hit a mid-January high of 95 13/16. When the market closed on Oct. 4, AOL was back down to 58 21/32. Yahoo (YHOO) hit its high of 250 1/16 in early January, 2000, adjusting for a two-for-one stock split in February (not adjusting for the split, the share price was around 420 at its top). On Oct. 4 it closed at 87 15/16, less than nine bucks above where it had been trading a year ago. Are those fair valuations? According to Salomon Smith Barney's Baker, a 10-year DCF analysis of Yahoo, assuming 40% average revenue growth and a 20% discount rate, gives you a stock price of 160. With AOL, Baker focuses on a multiple of free cash flow. At around 54, AOL is trading at 50 times free cash flow and its free cash flow is growing at 50%, he says. "If you look at the largest market cap companies -- Citigroup, Cisco, Oracle, Microsoft, and G.E. -- only a few of them have [free cash flow] growth of 25%, but most of them are trading at 1.6 to 1.8 times their free-cash-flow growth. Apply that to AOL, and you get a stock price of 100 to 120." Of course, you're not guaranteed that return. AOL might well underperform Citigroup or Cisco. Or it might do much better. The moral of the story is: If investors want a chance at outsized capital gains, they've got to be prepared to lose it all. The Internet is still risky business. Popper covers financial markets for BW Online in New Yor EDITED BY THANE PETERSON |
