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Friday, November 20, 1998

An Investment Opinion
by Warren Gump

Internet Stocks and Valuation

We have seen an amazing rise in Internet stocks this year. Stocks like Amazon (Nasdaq: AMZN) and Yahoo (Nasdaq: YHOO) are up over 400%, while eBay (Nasdaq: EBAY) has risen almost 700% since its late September IPO. Just because these stocks have skyrocketed doesn't necessarily mean that they are overvalued. Intuitively, that last statement makes my value-oriented heart palpitate. (Then again, perhaps it was just those peanut butter M&Ms that I munched on!) But when you think about it, buying a stock is essentially purchasing its future cash flows, discounted back to the present. If you make relatively minor changes to your expectations for a company, a soaring stock price may be justified.

In the examples below, I'm actually going to use reported earnings as a cash flow proxy. This assumption can be a major oversight if the business you're evaluating has cash flows that differ from earnings, but it simplifies things to convey the main thrust of this article: small changes in assumptions and return requirements can cause dramatic variations in a company's value.

There is a little bit of mathematics behind this article, but you Fools who aren't geeks can hold onto your britches. I'm going to avoid putting complicated calculations in the text. If you trust my calculations, thank you. (Do you want to buy this nice used car I have?) If not, send me an e-mail and I'll zap you the very simple Excel spreadsheet that shows the numbers behind the numbers. Fair enough?

Let's start out with a few of our base case assumptions. Let's go back a few years and imagine we plan on creating a revolutionary new Internet firm that is going to sell books over the Internet. We have relatively modest initial ambitions, expecting to sell $10 million in books in Year 1. Our gross margin is projected to be 20% ($2 million), while operating costs (marketing, product development, general and administrative expenses) will run about $5 million. Pulling all that information together, we jave a projected Year 1 operating loss of $3 million.

Here are our projections and assumptions for the future: Through the fifth year of operations, sales will double each year. In years six through ten, sales are expected to rise 50% annually. We project that sales will grow 15% annually thereafter. As some relatively fixed costs are leveraged, operating costs as a percentage of revenue decrease on a rapid curve in the first three years, plumeting from 50% in Year 1 to 35% in Year 2 to 20% in Year 3. For the next four years, operating costs decrease 2 percentage points a year, after which they hold steady at 12%. Gross margin remains constant at 20% in all of our projections. Tax expense is 40% of profits, and the company will issue a total of 5 million shares.

Just to keep tabs on where these assumptions take us, Year 10 revenues are $1.2 billion. Net profit would be $58.3 million, or $11.66 per share. Not too bad for a ten year old upstart.

The big question that needs to be answered is the value of this company. First, we need one more piece of information. What rate of return are you, the investor, going to require for investing in this startup. You know that the S&P 500 has given investors a compounded return of 11.0% between 1926 and 1997. (Thanks for the info, TMF AnnC!). To invest in a risky start-up business (remember this is a few years ago), though, you are going to want a much higher return. Let's say you want to earn 25% per year.

Crunching through my spreadsheet, I find the value of this investment to be $18.56. That is the amount I would pay to receive a 25% return, assuming I believed all of the above assumptions to be accurate. What happens, however, if I change one of those assumptions. In financial analysis terms, what is the "sensitivity" of my valuation to various assumptions. To find out, we simply change one of the variables, holding everything else constant. Off we go!

Sensitivity to revenue growth: Let's say that instead of $10 million in revenue during the first year, we presume it to be $15 million. Remember, none of our other assumptions change. We still expect revenue to double from this Year 1 base through Year 5. No changes to margins and no changes to our required rate of return. How much is our bookseller now worth? Pulling out my spreadsheet, the value of the investment jumps by 50% to $27.84. Neat, a 50% rise in first year revenues (which is carried through to all future years) results in a commensurate rise in the value of the stock. One caveat here, this model is structured so that expenses are a specified percent of revenue. If they were modeled in such a way that some expenses were fixed, the percentage change in value would not necessarily equal the percentage change in revenue.

Now, let's look at what happens if we change the long-term revenue growth forecast. Instead of long-term growth of 15% after Year 10, let's assume it to be 20%. My spreadsheet spits out a value of $34.21. That's 84% higher than our original value, just from a little change in our expected long-term growth rate. On the other hand, if revenue growth is projected to be only 10% beyond Year 10, the value of our investment would only be $13.34. That's 28% below our original estimated value of $18.56.

Now let's look at margins. Instead of our original assumption of 20% margins holding throughout the existence of this firm, let's presume that margins will fall to 16% from Year 4 onward as more competitors come online. Yikes! That change is not a very good one. The value of this company would tumble 53% to $8.70. A price war could really have a dramatic impact on the value of this company.

Let's make one minor tweak to our price war scenario. Instead of a bitter battle to the end, perhaps the war will kill some of the more aggressive competitors. To incorporate this in our model, we'll throw in margins of 16% in Years 4 and 5, but have them rebound to 20% thereafter. What is the impact of this change? It changes our valuation model to $18.15 -- a drop in value of only 2% from our base case outcome, but not that important in the overall scheme of things. For this more moderate impact to be realistic, however, you better be confident that margins will rebound after Year 5.

Let's now check out the sensitivity to one last variable, the required return. We started out assuming that this figure would be 25%. What happens if investors start to feel more confident about the stability and growth of this company and only require a 20% annual return? Well, that one change in my model will increase the value of the company to $49.32. Yup, that one little change adds 166% to the value of the company.

Taking the converse view, a 5 percentage point increase in the required return, to 30%, has a pretty dramatic impact, too. Making that little adjustment to my model knocks 49% off the value, taking it down to $9.39. Yowsers, stay away!

As demonstrated in this article, small changes in assumptions can dramatically alter the valuation of a business. In the above examples, only one variable is changed at a time, which is somewhat unrealistic in the real world. On a day-to-day basis, all of these variables are dynamic. The impact, for example, of both increasing revenue assumptions and lowering the required rate of return is going to be much more dramatic than changing each variable independently.

What is happening with the Internet stocks? Investors see the phenomenal revenue growth of recent quarters and are extrapolating recent results into the future. At the same time, the required rate of return is decreasing as these investments become more mainstream and investors lower the risk they assign to such stocks. Combining those two changes with, potentially, a dab of margin expansion or operating leverage can relatively easily lead to a company being worth 1,000% more than it was worth a year ago.

Will the values being spit out by the models ever be realized? It really depends on the reasonableness of the assumptions put into the model. Microsoft has continually exceeded expectations since its IPO in 1986 and has made numerous investors millionaires. However, the folks who had rosy projections for Boston Market now find their company embroiled in bankruptcy.

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