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May 3, 1999

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Subject: Subject: Re: Value
Author: IFindKarma

Rimpinths in post #10163:
IFK - the Smoot-Hawley Tariff Bill was passed in 1930. How could that have caused the crash of 1929?

There was no single cause of the crash of 1929. There were many causes -- too much straw on the camel's back, and the camel collapses.

Yes, Smoot-Hawley passed in 1930, but the market anticipates. I doesn't wait for the bill to pass and then react; rather, as soon as there's any real threat of the bill passing, it reacts immediately. Go back to the congressional records for autumn 1929, and you'll see that many believed that this restrictive tariff bill was likely to pass -- and so the market reacted. Badly.

But that was just one straw. US Steel's production figures coming out on October 15th and being down 17% was another straw, because it made people fear (rightly so) that the boom of the Roaring '20s was causing deflationary pressures on basic materials. Peoples' abuse of margin was another straw, because it forced them to sell low. The raising of interest rates 4 times in 2 years, including a jump from 5% to 6% in September 1929, was another straw -- the equity markets don't like such sharp interest rate hikes so quickly. The demographics of the post-Civil War Boomer generation entering retirement was perhaps the hugest straw of them all. Don't fight demographics.

My point is that it was a culmination of events that created the selling atmosphere that led to the crash. High prices in and of themselves do not necessitate a crash. You think they do, and I'm disagreeing with you.

I'm looking at interest rates around the world, and I'm looking at "Easy Al"'s desire to get reappointed next year, and I see interest rates at home that cannot be raised to the point that they become prohibitive. I'm looking at the free trade environment around the world -- and our willingness to incur trade deficits -- and I see a world in which U.S. corporate earnings have the conditions to grow abroad. I'm looking at the Boomer demographics, and I see a net inflow of money into the U.S. markets for years to come. You can disagree with me, but that's what I see.

Is this like how the South Seas Mania started twenty years before the South Seas Act was passed, as you previously claimed? You have a world of information at your finger tips, try looking up some dates sometime.

Remember, the South Seas Mania was predicated on a scam, and the Internet companies are not a scam. How do I know this? Because I know people working at many of those companies, and I've seen with my own eyes what they're doing and what they're trying to do. The prices of the stocks of Internet companies may run up too much, but there's no active deception going on here.

And yes, the conditions for the South Seas Mania were set into motion 20 years before the Mania reached its peak. And the South Seas Company started in 1711; the mania crescendo'ed in 1720. We've been over this history lesson before:

Could someone explain to me why someone would rather spend $133.3 billion to purchase AOL rather investing the same amount in bonds?

It's not something everyone would prefer. Some people, like you, prefer a sure thing. Give them 5%, and they're pleased as punch.

But get back to human nature. People aren't stupid. They're not going to buy into something that contains risk, if there's no chance of getting greater than 5%. They'd rather have the risk-free 5% than the risky 5%.

Therefore, there must be something in AOL which makes it worth assuming that additional risk. So what is it?

I see you went looking for answers, too, but you went to the balance sheet, and the balance sheet isn't going to cut it, as you astutely point out:
The important number is "Total stockholders' equity". What a shareholder should be interested in is total assets minue total liabilities, not just assets alone. IFK says that AOL is worth more than their current assets. AOL is currently worth about $133.3 billion. AOL itself says that shareholders' equity is about $2.8 billion. What are the other assets that make up the $130.5 billion difference, IFK?


You said, "Actually, I could make the case for ATHM and AOL being undervalued, too, solely based on their current assets, so their future revenue streams are just a bonus." Make your case. I wanted to figure out how $2.8 billion is magically transformed into $133.3 billion. Tell me what I'm missing.

You are missing television.

Look at the Nielsen Ratings for television shows:

What's #1? Friends.

Friends for the week of April 19-25, 1999, managed to get 20.8 million viewers to tune in for a half an hour.

And that was the top-rated show on all of television.

America Online gets 19 million account owners to tune in for 55 minutes a day on average, every single day of the year.

And these aren't brain-dead folks who are sitting on their couch in a zombie-like trance. Nor are they people who get up and go to the bathroom or flip the channels during commercial breaks. Instead, they're clicking, they're actively surfing, they're buying stuff... and they're paying for the privilege to do so.

So here's where you and I will disagree, Rimpinths. How much would you say it would be worth to own television?

Here's some background for the "television" AOL owns.

1. AOL has $2.7 billion in cash; furthermore, AOL is unafraid to use its stock to buy other companies. You'll be quick to point out that all of AOL's cash is owed in long-term debt, and that using one's stock to buy stuff is a scam, but that's the way business is done in 1999. Or would you prefer all business to be transacted your way?

2. AOL added 1.8 million users this quarter. The more people who join AOL, the more who want to join AOL, just as the more people who have television, the more people who want television. Part of the power of AOL over any other ISP is that it is nationwide, and that it has chatrooms and other services (ICQ, Digital Cities, Moviefone, When.Com).

3. There are 3.2 million AOL customers outside the U.S. Care to guess how much room there is for growth out there, if for no other reason the chatrooms and premium services that a free ISP elsewhere won't offer?

Now let's make the case that AOL is worth more than its assets. What, to me, is an asset to AOL?
1. A customer.
2. A content provider or advertiser.

Since I don't know much about the rates AOL charges its content providers or advertisers, I'm going to stick to AOL's customers in just five services: AOL Classic, CompuServe, AOL International, Netcenter, and ICQ. This is from the same school of thought as things Kevin Prigel has published, and I happen to agree with him:

Despite AOL's churn rate of 3%, AOL has been growing its subscribership between AOL Classic, CompuServe, and AOL International, by about 10% quarter-over-quarter for at least the last 8 quarters. But let's be more conservative than that. Let's say AOL has 19 million paying customers right now, and grows by 1 million customers every quarter between now and the next 5 years, while the Internet itself is still in hypergrowth mode. That's 19 million customers now, and about 39 million in 5 years.

So what is a customer worth? Let's forget about the $20/month for service they pay. Let's forget about the hundreds of dollars for goods and services they will purchase through AOL in the coming years.

Instead, let's go over to the cable industry. Another highly leveraged industry where companies are priced based on assets, because most of the infrastructure costs are incurred up front. So what's a cable customer worth?

As Kevin pointed out, Comcast offered MediaOne a package that came to roughly $5000 a customer -- that's discounted future earnings anticipated from those customers, and I'm assuming that Comcast wasn't stupid in making its offer, because AT&T four weeks later came out and upped the offer price to roughly $6000 per customer.

But I want to give AOL a 33% premium over that, because AOL customers average 55 minutes a day on their site, and because those are interactive minutes, not sit-on-the-couch minutes. If as an AOL customer I see an advertisement for something I like, I can click through, read about it, and be more likely to buy it. I think that's worth a 33% premium.

So the 19 million AOL customers, in my mind, are worth about $8000 apiece over the course of their lifetimes, or roughly $152 billion. And in 5 years, the 39 million customers will be worth roughly $312 billion.

That means to me that compared to 5 years from now, given conservative estimates of AOL's growth rate, and a reasonable valuation of AOL customers over cable customers, that AOL is fairly valued right now, and half the value it should be in 5 years.

But wait, there's more. We still have the AOL web sites and the instant message service, and I won't even begin to value the price AOL charges its advertisers or content providers because I'll assume they're built into that $8000/customer calculation we did earlier.

AOL has two big web sites, AOL.com and Netscape Netcenter, and they are two of the ten biggest web sites by nearly any rating system I've read (along with Yahoo, MSN, Lycos, Excite, the Go network, and others). Conservative estimates of users of AOL's web sites runs about 30 million (I've seen numbers as high as 50 million), and remember that unlike Yahoo this is a supplemental business, not the main business. Let's say these 30 million are only worth about $1000 apiece over the course of a lifetime, as unlike with AOL's Dial-up services, we don't have the dedicated attention of a web surfer. Still, that means I think the web properties are worth roughly $30 billion, which places them just a little less than what the market thinks Yahoo is worth.

Finally, we have ICQ, which grew to 32 million users this quarter -- and millions of these ICQ users are addicted to such a viral service, and use it every day. I think they are probably worth $500 apiece, over the course of a lifetime, between advertising and potential sales revenues. That's roughly $16 billion.

I don't know how to place values on some of AOL's other assets: Digital Cities, Moviefone, When.Com, and the deals with FirstUSA and eBay. But let's say they're worth something, too.

Then, based just on some of its current assets -- the customers who use AOL's dial-up and web products and services -- AOL is currently worth to me roughly $152b + $30b + $16b to me, or $198 billion, or 193 dollars a share. And with every customer added, that number grows.

Now, you're gonna say -- I know, I can hear it -- where's the earnings? But it's pretty clear you wouldn't have bought television either -- not a television company, mind you, but the whole darned medium -- because you failed to see how people could profit off the customer. You failed to see how people would shell out money each month for the cable bill (ever notice how cable rates keep going up, not down?), and you failed to see how advertisers would pay for airtime. AOL takes it one step further and allows stuff to be sold through the medium -- and not in a cheesy, QVC-sort of way. To me, this is the real deal.

$8000 a customer. Well, solely through paying $20 a month for the service, this amounts to roughly 33 years of being an AOL customer. But that's just through subscription fees. Think advertisers, and think taking a cut of all transactions done through AOL. And $8000 a customer could certainly be worth it.

Clearly this analysis is not for everyone. You need to buy into my assumptions. And not everyone will. And those who don't, won't think AOL is undervalued. They'll think like you, that they'd rather have $6 billion guaranteed, year after year:
In regards to earnings, if I buy AOL for $133.3 billion, I will be getting $257m in earnings, and a price-to-book (i.e. price-to-shareholders' equity) value of 90.50. If I buy $133.3 billion in bonds that earn 5%, I will be getting $6.7 billion in interest payments, and a price-to-book value of 1. Why on earth would I choose AOL?!! Tell me what I'm missing.

You're missing the ability of AOL to grow from 19 million customers to something bigger; with bonds you know exactly how they're going to grow, and you're paying for certainty.

In addition, you're missing the ability of AOL to retain its customers for decades. You're missing the appeal of the brand name. You're missing the international expansion. You're missing the ability of AOL to use its cash and its stock price to buy other companies. You're thinking too literally. You want a sure thing, and the stock market has no sure things.

You're not a risk taker. You want a guarantee, up front, of earnings. And if you don't see them, you won't buy.

That's fine. 5% returns are made precisely for people who don't want to take risk, and you can sleep comfortably in your bed at night.

But could AOL be a whole lot bigger than it is now? I think so. And could that bigness translate eventually (say 5-10 years) into more earnings than the Microsoft juggernaut makes? I think so, too. I think AOL will one day be bigger than Microsoft. I think that AOL will one day make more money than Microsoft. And I don't think AOL's stock price will ever be considered "cheap" between now and then. Because the market knows what this company will one day be worth.

And like I said in an earlier post, AOL's people know how to manage hypergrowth extremely well. They've been doing it for years.

You could make the case that AOL will earn more than $6.7 billion in the future. But that's a LOT of money!

Of course it's a lot of money. The question is, can AOL do it? And my answer is, I think so. I think AOL will make in income more than $6.7 billion in the next decade. And that's what you say I'm paying for, right? A single stock price that completely represents the grand sum total of future discounted earnings. Yeah, I think it's worth it.

That's more than the greatest company on the face of this earth, MSFT. Moreover, how long do you think it will take for AOL to be earning that much money? Five years, ten years, twenty years?

Future discounted earnings over the rest of the life of the company. As more news comes available, we know more about the future of the company, and the stock price changes accordingly.

Let's go with a extremely optimistic outlook (or what I would call unrealistic) and say that AOL will be earning that much in five years. In five years, your $133.3 billion initial investment in AOL will be reaping $6.7 billion in earnings per year in the future. During that time, the interest on the bonds will have compounded, and you would then be earning $8.5 billion, so you'll have to up the ante for AOL.

And in 2004 you would love to get your hands on AOL at 143 a share, but by that point the new information has been priced into the stock and it's worth roughly four times that.

My point is that a company in hypergrowth mode never has a stock price that is cheap. Only companies that are mature and growing at a small, sustained rate, have relatively cheap stock prices.

Are we paying too much for AOL shares at the current price? You think so, I think not. But like I said, that's what makes a market -- disagreement over what a company is worth.

In the future we'll see who's right and who's wrong. And in the meantime, we'll both sleep well.