Are Internet Stocks Over- Valued? Paul A. Gompers Harvard Business School pgompers@hbs.edu
THURSDAY, JUNE 3, 1999 Internet Stock Index S&P 500 INTERNET STOCKS: WHAT A RIDE IT HAS BEEN!
Amazon.com: Can we justify its value? 1998 1999 2000 2001 2002 2003 2004 Sales $610.0 $2,135.0 $6,938.8 $20,816.3 $62,448.8 $187,346.3 $562,038.8 Net Income -$125.5 -$550.9 -$514.2 -$60.7 $1,892.8 $9,367.3 $28,101.9 Net Margin -21% -26% -7% 0% 3% 5% 5% Assets (NWC + FA) -$75.0 $106.8 $346.9 $1,040.8 $3,122.4 $9,367.3 $28,101.9 Change in Assets (NWC + FA) $181.8 $240.2 $693.9 $2,081.6 $6,244.9 $18,734.6 Free Cash Flow -$732.7 -$754.3 -$754.5 -$188.8 $3,122.4 $9,367.3 Present Value at: $30,608.00 Discount Rate 18% Growth rate after 2008 10% Assumption: Sales Growth Rate 250% 225% 200% 200% 200% 200% NWC+FA/Sales 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% Assume no significant depreciation Aggressive growth assumptions Same Margins as Base Case
Agenda Is the stock market overvalued? Can it help explain Internet Stocks. Explanations. Lower risk. New Business Model. New Economy. The Internet Gorilla. Lessons.
Is the Stock Market Overvalued?
Dow Jones Industrial Average 1980-1999 12,000 10,000 Index Level 8,000 6,000 4,000 2,000 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
Standard & Poor s 500 Index 1980-1999 1,600 1,400 1,200 Index Level 1,000 800 600 400 200 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
NASDAQ Composite Index 1980-1999 3,000 2,500 Index Level 2,000 1,500 1,000 500 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
Wilshire 5000 Index 1980-1999 14,000 12,000 10,000 Index Level 8,000 6,000 4,000 2,000 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
Various U.S. Stock Market Indices 1980-1999 20 18 16 Index Level (Jan 1980 = 1) 14 12 10 8 6 4 2 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 DJIA S&P 500 NASDAQ Wilshire 5000
Various U.S. Stock Market Indices 1990-1999 6 5 Index Level (Jan 1990 = 1) 4 3 2 1 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 DJIA S&P 500 NASDAQ Wilshire 5000
FTSE 100 Index 1984-1999 7,000 6,000 5,000 Index Level 4,000 3,000 2,000 1,000 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
Nikkei 225 Index 1980-1999 Index Level 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
S&P 500, Nikkei 225, and FTSE 100 1980-1999 14 12 Index Level (Jan 1980 = 1) 10 8 6 4 2 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 S&P 500 Nikkei 225 FTSE 100
S&P 500, Nikkei 225, and FTSE 100 1990-1999 4.5 4.0 3.5 Index Level (Jan 1990 = 1) 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 S&P 500 Nikkei 225 FTSE 100
Value Drivers
Glossary of Terms V = Market value of equity CF = Cash flow t = Time Period K = Discount rate
Valuing a Firm CF 1 CF 2 CF 3 CF 4 CF 5 V = S t = 1 CF t (1 + K) t
Valuing a Firm Three rules of valuation: More cash is preferred to less cash. Cash sooner is preferred to cash later. Less risky cash is preferred to more risky cash. Combination of the three determine the value of any opportunity.
Explanations for High Valuations Less Risk The New Business Model The New Economy The Internet Gorilla.
Less Risk
Is Market Risk Constant? 40% Excess Market Returns: 1926 to 1997* 20% 0% -20% -40% 1926 1936 1946 1956 1966 1976 1986 1996 Year *Shaded areas identify NBER business cycle contraction periods.
Is the Risk Premium Constant? Likelihood Duration (Years) Risk Premium Low-Risk Periods High-Risk Periods 87% 7.2 2.9% 13% 1.0 37.2% What you learned in First Year Finance All Periods 100% 7.4% Source: Mayfield (1999) State-Dependent Volatility and the Market Risk Premium.
Has the Risk Premium Changed Over Time? 1926 to 1939 1940 to 1997 Likelihood Duration (Years) Risk Premium Likelihood Duration (Years) Risk Premium Low-Risk Periods High-Risk Periods All Periods 65% 4.0 2.5% 95% 4.1 2.5% 35% 1.9 35.3% 5% 0.2 35.3% 100% 14.0% 100% 4.2% Source: Mayfield (1999) State-Dependent Volatility and the Market Risk Premium. Lower Equity Risk Premium
Lessons Equity risk premium seems to be lower. 4.2% versus 7.5%. Lower risk economy. More interest in investing in stocks. Baby boomers have seen appreciation of stocks over past 70 years relative to bonds. Lower risk premium can help to explain. High overall stock market. Very high Internet valuations.
Why so Important to Internet Firms Payoff to Internet stocks in the distant future. Low equity risk premium would: Greatly decrease the discounting of those future cash flows. Make Internet stocks look attractive.
The New Business Model
The New Business Model Amazon.com Receives money, and then acquires books The larger the company grows, the more money it generates Dell Receives money, and then builds computer Cash generation more limited due to higher receivables
Amazon.com and 1997 Cash Flow Amazon.com Barnes & Noble Payables 0.22 0.16 Receivables 0.00 0.02 Inventories 0.06 0.30 Net Working Capital 0.16 (0.16) Net Plant, Property & Equipment 0.06 0.17 Cash per $ of Sales 0.10 (0.33) Amazon.com generates 43 more cash per dollar of sales than Barnes & Noble
Market Capitalization Amazon.com and Barnes & Noble $ Millions 30,000 25,000 Amazon.com Barnes & Noble 20,000 15,000 10,000 5,000 0 96Q1 96Q3 97Q1 97Q3 98Q1 98Q3 99Q1 Calendar Quarter
Dell 1998 Cash Flow and Compaq Dell Compaq Payables 0.13 0.14 Receivables 0.11 0.22 Inventories 0.01 0.06 Net Working Capital 0.00 (0.15) Net Plant, Property & Equipment 0.03 0.09 Cash per $ of Sales (0.03) (0.25) Dell generates 22 more cash per dollar of sales than Compaq
Market Capitalization Dell and Compaq $ Millions 120,000 100,000 Compaq Dell 80,000 60,000 40,000 20,000 0 96Q1 96Q3 97Q1 97Q3 98Q1 98Q3 99Q1 Calendar Quarter
The New Business Model Cash Intensity for S&P500 Companies Cash Intensity = (Net PPE + Working Capital)/Sales 0.88 Weighted Ratio 0.86 0.84 0.82 0.80 0.78 0.76 0.74 0.72 0.70 1990 1991 1992 1993 1994 1995 1996 1997 1998 S&P 500
Effects of New Business Model Lower cash needs. Lower working capital requirements. Lower asset intensity. Produce only as needed. Need less inventory. Need less PPE. Effects of New Business Model. Higher ROE. Higher cash flows. Greater value creation.
The New Economy
The New Economy The economy is increasingly dominated by technology. Computer hardware and software were the first phase of the economic transformation. Information and connectivity will be the second phase. The shifts are fundamental in nature.
The New Economy 1980 Market Value of 1999 S&P500 Companies, by Business Segment Other 27% Technology 10% Finance 5% Manufacturing 58%
The New Economy 1999 S&P500 Market Value, by Business Segment Other 25% Technology 19% Finance 16% Manufacturing 40% Total Market Value of 1999 S&P 500 = $10 trillion
S&P 500 Sector Indices 1990-1998 Sector Indices 12 10 8 6 4 2 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 Technology Manufacturing Service Finance Other S&P 500
Current Market/Book Ratios for S&P 500 Companies Selected Industry Segments 16.4 9.4 3.9 Technology Manufacturing Finance
The New Economy Declining Computing Costs 100 80 60 40 20 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 Producer Price Index - Electronic Computers
The New Economy Declining Computing Costs 100 80 60 40 20 0 1991 1992 1993 1994 1995 1996 1997 Cost of MIPS
The New Economy Higher Computer Productivity Cumulative Processor Capacity, in Mips (Logarithmic scale)
Implications of the New Economy Computing is becoming a way of life. Pervading all aspects of business and consumer markets. Engine for the Internet will continue to explode. New technologies and opportunities. Ubiquitous platform. The Internet will change the way we live and do business.
The Internet Gorilla
Internet Soundbites In 1998, business spent $60 billion on products and services to develop their Internet presence. Internet traffic is doubling every 100 days. Business to business services estimated to be $200 billion in 2002. Worldwide Internet commerce could top $3.2 trillion in 2003.
Worldwide Online Households Households in Millions 50 40 30 20 10 0 1997 1998 1999 2000 2001 US Western Europe Asia/Pacific Japan ROW
Online Purchase Intentions Accelerate in 1999 Do you expect to make an online purchase in 1999? 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Yes No
Online Purchase Intentions Accelerate in 1999 Do you research off line purchases online? 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Yes No
Amazon, AOL, Yahoo!, And ebay Are The Leading Shopping Destinations Where have you made online purchases? 25% Enough Said! 20% 15% 10% 5% 0% AOL Amazon.com Yahoo! ebay Excite Music Boulevard CDNow Egghead etoys Walmart MSN Infoseek Onsale Buy.com Lycos
Consumer Spending Online How much do you expect to spend online in 1999? More than $500 25% $50 or less 8% $51 to $100 17% $101 to $500 50%
Bottom-Line on the Internet The opportunity is real. The opportunity is of a dimension that exceeds the magnitude of the industrial revolution. Will change the way goods and services are delivered. Pervade every aspect of personal and business life. Estimates of potential market size might be too-low! Those who dominate the market will be huge. Wave of hardware and software firms in computer industry created $1 trillion in market value. Internet will do the same.
Add them all up and what do you get? Less Risk The New Business Model The New Economy The Internet Gorilla.
Amazon.com Valuation: Revisited Believable!! 1998 1999 2000 2001 2002 2003 2004 Sales $610.0 $1,220.0 $2,440.0 $4,270.0 $6,832.0 $10,248.0 $15,372.0 Net Income -$125.5 -$314.8 -$180.8 -$12.4 $207.1 $512.4 $768.6 Net Margin -21% -26% -7% 0% 3% 5% 5% Assets (NWC + FA) -$75.0 -$101.7 -$203.3 -$355.8 -$569.3 -$854.0 -$1,281.0 Change in Assets (NWC + FA) -$26.7 -$101.7 -$152.5 -$213.5 -$284.7 -$427.0 Free Cash Flow -$288.1 -$79.1 $140.1 $420.6 $797.1 $1,195.6 Present Value at: $30,657.31 Discount Rate 12% Growth rate after 2008 10% Assumption: Sales Growth Rate 100% 100% 75% 60% 50% 50% NWC+FA/Sales -8.3% -8.3% -8.3% -8.3% -8.3% -8.3% Assume no significant depreciation Aggressive growth assumptions Same Margins as Base Case
Lessons Internet is far from overvalued. Financial markets are a different beast. The Internet can, has, and will change the way people do business. If anything, the recent sell-off of Internet stocks has made them a good buy.