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A Reality
Check On Evaluating Internet Stocks By Kathleen Sindell, Ph.D. Originally published in Investor Direct Magazine, August 1999 |
| Reprinted with the permission of Investor Media Network, Copyright © 1999 |
| For the last several years investors have been trying to
evaluate those absurdly high priced Internet stocks. The classic discounted dividend
valuation method does not work, because many Internet companies do not have earnings or
dividends. Thus some investors believe their only Internet stock analysis tool is
intuitive judgement. This means they are operating blindly. David D. Alger, CEO of Fred Alger Management, a New York based investment firm, wrote a wonderful article called "Big Profits Are in Store From Online Revolution" (Wall Street Journal, April 26, 1999). Using the abbreviated income statement valuation method to appraise AOL, Alger shows why AOL's current P/E (price earnings) ratio of 224.95 is not out of line. PE ratios are important because a firm's stock price is often determined by multiplying the EPS (earnings per share) times the P/E ratio. Market determined P/E ratios include not only earnings and sales growth but also the risk and volatility of the company's performance, the debt-equity structure and other factors. In this column I compare Alger's abbreviated income statement method for AOL to a known Wall Street winner Dell Computer Inc. Assumptions and Forecasting EPS Table 1 shows the abbreviated income statement method supplied Alger. Here you multiple your sales prediction times the estimated after-tax profit margin to determine your earnings forecast. The estimated earnings are then divided by the number of shares outstanding to determine the earnings per share (EPS). Table 1 Abbreviated Income Statement Method for Determining the EPS for AOL
*Based on the estimates used in David D. Alger's article "Big Profits are in Store From Online Revolution" (Wall Street Journal, April 26, 1999). In his Wall Street article, Alger assumes that AOL sales in 2004 will be 5.7 times what they are today (as shown in Table 1). This assumption is based on AOL acquiring 18 million subscribers and increasing their monthly service fees to $28. Besides receiving an additional $3.5 billion in revenue from advertising and other sources. Is this possible? Assumptions about the After-Tax Profit Margin Table 1 shows that Alger assumes that AOL will have an after-tax profit margin of 26%. Alger believes this is realistic because AOL will likely increase their subscription base while keeping their marketing costs constant. Does AOL have what it take achieve a 26% after-tax profit margin? Determining the Fair Market Value of an Internet Stock Table 2 shows how Alger assumes that in five years AOL will continue to grow at a 30 % rate which justifies a P/E ratio of 50. According to Alger, this means that the stock price in 2004 should be $205.00. Table 2 Determining the Current Stock Price
*Based on the estimated used in David D. Alger's article "Big Profits are in Store From Online Revolution" (Wall Street Journal, April 26, 1999). If we discount the forecasted 2004 stock price, as indicated in Table 2, by 13% (our investor required rate of return) the estimated stock price for 1999 is $111.32 per share. On June 30, 1999 AOL was selling for $110.00 a difference of $1.32. This is about a 1.2% difference in the estimated and actual price. A Reality Check By Comparing Dell to AOL In order to validate Alger's approach, I have chosen a "high flyer" of the 1990s Dell Computer, Inc. and compared the two companies. Are the sales forecasts realistic? Alger forecasts AOL's sales to increase 5.7 times in five years. Dell's sales increased 6.4 times from 1994 to 1999. (See Table 3 for comparison details). This indicates that this assumption is not unrealistic. Is the after-tax 26% profit margin reasonable? Dell and AOL are in two different industries so I can not compare after-tax profits but I can compare the growth in earnings. Dell's current after-tax profit margin is 8%. For the last four years Dell's earnings have increased by 1.8 times each year. For AOL to reach the Alger after-tax profit goal of $4,160 million, AOL's after-tax profits need to increase 2.1 times a year for the next five years. Based on Dell's performance its possible. (Note: For the time periods analyzed, these are comparable sized companies.) Is the P/E ratio sensible? Alger assumes that AOL will continue to have a 30% growth rate, which justifies a P/E ratio of 50 in the year 2004. In comparison, Dell's growth rate was over 100% per year for the last four years and the company's current P/E ratio is 63 (as shown in Table 4). Therefore Alger's prediction of 50 and Dell's current P/E ratio of 63 are comparable. Table 3Abbreviated Income Statement Method for Determining the EPS for Dell
Table 4 shows how I calculate the estimated 1999 value of Dell stock by multiplying their current EPS ($0.59) times their current PE ratio (63) to arrive at a fair market value of $37.17. Dell's price as of June 30, 1999 was $37.00, a difference of $0.17. However, in 1994 if Dell had a P/E ratio of 224.95 like AOL their stock price would be much higher now. Table 4 Determining the Current Stock Price
Summing it up In conclusion, the abbreviated income statement method as demonstrated by David Alger shows a fundamental analysis method that is useful for valuing Internet stocks. Even with soaring revenue forecasts, predictions of lofty profit margins and high P/E ratios this approach is realistic. This means that investors do not have to shut their eyes, take a deep breath and blindly plunge into the Internet stock market. However, they will have to do their homework and develop a set of assumptions for each Internet stock that they analyze.
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