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Where's the Beef? More on Using the Abbreviated Income Method to Value Internet Stocks By Kathleen Sindell, Ph.D. Originally published in Investor Direct Magazine, September 1999 |
| Reprinted with the permission of Investor Media Network, Copyright © 1999 |
| Recently I did a "reality check" on the article written by
David D. Alger, CEO of Fred Alger Management, a New York based investment firm. Alger
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 America Online (AOL), Alger shows why AOL's current
P/E (price earnings) ratio of 224.95 is not out of line. Last month when I compared these
assumptions to a known winner, Dell Computer (DELL), I concluded that Alger was right on
target and the abbreviated income statement method was useful in valuing Internet
stocks…but that was last month. When Assumptions are Incorrect The following shows the value of in-depth research and how faulty assumptions may led to bad conclusions when using the abbreviated income method. Mail.com (MAIL) on June 18, 1999 went public at $7 a share. Shares rapidly increased in price to $20 per share. Using the abbreviated income method to value Mail.com on June 18, 1999 Paine Webber analysts developed the following set of assumptions to justify Mail.com's intrinsic stock value of around $40. (As of July 31, 1999 Mail.com was selling for $17 7/8.) 1. Paine Weber Analysts expect sales to increase to $56.3 million in 2001. Mail.com generates revenues from advertising, direct response and e-commerce activities, and from membership subscriptions. In comparison, annual sales in 1998 were $1.5 million. Revenue for the six months ended June 30, 1999 increased 1,375% to $3.2 million from $220,000 in the comparable period a year ago. 2. In 2001 Paine Weber Analysts anticipate that Mail.com will have an after-tax profit margin of 30%. (For your information the current after-tax profit margin for the computer services industry is 7.15%, for the technology sector it is 13.55%, and the S & P 500 it is 11.67%). 3. Paine Weber Analysts expect a continued annual growth rate of 21% justifying a PE ratio of 100 and assume that the number of outstanding shares (about 15.9 million) to remain the same over the next two years. Crunching the Numbers for Mail.com Table 1 shows that Mail.com had $1.5 million in sales as of December 1998. Paine Weber Analysts expect annual sales to reach $56.3 million in 2001. Profits are estimated to be 30% of this amount. This results in an estimated 2001 EPS of $1.062. (EPS is determined by taking the estimated amount of after-tax profits and dividing by the number of outstanding shares.) T able 1Abbreviated Income Statement Method for Determining the EPS for Mail.com
*Based on the estimates used by Paine Weber Analysts (Individual Investor Online, July 28, 1999). Table 2 shows how the estimated 2001 EPS of $1.062 is multiplied by Paine Weber Analysts' expected PE ratio of 100 to determine a 2001 stock price of $106.20. This amount is then multiplied by the investor's required return (in this case 50%) to arrive at a 1999 target stock price of $39.51. Table 2Determining the Current Intrinsic Value of Mail.com
* Based on the estimates used by Paine Weber Analysts (Individual Investor Online, July 28, 1999). Comparing Mail.com's Forecast to Earnings Paine Weber's expectations for Mail.com were not based on realistic assumptions. Within two weeks of their predictions Mail.com announced quarterly returns that were less than anticipated due to higher than expected costs of goods sold, miscalculated interest income, and the addition of two million outstanding shares. As of June 1999 Mail.com's after-tax income was approximately <$14.4> million. This is a big difference from Paine Weber's expected 30% after-tax profits. Realistically, can Mail.com make up the <$14.4> million loss and add $16.9 million to their bottom line in 18 months? Summing It Up This example illustrates two things. First, Wall Street analysts can be as wrong as any novice individual investor. Second, poorly developed assumptions that are this wrong in the short-term can lead to even worse long-term predictions. What this demonstrates is that investors need to do their homework when developing a set of assumptions for the abbreviated income statement method. For example, when I applied Alger's set of assumptions to the Dow Jones Internet Index, I discovered one overwhelming fact. Each Internet stock has to be analyzed on its own merits. The abbreviated income method of valuation is definitely not a one size fits all type of valuation tool and assumptions must be constantly monitored for changing economic conditions.
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