Valuing Dot-Coms

You don't have to step through the looking glass into a parallel universe to understand the valuations of Internet stocks. Discounted-cash-flow analysis can focus your mind on the right issues, help you see the risks, and separate the winners from the losers. In the present era of cheap and accessible capital, Internet entrepreneurs have succeeded in quickly transforming their business ideas into billion-dollar valuations that seem to defy the common wisdom about profits, multiples, and the short-term focus of capital markets. Valuing these high-growth, high-uncertainty, high-loss firms has been a challenge, to say the least; some practitioners have even described it as a hopeless one. In this article, we respond to that challenge by using a classic discounted-cash-flow (DCF) approach to valuation, buttressed by microeconomic analysis and probability-weighted scenarios. Although DCF may sound suspiciously retro, we believe that it works where other methods fail, reinforcing the continuing relevance of basic economics and finance, even in uncharted Internet territory. [1] Yet it is important to bear in mind that while the valuation techniques we sketch out can help bound and quantify uncertainty, they won't make it disappear. Internet stocks are highly volatile for sound and logical reasons, and they will remain highly volatile. DCF analysis when there is no CF to D Three related factors make it hard to value Internet companies. First, like many start-ups, they typically have losses or very small profits for a few years, partly because of the high marketing costs (aimed at attracting customers) that they must write off against current earnings. Second, these companies are growing at very high rates: successful ones will increase their revenues by 100 times or more in the early going. Finally, the fate of these companies is quite uncertain. Shorthand valuation approaches, including price-to-earnings and revenue multiples, are meaningless when there are no earnings and revenues are growing astronomically. Some analysts have suggested benchmarks such as multiples of customers or multiples of revenues three years out. These approaches are fundamentally flawed: speculating about a future that is only three or even five years away just isn't very useful when high growth will continue for an additional ten years. More important, these shorthand methods can't account for the uniqueness of each company. The best way of valuing Internet companies is to return to economic fundamentals with the DCF approach, which makes the distinction between expensed and capitalized investment, for example, unimportant because accounting treatments don't affect cash flows. The absence of meaningful historical data and positive earnings to serve as the basis for price-to-earnings multiples also doesn't matter, because the DCF approach, by relying solely on forecasts of performance, can easily capture the worth of value-creating businesses that lose money for their first few years. The DCF approach can't eliminate the need to make difficult forecasts, but it does address the problems of ultrahigh growth rates and uncertainty in a coherent way. In this discussion, we assume that the reader has a basic knowledge of the DCF approach. Three twists are required to make this approach more useful for valuing Internet companies: starting from a fixed point in the future and working back to the present, using probability-weighted scenarios to address high uncertainty in an explicit way, and exploiting classic analytical techniques to understand the underlying economics of these companies and to forecast their future performance. We illustrate this approach with a valuation of Amazon.com, the archetypal Internet company. In the four years since its launch, it has built a customer base of ten million and expanded its offerings from books to compact discs, videos, digital video discs, toys, consumer electronics goods, and auctions. …