eBusiness: The Hope, the Hype, the Power, the Pain

| Table of Contents | Reading List

The Finances of eBusiness

But how do we know when irrational exuberance has unduly escalated asset values..?, ---Alan Greenspan, chairman of the Federal Reserve Board.[1]

The Internet will provide a dramatic drop in costs, destroy old competitive advantages and remake business models. The Internet is clearly reshaping the flow of capital. -- Michael Dell, CEO Dell Computer. [AP]

There is such an overvaluation of tech stocks that it's absurd. I would put our company, and I would put most companies, in that category. -- Steve Ballmer, President, Microsoft

While strategy defines how the game is played, finance lays out the rules of scoring. Although the underlying rules of economics and finance did not change, the rules of thumb and practices in the new economy look very different to those who have been in business for decades. We will discuss how companies are:

· Creating Market Value

· Using Market Capitalization to Create Acquisition Currency

· Valuation Strategies: Assets, Earnings, Revenues, Losses, or Eyeballs.

· Venture Capital.

· IPO

· Investment Strategies

Creating Market Value

During the second half of the twentieth century, investors in North America adopted an investment posture that valued capital gains far more than dividends. In part, this was because capital gains were taxed at lower rates than dividends. Also, the taxation could be delayed until the sale of the securities and thus one could time when the taxation occurred. Dividends are taxed in the year in which received and there is little favorable tax treatment and no ability to time (to chose when to pay taxes and take profits or losses). Capital gains were also desirable because they could occur for a variety of reasons rather than just because a company had a growth in earnings. Dividends usually require significant earnings. Investors also seemed to approve of management policies of reinvesting earnings (while hopefully creating market value) rather than paying them out as dividends. In the section on valuation strategies, we will see how this drives management decisions.

Since market value could be created through earnings growth, revenue growth, or excitement about the future prospects of companies, there were a variety of strategies available to companies to allow them to meet investor expectations, raise money, and increase their market capitalization. Because, investor excitement or hype worked so well in creating market capitalization, both new and old economy companies used it more and more often. Established enterprises experienced extreme frustration as their market capitalization was stuck at very low multiples of earnings or revenues, while the new enterprises enjoyed very high valuations even though the multiples of revenues were outrageously high and earnings were non-existent. After the fall of the market in late 2000, Regis McKenna, Silicon Valley Marketing expert, noted, "Most of that advertising is not value creation. It's aimed at investors, to keep the market value up.[2]"

Many old economy companies found a way around that by spinning out new companies from the old or by creating tracking stocks to extract market value from some of their assets that were “hidden” within the larger enterprise. Tracking stocks were stocks issued and trading whose worth was based upon and linked to sub-division of the larger company without actually spinning those components off into economically separate units. In general tracking stocks were not as well received by markets as actual spin-offs were.

Using Market Capitalization to Create Acquisition Currency

In the 1990s, market capitalization was much more closely related to investor expectations of future success than it was to current financial success as measured by revenues and earnings. The high market capitalization that was accorded to many of the new eBusinesses drove business strategy. On the one hand, the high valuations were an expression of an expectation of future growth for the company. Woe to the company that disappointed in that growth. This led to strategies that emphasized growth over any other objectives. On the other hand, the high valuations were a resource to be used to acquire the other resources that a company needed to be successful. CISCO is famous for the acquisition strategy that they used and that was enabled by the high market value accorded their stock. Lucent, after the tri-vestiture from AT&T and NCR experienced a dramatic run-up in market capitalization and then used that valuable stock as currency to acquire new technologies, particularly in the optical networking arena. For example, Lucent spent $900 million to acquire Nexabit when Nexabit had yet to release a product and had essentially no revenues and no earnings![3]

Using stock to acquire other companies depends upon having a well-valued (some would say “hyped”) currency. The large market capitalization accorded to rapidly growing internet and technology companies in 1998 and 1999 were exactly the thing that would allow these acquisitions. As those capitalization fell in 2000, this method of growth became far more difficult.

Wall Street Analysts

The opinion of the analysts on Wall Street that follow specific industries is a key factor in determining stock valuation. Companies often devote quite a bit of time to presentations and meeting with analysts to try to influence their opinions. Jim Clark often liked to say that he had analysts “drinking his Kool-Aid.” What he meant was the he had told them his story and they liked the story.

Analyst’s opinions tend to be relentlessly positive. In Table 6-1 you can see the distribution of analyst recommendations for 1999 as compiled by Zack’s Investment Research.[4]

With only 0.6% of all recommendations as either “sell” or “market under-perform” and over 82% of the recommendations as either “strong buy” or “moderate buy,” analysts have been relentlessly positive. There has been quite a lot of concern abut the close relationship between analysts and the investment banking businesses of their firms. Analyst’s who give low ratings may endanger their firms ability to do business with those firms that the analysts cover. There is a strong concern that this can influence an analyst to rate a stock higher than it might deserve. Whatever the reason, it is certainly true that analysts very rarely give a stock a low rating.

When valuing a firm for investment there is a tension between those analysts who focus on equity versus those that focus on debt.[5] Most analysts at investment banks are focusing on equity and they are most interested in the company’s growth prospects. Part of their analysis must project how the market will reward company actions. Debt analysts tend to focus on the details of the companies financial situation. Equity analysts tend to project the future. Debt analysts tend to examine the immediate financial past. Not surprisingly they often reach different conclusions.

During the rapid growth of the dot.com’s the Equity Analysts had the upper hand. Often tightly coupled to the company’s investment banking business, the equity analyst’s recommendations were invariably positive with less than one quarter of 1% of the recommendations as “sell.” This sentiment prevailed as long as the market was going up, but came in for serious questioning as the market declined.

Valuation Strategies: Assets, Earnings, Revenues, Losses, or Eyeballs.

Some would say that the valuations given to these new companies are akin to the famous "Tulip Hysteria" and other examples of the "Madness of Men." Alan Greenspan termed the valuations given to the stock market an irrational exuberance in 1998 when the market was only at 6500. In the spring of 2000, it was over 11,000!

How does one value a company? Over the years, investors have looked at different kinds of metrics for success. Among those are:

· Assets

· Earnings

· Revenues

· Intellectual Capital

· Customers

The main metric of personal financial success is assets. What do you own? How much money do you have? This can also be used a measure of financial success for corporations but is no longer viewed as a very good metric in this regard. For an investor to benefit from a corporation’s assets, the assets either have to be used to generate earnings or they have to be liquidated and distributed. In general, (but not always) liquidation occurs after failure. Investors prefer to benefit through growth in earnings. For this reason, earnings are generally viewed as the more desirable metric for the financial success of a corporation.

Most financial reporting includes various ratios for each company. Those who favor looking at earnings will focus on the price/earnings ratio (Price/Earnings) or the ratio of market capitalization to total earnings, while those who look at revenues will look at the ratio of market capitalization to revenues or sales (Price/Sales). The most conservative investors might look to the ratio of price to book value of the company (Price/Book). For example, in December of 2000, Intel had a Price/Earnings of about 21, a Price/Sales of about 6.8, and a Price/Book of about 5.8.

Financial success can be further abstracted by asking how an investor profits from earnings. This can happen either through dividends paid to the investor from corporate earnings or from the capital appreciation of the stock that the investor holds. Over the years, the relative values that investors assign to dividends versus capital gains has changed. More conservative investors, particularly those who are older and perhaps dependent upon a predictable cash flow from investments tend to favor dividends. Less conservative and younger investors often favor capital gains. Over the last 50 years the balance has shifted in the direction of a preference for capital gains. There are many reasons for this. Taxation policy often favors capital gains since capital gains can usually be deferred for many years and then are taxed at a lower rate when taken. Younger investors are often investing for retirement (or at least later in life) and do not have an immediate need for the income from the investment. They would prefer to leave the earnings and allow them to compound.

The shift to a preference for capital gains can also lead to another way of measuring the value of a company and that is through earnings growth. The market capitalization of a company is the value of each share of stock times the number of shares outstanding.

Market Cap = share market value * shares outstanding

There is some dissension about how to measure the latter figure. Some feel that options should be included and others do not. You can find sites with it calculated either way! Conversely the market value of each share may be viewed as the market capitalization of the company divided by the number of outstanding shares.

Economists tell us that the market capitalization of any company can be divided into a current value and a future growth value. The current value can be calculated by assuming that the earnings were obtained by an investment that was earning an average rate of return on capital. Suppose a company was earning $2 per share per year on a current stock price of $100. If the investor could have invested $20 at 10% assured return then she would have achieved the same earnings that she did by investing $100 in the stock of this company. Looking at this from the investment of the $100, she could have invested that in the safe financial instrument and received $10 per year in earnings. Why invest the extra $80 in the stock? Or conversely, why give up the extra $8? She must be expecting the stock price to increase by at least the $8.00 over the coming year.

She is expecting an 8% rate of growth in the stock price. We can say that the current value of the stock is $20.00 and the future growth value of the stock is $80 - if there is a steady rate of growth of 8% per year.

Investors who are looking for capital gains (most investors today) are then looking for rapid growth. In a friction free market, the growth value of each company will be discounted so that the rates of return are the same for any investment. In real markets, growth is much harder to predict. There are winners and there are losers ,and the ability to forecast the growth prospects of an organization is a key to investment success.

This encourages investors to look for leading indicators of future growth. How can one know how fast a company can grow? In the period of rapid growth from 1990-2000, investors and analysts used a number of such leading indicators or harbingers of growth. More attention began to be focused on the top line, revenue growth, rather than the bottom line, earnings growth, since it was assumed that revenue growth could eventually be converted into earnings growth once a competitive advantage was established. That was far from a certain assumption, but it was widely used in the 90’s.

One example of a leading indicator in the late 90’s was the number of persons (eyeballs) visiting sites times the length of time that they stayed (stickiness). In this regard, note that investment bankers (spring 1999) were using the rule of thumb that eCommerce companies were worth $25 per eyeball pair - hour. This refers to the amount of time that each customer visits an eCommerce site and spends looking at the content on that site.

The last approach to valuation assumes that "loyal" customers who visit a site regularly are doing so in anticipation of purchases and that each hour spent will result in some average revenue to the site. This is a plausible, but largely untested premise. Catherine Skelly, Vice President of Gruntal & Co. observed “It’s not the number of eyeballs you attract, It is what you do with them.[6]”

Amazon.com provides an excellent illustration of how the valuations of eBusinesses affect strategy. Consider this observation from Business Week[7]:

It's not easy to develop a valuation model that explains why a Net stock that trades at 300 times next year's earnings is a steal. Certainly, there's evidence to suggest that the people trading these stocks are not the type to dissect financial statements (page 122). ``I bought eBay (at $125) because I thought it would go up fast,'' says Rod Puckett, 27, a contractor in Rockford, Ill. ``These stocks are like McDonald' s when it first came out, I hope.''

Still, in the quest for the Holy Grail of Internet valuation, analysts are slicing, dicing, and torturing numbers until they can be molded into what might pass for a rationale to back up a table-pounding investment recommendation.

Perhaps you can't be persuaded to buy Yahoo! for 320 times projected 1999 earnings. Is there a way to make the stock more compelling? Shaun G. Andrikopoulos, who follows Net stocks for investment bank BT Alex. Brown Inc., came up with Theoretical Earnings Multiple Analysis, or TEMA. By that measure, which projects future earnings by estimating revenue growth and the operating margins that the company would hope to achieve when it has matured, Andrikopoulos says the p-e on year 2000 earnings is just 192. But factor in a revenue growth that's 55% higher--and he thinks Yahoo!, with a history of higher-than-expected sales growth, deserves that--and the TEMA p-e drops to 124. He's recommending the stock.

The analyst claims that his model gives a ``feel for the realistic theoretical earnings power of Yahoo!'' Realistic theoretical earnings? That might fly in an investment bank, but in English it's oxymoronic

Expectations Analysis

If traditional methods of valuing corporations do not really work for eBusiness, and the proxy methods of clicks and eyeballs remain speculative, then what might a skeptical investor do to evaluate the market valuations being given to the eBusinesses? Expectations analysis provides one method of looking at valuations and understanding the implications.

Amazon.com has often been used to illustrate methods of valuing corporations. Business week tried to explain how one might justify the Amazon.com valuation in a 1999 article.

One way is to start with the market price of the stock and determine what kind of revenue growth that price implies. The question then becomes whether that growth rate is realistic. Let's take Amazon.com. An analytical approach called Economic Value Added (EVA) indicates that with the stock at 214 a share, investors are implying that revenues will grow 59.6% a year over the next 10 years, taking annual sales to $63 billion from the current $587.6 million.[8]

This calculation was based upon a number of assumptions. The key equation for estimating market value is:

Market Value = Current Operations Value + Future Growth Value

In order to calculate Current Operations value we would need to have earnings, something that Amazon.com did not have. The only way out of this box is to make an assumption about a normal operating margin for Amazon.com. Business Week uses 10% in its example. A later analysis by the Wall Street Journal assumes 8%. At the time of the Business Week calculation in 1998 the stock price of $214 led to a market capitalization of:

$ 214 per share * 50.2 million shares = $10.8 billion.

The net income then can be calculated as 10% of sales of $587 million less taxes to yield a net operating income after taxes (NOPAT) of approximately $41.1 million. Now another assumption needs to be made. What would the cost of capital be? Business Week assumed a relatively expensive 15% yielding a Current Operations Value of:

Current Operations Value = $41.1 million / 15% = $274.2 million.

This works out to $5.50 per share of the $241 stock price. This means that the real value in Amazon.com shares must lie in the potential for future growth:

Future Growth Value = $10.8 billion - $274 million = 10.5 billion

If one calculates the growth required in revenues to justify this valuation over the next ten years to give a future growth value of 10.5 billion, the answer comes out to be 59.6% per year!

How does one get that? You require that the Current Operations Value (COV) grow at a rate (G) large enough to justify the market capitalization which is growing at historical rates R. The graph below demonstrates this.

Let us assign some symbols for ease of calculation Let

G = Growth (%) that the company will have to show, and

R= Historical Return (10-12%) enjoyed by stock owners

CC = Cost of Capital

Earnings = Current Earnings or Estimated Potential Earnings at current Revenue

COV = Current Operations Value (COV₀ is the value in year 0 and COV₁₀is the year 10 value)

MC = Market Cap (similarly: MC₀ or MC₁₀ ) and then

MC₁₀ = MC₀(1 + R) ¹⁰

COV₁₀ = COV₀(1 + G) ¹⁰

Now by the end of ten years we want

MC₁₀ = COV₁₀

Equating those and solving for G leads to an equation for the anticipated growth percentage.

G = (1+R)(MC₀/COV₀)^0.1- 1

Note that the 0.1 exponent in this equation comes from 1/10 where ten was the number of years. In general: for n years the exponent simply becomes 1/n.

Since COV₀ = Earnings/Cost of Capital

COV₁₀ = Earn/CC

G = (1+R)(CC*MC₀/Earn)^(1/n)- 1

To summarize using two assumptions of 10% net operating margin and 15% cost of capital, one can show that the market is “expecting” growth of 59.6% per year, which would result in annual revenues of about $64 billion per year in 2009. If one had used a more conservative cost of capital of 10% then the current operations value would have become $411 million and that would have not changed the conclusion significantly. (less than 2%!)

How realistic was this market expectation of 59.6% growth? The size of the book market in 1997 was $26 billion and growing at just over 5%. Forecasts of future growth were closer to 4.8%. It was not possible to meet the investor’s expectations and remain a bookstore.

This expectation can be a guide to both investment and business strategy. Since neither the growth in the book market nor Amazon’s increased market share could lead to these kinds of revenues, it was clear that investors were betting on Amazon.com’s “Real Options.”[9] These real options include entering into other businesses in which Amazon might go after greater revenue growth.

Thus, it was not surprising then that Amazon.com shocked Wall Street by announcing the formation of Zshops, an on-line shopping mall, on 29 September 1999. The market responded positively as Amazon enjoyed a huge bump of 23% in it's stock price. This dramatically expanded the reach of Amazon as they tried to position themselves for one-stop shopping for nearly everything! [CBS MarketWatch.com]

It also helped to explain a brouhaha over the hiring of Wal-Mart employees. Amazon.com had become embroiled in a legal battle against Wal-Mart, who alleged that Amazon.com had stolen many of their trade secrets by hiring away Wal-Mart IT personnel in large numbers. This would only be a large problem if Wal-Mart viewed Amazon.com as a potential competitor. This was unsurprising to those who had done an expectation analysis because they knew that Amazon had no other choice! Amazon.com must expand into other product lines in order to maintain the growth called for by its very high valuation. One example of this expansion is in pharmaceuticals, and Amazon.com had managed to make a two jump hire of a key Wal-Mart Executive from this area.[10][InformationWeek]

In February 2000 Alfred Rappaport made a similar calculation again for Amazon based upon February numbers.[11] His conclusions were that the February 22 share price of $63.5625 reflected investor expectations of annual growth of 55% to revenues of $105 billion. This growth rate is surprisingly unchanged over the result from the prior year! He also pointed out that the analyst’s consensus five-year growth for Amazon.com was only 48% per year, and that it would be hard to expect more than about 40% over the following five years. At a 40% growth rate, Amazon’s stock value would only be $35. If the investor’s target price for Amazon was $96 per share, then it would require growth of $67% per year for the last five years.

These are all daunting numbers to any investor. It is no wonder that Amazon.com’s reply to inquiries about its valuation at that time was “Our focus is not on the stock price in the short term. Our focus is to build a lasting company. The stock will take care of itself.”

AMAZON COM (NasdaqNM:AMZN) - More Info: News , Msgs , Profile , Research , Insider , Options

Chart

[Internet Valuation]

Valuation by Network Economics

The largest websites as of the end of 1999 were reported to be those shown in the accompanying figure.

Rank	Company	Unique Visitors
		(millions)
1	AOL	53.8
2	Yahoo	42.4
3	Microsoft	40.5
4	Lycos	30.4
5	Excite@Home	27.7
6	Go Network	21.4
7	Amazon.com	16.6
8	NBC	14.9
9	About.com	12.6
10	Time Warner	12.2
11	Real.com	11.9
12	AltaVista	11.6
13	Go2Net	11.2
14	eBay	10.4
15	CNET	9.7
16	ZDNet	9.6
Media Metrix; Dec. 99

Because of Metcalf’s Law, the valuations of the largest sites far exceed those of smaller sites. Using this a rule of thumb one would expect the AOL site which has 4.4 times as many visitors to be worth nearly 20 times the Time Warner site based upon network economics only. This may partially explain why Time Warner, with four times the revenues of AOL was willing to merge with AOL for only 45% of the stock in the resulting company. If the management of Time Warner felt that the future road to the market led through the Internet, then they would highly value the established network of AOL.

Network economics is not the whole story. Extracting value from a network depends critically on the business model. Just how does one profit from the network? Is it by selling things to the netizens? Or, is it through subscriptions, advertising, or collecting and reselling information about the netizens? Until a profit making business model is developed for the network, there is no inherent advantage to that network from a business perspective. Network economics is a proxy for potential business value, but other items determine whether that potential may be achieved.

In early 2000, the use of network economics to develop valuations received broad criticism for ignoring the critical process of extracting value. As one author noted: “Investors in Internet companies that equate “user base” to market capitalization are like the depositors in the Albanian funds that paid annual 100% interest.[12]”

Venture Capital.

Venture Capital is the rocket fuel for entrepreneurs and there has been an ample supply of rocket fuel available to new businesses. Once again we see a curve that has aspects of exponential growth. For venture capital that growth has a doubling time of about 5 years over the last half of the 1990’s and the last half of the 1980’s. Note that the exponential growth of the 80’s showed definite signs of peaking in the early 90’s. The exponential growth resumed in 1993. Mathematically it cannot continue indefinitely.

Source: Venture Economics Information Services

IPO

For years it was a rule of thumb that venture capitalist wanted new companies to be able to show four profitable quarters prior to going public. Jim Clark shattered that rule by taking Netscape public in 1995 with no profits and sparse revenues. The Netscape IPO defined an entirely new set of rules that has dominated IPOs for the last five years. The central tenant of the new rules was the first mover advantage. The goal was to create such a lead on potential competitors that no one could catch up. From this perspective revenues are beside the point and profits might be a sign that you were not serious about building the business. These new companies could not be valued based upon a price to earning multiple. They had no earnings. Multiples of revenues were not even useful since many companies had hardly started earning revenues prior to going public.

Valuations were based upon vision and the ability to “tell the story.” As Jim Clark put it after the Netscape IPO, “People started drinking my Kool-aid.”[13] A record of revenues and earning became a hindrance to the success of a new corporation. It gave bankers, venture capitalist, and investors things to look at and multiply by rules of thumb. It was prima facie evidence that management was too slow and lacked aggressiveness. If there are no revenues or profits, then multiples of revenues or profits are meaningless and valuation must be based upon other criteria. The IPO’s of the rest of the decade were all done according to Jim Clark’s rules.

The Netscape IPO also changed the balance of power between “propeller heads,” the engineers and scientists that were inventing the new world and “the suits,” the investors who were used to calling the shots. Clark, a former computer science professor, formed Netscape with Marc Andreessen, a 22-year-old recent computer science graduate with no business experience. At the end of the IPO, Clark retained 25% of the company. The CEO that he had recruited, Jim Barksdale, owned about 10% and John Doerr, the lead venture capitalist had about 11.5%. This meant that the venture capitalists were minority stakeholders. Marc Andreessen ended up with 2.6% that was eventually worth over $80 million after the IPO. It was the first IPO where the propeller heads were the big winners and the venture capitalists were along for the ride. It was a whole new world.

The Crash of the Dot-Coms

When one considers the finances of eBusiness, the reality of the Hope, the Hype, the Power, and the Pain is never more evident! Having predicted the end of business as we know it and uncritically jumped upon the bandwagon of dot coming the world, the media pundits rushed to trash and bash the new world once the bottom fell out of the Internet stock indexes. It is instructive to note that they did not rush forward to warn of this before the crash. Instead they rushed to warn us after the crash!

The cynical reader might be tempted to note that predicting past events is one of the real strengths of analysts and the media and is much more reliable than predicting future events!

On October 30, 2000, Fortune Magazine rushed out with an issue covering the dot-com crash headlined “Lessons for the Dot-Com Crash.[14]” It pictured a young business man reading the newspaper and exclaiming: “It all seemed so grand! We were changing he world! We were rich… now what??” A dog in the background suggests that he should “Quit whining and get a real job!” They go on to suggest that there are 12 lessons learned form the experiences of the last few years:

· The Internet isn't as "disruptive" as we thought.

· If it doesn't make cents, it doesn't make sense.

· Time favors incumbents.

· Making a market is harder than it looks.

· There is no such thing as "Internet time."

· "Branding" is not a strategy.

· Entrepreneurship cannot be systematized.

· Investors are not your customers.

· The Internet still changes everything.

· The Internet changes your job.

· The distinction between Internet companies and non-Internet companies is fading fast.

· The real wealth creation is yet to come.

While some of these are debatable at best, there is a certain truth in each. It would be useful to understand the complexities of each of these statements and the guidance that each might provide.

Throughout this text, we have tried to develop the ability of critical analysis that helps the reader to avoid these kinds of large amplitude swings in opinion. eBusiness is just business and the rules of economics continue to apply. We have encouraged the reader to continue to apply the usual business analysis tools to analyze the prospects for eBusinesses.

With this perspective, what is happening in the dot-com world is a predictable as a sunrise in the east. A sudden surge of capital availability drives the creation of a host of new businesses in areas where the barriers to entry and the switching costs are small. With far too many entrants in the field, a consolidation begins to take place. Many are called but few are chosen. Only the strongest businesses, with the best business models, the best strategies and the strongest financing, will survive. It is a timeless story.

Don’t be fooled, the changes wrought by the Internet are real, are lasting, and will indeed change the world. However, these changes are subject to the same laws of economics and science that all other businesses are experiencing. The dot-com revolution is not over, but it is entering a more mature phase in which a more critical investing public will give much closer scrutiny to the fundamentals. The return to more traditional levels of valuation is just the natural adjustment of the market to the maturity of eBusiness. There is also a tendency for the market to over-react to valuations on the downside just as it had earlier over-reacted on the upside. Over the longer term, valuations should seek more rational levels.