May 28, 2003
Internet Stocks Go Boom…You know what comes next

When attempting to value an internet stock – assuming you are not planning to buy stock and then pray that you can pawn it off to some sucker at a higher price – you need to rely on more than Wall Street earnings estimates and long-term growth rates.  Nevertheless, to keep things simple (and to avoid having to look at any of these slot machines in detail) consider the earnings and growth rates of the top 3 internet stocks: Amazon, Ebay, and Yahoo. 

Legend
GR: Expected growth rate for each of the next 5-years (or longer).
EPS: Earning per share using consensus Wall St. estimates (for 03 & 04) and GR.
P/E: Price to Earnings Multiple should EPS estimates be met.
E/P: Earnings to Price (earnings yield) should EPS estimates be met. 

Ebay - $103.50/Share   42%GR         Year EPS P/E E/P 2003 1.46 70.89 1.41% 2004 2.07 50.00 2.00% 2005 2.94 35.21 2.84% 2006 4.17 24.80 4.03% 2007 5.93 17.46 5.73% 2008 8.42 12.30 8.13% 2009 11.95 8.66 11.55% 2010 16.97 6.10 16.40%

YHOO - $29.97/Share   30%GR         Year EPS P/E E/P 2003 0.35 85.63 1.17% 2004 0.46 65.15 1.53% 2005 0.60 50.12 2.00% 2006 0.78 38.55 2.59% 2007 1.01 29.66 3.37% 2008 1.31 22.81 4.38% 2009 1.71 17.55 5.70% 2010 2.22 13.50 7.41%

AMZN - $34.85/Share   22.9%GR         Year EPS P/E E/P 2003 0.48 72.60 1.38% 2004 0.68 51.25 1.95% 2005 0.84 41.70 2.40% 2006 1.03 33.93 2.95% 2007 1.26 27.61 3.62% 2008 1.55 22.46 4.45% 2009 1.91 18.28 5.47% 2010 2.34 14.87 6.72%

As the above data illustrates, the earnings yield (E/P) on all three of these stocks is ridiculously low. To be sure, instead of investing in any of the above companies with a 1-year horizon, you could get more bang for your buck by parking your money in Treasuries.

Regardless, what the above data means for a company like Ebay is that, according to Wall Street, $1 invested in Ebay today will earn 1.4 cents in earnings in 2003, 2 cents in 2004, 2.8 cents in 2005, and so on.  It is difficult to believe that any investor would be satisfied if they received only 6.2 cents at the end of 2005 for every dollar invested today.

Leader Comparison

For an example of why i-nets are ‘overvalued’ using the above valuation tests consider a couple of other industry leaders in Home Depot and IBM. These companies are not ‘cheap’ by any stretch of the imagination, yet their earning yields are more attractive right now, and expected to be more attractive for each of the next 5 years (Ebay’s earnings yield will overtake IBM’s in 2008).

Home Depot - $31.45/Share 15%GR           EPS P/E E/P 2003 1.73 18.18 5.50% 2004 1.96 16.05 6.23% 2005 2.25 13.95 7.17% 2006 2.59 12.13 8.24% 2007 2.98 10.55 9.48% 2008 3.43 9.17 10.90% 2009 3.94 7.98 12.54% 2010 4.53 6.94 14.42%

IBM - $87.87   10%GR         Year EPS P/E E/P 2003 4.32 20.34 4.92% 2004 4.87 18.04 5.54% 2005 5.36 16.40 6.10% 2006 5.89 14.91 6.71% 2007 6.48 13.56 7.38% 2008 7.13 12.32 8.11% 2009 7.84 11.20 8.93% 2010 8.63 10.18 9.82%

Furthermore, both HD and IBM have forward P/E multiples – which is the more popular way to look at earnings – that are high but not absurd.   Quite frankly, with the i-nets carrying 70+ forward P/E multiples growth must be perfect or the company’s stock price will collapse.

Wish List Stats

Needless to say, some Wish List stocks (not all) are more attractive using the above tests.  For example, DMN and HDR look like undervalued gems when comparing their near term earnings yields to any of the above companies.

DMN - $6.71/Share   13%GR         Year EPS P/E E/P 2003 1 6.71 14.90% 2004 1.15 5.83 17.14% 2005 1.30 5.16 19.37% 2006 1.47 4.57 21.88% 2007 1.66 4.04 24.73% 2008 1.88 3.58 27.94% 2009 2.12 3.17 31.58% 2010 2.39 2.80 35.68%

HSPC Inc. - $9.00/Share 22%GR         Year EPS P/E E/P 2003 1.30 6.92 14.44% 2004 1.59 5.67 17.62% 2005 1.93 4.65 21.50% 2006 2.36 3.81 26.23% 2007 2.88 3.13 32.00% 2008 3.51 2.56 39.04% 2009 4.29 2.10 47.63% 2010 5.23 1.72 58.11%

To note: Todd and I own shares in DMN and HDR. Each company is likely to remain on the Wish List, but we would not consider purchasing more HDR given its recent rally.    

Conclusions

Today’s investment climate is one of security and liquidity: meaning investors (or the fund managers that gamble the investor’s money) find security in the most popular and liquid stocks.  Quite frankly, if a fund manager is not keeping up with the broader market they will quickly purchase a company like Ebay on the hope that they ride a few more dollars out of its rally. These desperate fund managers do not believe that buying Ebay is the best investment per se, only that a liquid and popular company like Ebay may be the most likely stock to rally before their next judgment day (when the next quarter ends). 

Given that investing is all about getting a return on capital it may be surprising for some that the i-nets and large cap leaders are so richly valued compared to other companies. However, this is what the mania was and is all about: suckers chasing performance. As a quick example, here is a quote that CBS MarkertWatch recently carried (for what reason I do not know):

“I bought EBay.  Although corporate spending in the tech market is still tight, I think large companies are finally burning through the excess capacity. I am seeing that in my industry, information technology and software. Usually, this is one of the first signs of a recovery.”
Brian Townsend, a long-time employee of BMC Software.

Perhaps Merrill’s tech survey, which recently said companies are now planning to spend less money on capital expenditures in the second half of 2003 than they thought they would spend in March, is wrong and Mr. Townsend’s friend in the BMC shipping department is right. Or perhaps Mr. Townsend, and all the would be BMC prognosticators (a company that has only been around since 1980), are completely out to lunch when it comes to timing the so called ‘recovery’?  Whatever the case may be, Mr. Townsend admits to purchasing Ebay – he admits to wanting to receive 6.2 cents on $1 invested through 2005.

Another quote helps describe the mind state of a Mr. Townsend:

 “A real estate professional, Stephen Baker is confident he can recognize the peaks and valleys of an investment cycle...“I think savvy investors are going to cash out on the high of real estate and turn to buy in on the low of equities, and that's where I'm gambling.””

Note the word ‘gambling’, and how Mr. Baker uses the word ‘high’ and ‘low’ as a rational for investing in stocks now. Would a $75 orange be cheap if an apple cost $200? No. Rather, both pieces of fruit -- and this could be the case for both stocks and real estate today -- would be overpriced.

In short, Ebay, Yahoo, and Amazon are all industry leaders, and are likely to remain industry leaders for the foreseeable future.  However, knowing this does not mean any of these companies offers an attractive return unless you believe in the greater fool theory. This is not to say buying Ebay and the others could not prove profitable. After all, at this very moment countless slot machines are hitting in Vegas and someone is yelling Bingo somewhere...Similarily, the buzz in the markets today can be intoxicating if you don’t mind betting against the odds.

Silly stats: When extrapolating growth estimates infinitely into the future ‘the odds’ of internet stocks offering a superior return to that of many others companies before 2010 is remote (table below)

Sensible conclusion: Internet stocks are soaring today because fund managers are riding momentum. Fund managers are able to go for this joy ride because investors did not learn anything from the 1990s mania.

All data and information within these pages is thought to be taken from reliable sources but there is no guarantee as such. All opinions expressed on this site are opinions and should not be regarded as investment advice.
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