Issues in Valuation EBusiness Valuation AGENDA 1 DCF

Issues in Valuation E-Business Valuation

AGENDA 1. DCF Method and Forecasting 2. Valuation of Dot. coms – Introduction – DCF Method – Mc. Kinsey Method: DCF starting from the future – The PEG ratio – The Price-to-Sales Ratio – Other multiples

Consistency (or 2 out of 3 ain’t bad) • To conduct a DCF there are three layers of assumptions that you need to make: – Growth in revenues – Investment Rates – Financing • You only need to determine two of these. The third one is then given.

Example 1 • If a firm has a target capital structure. – Financing then determines the investment policy. You just need to forecast how well the firm will invest (NOPLAT → g) to complete your valuation model. – Examples include firms in emerging markets, which are financially constrained.

Example 2 • Suppose the investment policy is constrained by competition. – In mature industries such as tobacco and steel growth opportunities are not available. – This fixes growth in revenues and investment rates. • Only need to determine the firm’s financial policy (dividends, repurchases, equity & debt issues).

Paper and Pencil Back of the Envelope Forecasting Year 2000 Forecast 2001 Income Statement Sales Assumptions Description Value 1000 % of Sales (t-1) COGS % of Sales (t) Gross Profit Arithmetic Interest % of Debt (t) Taxable Income Arithmetic Taxes % of Taxable Income Net Income Arithmetic Dividends % of Net Income Retained Earnings Arithmetic 1+0. 07 0. 1 0. 53 0. 6

Paper and Pencil Continued Balance Sheet Current Assets % of Sales (t) 0. 15 Fixed Assets % of Sales (t) 0. 7 Total Assets Arithmetic Current Liabilities % of Sales (t) 0. 07 Debt (PLUG) Equity Stock 400 Constant Accumulated Earnings 100 Arithmetic Total Liabilities Arithmetic 400

Pro Forma Assumptions Sales growth Initial sales FA_Sales CL_Sales COGS_Sales Interest Dividend Payout Tax rate 7% 1, 000 70% 15% 7% 70% 10% 60% 53%

Forecasts Year 0 1 2 3 4 5 1, 070 1, 145 1, 225 1, 311 1, 403 COGS 749 801 858 918 982 Gross Profit 321 343 368 393 421 28 28 27 Taxable Income 293 316 340 366 393 Taxes 155 167 180 194 209 Net Income 138 148 160 172 185 Dividends 83 89 96 103 111 Retained Earnings 55 59 64 69 74 Income Statement Sales Interest

Forecasts Continued Year 0 1 2 3 4 5 Current Assets 161 172 184 197 210 Fixed Assets 749 801 858 918 982 910 973 1, 041 1, 114 1, 192 75 80 86 92 98 280 279 277 275 273 Balance Sheet Total Assets Current Liabilities Debt (PLUG) Equity Stock 400 400 400 Accumulated Earnings 100 155 214 278 347 421 910 973 1, 041 1, 114 1, 192 Total Liabilities

Valuation of Dot. coms • Valuation of Internet companies has been a hotly discussed topic. • Most Internet companies have a limited history and have been losing money. • Yet, share prices of Internet companies are (still) extremely high compared to their financial performance.

Relative Values • • • Then: December 2000 AOL (TWX) $132 B > Procter & Gamble (PG) $122 B Schwab (SCH) $43 B > Merrill Lynch (MER) $29 B Yahoo (YHOO) $40 B > New York Times (NYT) $6 B e. Bay (EBAY) $23 B > Sotheby’s (BID) $2 B Priceline. com (PCLN) $23 B > US Airways (UAIR) $5 B Amazon (AMZN) $22 B > Barnes & Noble (BKS) $2 B And Now: August 2004 AOL (TWX) $77 B < Procter & Gamble (PG) $139 B Schwab (SCH) $12 B < Merrill Lynch (MER) $47 B Yahoo (YHOO) $38 B > New York Times (NYT) $6 B e. Bay (EBAY) $50 B > Sotheby’s (BID) $1 B Priceline. com (PCLN) $. 7 B > US Airways (UAIR) $. 16 B Amazon (AMZN) $15 B > Barnes & Noble (BKS) $2 B

. Com Values – Give Up Now? • There are several features of internet firms that make their valuation a very, very difficult task. – Is it still worth trying? – No choice, every day the market has to take its best guess as to each firm’s value. Just learn to deal with it. – You get points not for being 100% right, just being right over 50% of the time! • Three years ago, everybody expected the internet consulting business to surge. – 2000 year-end forecasts estimated the demand for internet consulting to grow a 50 -60% per year, resulting in a market for these services at 60 -70 billion in the year 2003! – Good example of forecasts gone wild.

Forecasts with Negative Earnings • Current earnings growth rates cannot be used in valuation. What do you do now? • Use analyst estimates of future earnings. But how did they get their estimates? • Use your own judgment regarding future costs, and revenues. – Dot com firms typically have large fixed costs and relative to traditional firms lower marginal costs. – A typical forecast will keep the fixed and marginal costs fairly constant from year to year. – To get the future earnings you now only need to project out sales growth. Not easy, but at least you now have a baseline to work with. • The Going Concern Assumption – Many Dot. coms have failed in the last several years. – Before you assume a terminal value with an infinite life, ask yourself whether or not you believe the probability that the firm will survive is one? If not remember to adjust you expected cash flows for the probability the firm will go out of business.

Other Hurdles • Absence of Historical Data – Cannot estimate betas based on historical information about stock prices. – I would use an asset beta of one. On average it should be right! • Absence of Comparable Firms – Cannot value the company based on multiples. – But, you can get a handle on things by looking at a related industry. For example Priceline is a travel company. What is the beta for firms in the overall travel and tourism industry?

Amazon. com Comparison Data Profitability Company Industry 1 Market 2 Gross Profit Margin 23. 69% 54. 25% 49. 37% Pre-Tax Profit Margin Net Profit Margin Return on Equity Return on Assets Return on Invested Capital 4. 61% -14. 60% 1. 17% -1. 92% --1. 30% 8. 79% 5. 59% 11. 20% 1. 90% 28. 40% -1. 80% 5. 50%

Amazon. com Valuation Price/Sales Ratio Price/Earnings Ratio Price/Book Ratio Price/Cash Flow Ratio Company Industry 1 Market 2 2. 62 4. 81 1. 23 58. 45 -- 40. 67 -- 5. 73 2. 47 55. 11 91. 42 10. 82

Amazon. com Operations Days of Sales Outstanding Inventory Turnover Days Cost of Goods Sold in Inventory Asset Turnover Net Receivables Turnover Flow Effective Tax Rate Company Industry 1 Market 2 7. 54 38. 78 49. 12 19. 8 25. 3 8. 4 18 3. 4 14 0. 7 43 0. 4 57. 1 10. 5 8. 2 0. 00% -- 33. 60%

Amazon. com Financial Current Ratio Quick Ratio Leverage Ratio Total Debt/Equity Interest Coverage Company Industry 1 Market 2 1. 7 2. 42 1. 41 1. 4 --- 2. 2 1. 73 0. 24 1 5. 87 1. 38 3. 4 2 2. 7

Amazon. com Per Share Data ($) Revenue Per Share Company Industry 1 Market 2 14. 74 3. 61 21. 85 0. 66 -0. 13 0. 66 Dividends Per Share 0 0. 01 0. 33 Cash Flow Per Share 0. 7 0. 19 2. 48 Working Capital Per Share 1. 59 -0. 18 Long-Term Debt Per Share 4. 33 0. 67 11. 33 Book Value Per Share -1. 94 3. 03 10. 87 Total Assets Per Share 4. 64 5. 24 63. 82 Fully Diluted Earnings Per Share from Total Operations

Amazon. com Growth Company Industry 1 Market 2 34. 40% 20. 60% 15. 90% 12 -Mo. Net Income Growth -- -- 201. 90% 12 -Mo. EPS Growth -- -- 61. 00% 12 -Mo. Dividend Growth -- -83. 30% -25. 00% 36 -Mo. Revenue Growth 22. 60% -2. 40% 4. 40% 36 -Mo. Net Income Growth -- -- 11. 40% 36 -Mo. EPS Growth -- -- -8. 40% 36 -Mo. Dividend Growth -- -- -9. 10% 12 -Mo. Revenue Growth 1 Industry: Internet Software & Svcs Public companies trading on the New York Stock Exchange, the American Stock Exchange, and the NASDAQ National Market. 2 Data from Hoover’s Online.

DCF Applied to Internet Firms • At the time of the valuation we might expect an Internet firm to lose money for at least 5 -10 years. – Will it run out of cash first? • Since this is close to the forecast horizon in the DCF method, all the value creation takes place in the continuation period. • In this sense, DCF is not different from multiples valuation. • The following are some suggestions to cope with these difficulties: – Lengthen the projection period from 5 to 10 -15 years before assuming constant growth. – Use a multiple stage model and apply different growth rates and discount rates as the return and risk profile of internet companies change over time, – Use techniques such as scenario analysis to reduce the risk of assuming one outcome, which may turn to be way off.

Mc. Kinsey Approach: DCF starting From the future • This method consists of estimating the key value drivers once a sustainable growth state has been reached. • The difficult part involves a thorough analysis of the economic environment. – Competition – Industry position • The previous analysis would yield a forecast of free cash flows for something like ten years from now. • Next link the present to the future in a consistent way such as linear growth. • The discount rates may vary in different subperiods. • Uncertainty may be resolved by means of scenario analysis

PEG Ratio Method • The PEG ratio (Price-to-Earnings/Growth Rate) is based on Peter Lynch’s basic theory that a stock should trade around the price where the P/E = g. • Average PEG ratio should equal 1 under this theory. • Given this theory, the PEG value is the expected earnings per share times the expected long-term growth rate. P/E = g => P = g×E. • The critical underlying assumption is that the PEG ratio equals 1 in the long run. – Implies current growth is a good indicator of future growth.

PEG: The Good and Bad • The Good – If all firms within a sector have similar growth rates and market risk, a strategy of picking the lowest PE ratio stock in each sector will yield undervalued stocks. – Portfolio managers and analysts sometimes compare PE ratios to the expected growth rate to identify under and overvalued stocks. • Firms with PE ratios less than their expected growth rate are viewed as undervalued. • The Bad – There is no general basis for believing that a firm is undervalued just because it has a PE ratio less than expected growth. – This relationship may be consistent with a fairly valued or even an overvalued firm, if interest rates are high, or if a firm has a high market risk. – As interest rates decrease (increase), fewer (more) stocks will emerge as undervalued using this approach.

PEG: Application • The PEG ratio is the ratio of P/E to expected growth in earnings per • share. PEG = PE / Expected Growth Rate in Earnings. • Check to make sure the earnings and growth rate used to compute the PEG ratio are: – From the same initial year. – Calculated over the same period (2 years, 5 years). – Derive from the same source (analyst projections, consensus estimates). • Are the earnings used to compute the PE ratio consistent with the growth rate estimate? – No double counting. If the estimate of growth in earnings per share is from the current year, it would be a mistake to use forward EPS in computing PE. – Double counting puts the growth rate in twice. Once in the PEG and a second time in the projected earning’s boost.

PEG and Fundamentals • Remember that High risk companies will trade at much lower PEG ratios than low risk companies with the same expected growth rate. – A company that looks to be the most under valued on a PEG ratio basis may just be the riskiest firm in the sector. • Companies that can attain growth more efficiently by investing less in better return projects will have higher PEG ratios than companies that grow at the same rate less efficiently. – Companies that look cheap on a PEG ratio basis may be companies with high reinvestment rates and poor project returns. • Companies with very low or very high growth rates will tend to have higher PEG ratios than firms with average growth rates. This bias is more pronounced for low growth stocks. – PEG ratios do not neutralize the growth effect.

Price to Sales • Unlike price-earnings and price-book value ratios, which can become negative and not meaningful, the price-sales multiple is available even for the most troubled firms. • Unlike earnings and book value, which are heavily influenced by accounting decisions on depreciation, inventory and extraordinary charges, revenue is relatively difficult to manipulate. • Price-sales multiples are not as volatile as price-earnings multiples, and hence may be more reliable for use in valuation. • Over time, studies have shown that companies revert to a "normal, " or average, PSR applicable to the industry in which they operate. – Big supermarkets, courtesy of their low margins and competitive environment, usually trade on a PSR of about 0. 5

Calculation • The PS ratio equals the equity value divided by the firm's sales. You can either use total values or per share values. Either will give you the same answer as the units cancel. • • • For Amazon (8/6/2004): Revenues per share $14. 74 Stock Price 35. 90 PS Current 2. 44 = 35. 90/14. 74 PS Current (Industry) 4. 81

Other Multiples • Basically these are ratios based on measures of web traffic: – Price/Customer or User. – Hit ratios/Click-through ratios (i. e. price/hits etc). – Price/”growth flow” (growth flow = earnings with R&D added back in). Sources: www. mediametrix. com www. internet. com