The so-called Internet Bubble gripped stock markets in 1998

The so-called Internet Bubble gripped stock markets in 1998, 1999, and 2000, as discussed in the chapter. Internet stocks traded at multiples of earnings and sales rarely seen in stock markets. Start-ups, some with not much more than an idea, launched initial public offerings (IPOs) that sold for very high prices (and made their founders and employees with stock options very rich). Established firms, like Disney, considered launching spinoffs with"dot.com" in their names, just to receive the higher multiple that the market was giving to similar firms. Commentators argued over whether the high valuations were justified. Many concluded the phenomenon was just speculative mania. They maintained that the potential profits that others were forecasting would be competed away by the low barriers to entry. But others maintained that the ability to establish and protect recognized brand names-like AOL, Netscape, Amazon, Yahoo!, and eBay-would support high profits. And, they argued, consumers would migrate to these sites from more conventional forms of commerce.

America Online (AOL) was a particular focus in the discussion. One of the most well established Internet portals; AOL was actually reporting profits, in contrast to many Internet firms that were reporting losses. AOL operated two worldwide Internet services, America Online and CompuServe. It sold advertising and e-commerce services on the Web and, with its acquisition of Netscape, had enhanced its Internet technology services. See Box1.3. For the fiscal year ending June 30, 1999, America Online reported total revenue of $4.78 billion, of which $3.32 billion was from the subscriptions of 19.6 million AOL and CompuServe subscribers, $1.00 billion from advertising and e-commerce, and the remainder from network services through its Netscape Enterprises Group. It also reported net income of $762 million, or $0.73 per share. AOL traded at $105 per share on this report and, with 1.10 billion shares outstanding, a market capitalization of its equity of $115.50 billion. The multiple of revenues of 24.2 was similar to the multiple of earnings for more seasoned firms at the time, so relatively, it was very high. ACL's P/E ratio was 144. In an article on the op-ed page of The Wall Street Journal on April26, 1999, David D. Alger of Fred Alger Management, a New York-based investment firm, argued that AOL’s stock price was justified. He made the following revenue forecasts for 2004, five years later (in billions):

Subscriptions from 39 million subscribers ........ $12.500

Advertising and other revenues ........... 3.500

Total revenue .................. 16.000

Profits margin on sales, after tax ........... 26%

To answer parts (A) and (B), forecast earnings for 2004.

A. If AOL’s forecasted price-earnings (P/E) ratio for 2004 was at the current level of that for a seasoned firm, 24, what would AOL’s shares be worth in 1999? AOL is not expected to pay dividends.

B. Alger made his case by insisting that AOL could maintain a high P/E ratio of about 50 in 2004. What P/E ratio would be necessary in 2004 to justify a per-share price of $ 105 in 1999? If the P/E were to be 50 in 2004, would AOL be a good buy?

C. What is missing from the see valuations? Do you see a problem with Alger's analysis?

Answer:





Introduction



This case can be used to outline how the analyst goes about a valuation and, specifically, to introduce pro forma analysis.  It can also be used to stress the importance of strategy in valuation. The case involves suspect analysis, so is the first in an exercise (repeated throughout the book) that asks: What does a credible equity research report look like?







The case can also be introduced with the Apple example is Box 1.6. The case anticipates some of the material in Chapter 3. You may wish to introduce that material with this case - by putting Figures and in front of the students, for example.







You may wish to recover the original Wall Street Journal (April 26, 1999) piece on which this case is based and hand it out to students. It is available from Dow Jones News Retrieval. With the piece in front of them, students can see that it has three elements that are important to valuation - scenarios about the future (including the future for the internet, as seen at the time), a pro forma analysis that translates the scenario into numbers, and a valuation that follows from the pro forma analysis. So the idea - emphasized in Chapter 3 -- that pro forma analysis is at the heart of the analysis is introduced, but also the idea that pro forma analysis must be done with an appreciation for strategy and scenarios that can develop under the strategy.







To value a stock, an analyst forecasts (based on a scenario), and then converts the forecast to a valuation.  An analysis can thus be criticized on the basis of the forecasts that are made or on the way that value is inferred from the forecast.  Students will question Alger's forecasts, but the point of the case is to question the way he inferred the value of AOL from his forecasts.







Working the Case



A.



Calculation of price of AOL with a P/E of 24 in 2004







Earnings in 2004 for a profit margin of 26% of sales:



$16.000 × 0.26                                                







$4.160 billion



Market value in 2004 with a P/E ratio of 24



$99.840



Present value in 1999 (at a discount rate of 10%, say)



$61.993



Shares outstanding in 1999



1.100



Value per share, 1999



(Students might quibble about the discount rate; the sensitivity of the value to different discount rates can be looked at.)



$56.36



B.



Market value of equity in 1999: 105 × 1.10 billion shares







$115.50 billion



Future value in 2004 (at 10%)



$186.014



Forecasted earnings, 2004



$4.160 billion



Forecasted P/E ratio



44.7



So, if AOL is expected to have a P/E of 50 in 2004, it is a BUY.







C. Use Box 1.6 as background for this part. There are two problems with the analysis:







1.   The valuation is circular: the current price is based on an assumption about what the future price will be. That future price is justified by an almost arbitrary forecast of a P/E ratio. The valuation cannot be made without a calculation of what the P/E ratio should be.  Fundamental analysis is needed to break the circularity.



Alger justified a P/E ratio of 50, based on



- Continuing earnings growth of 30% per year after 2000



- "Consistency" of earnings growth



- An "excitement factor" for the stock.



Is his a good theory of the P/E ratio?  Discussion might ask how the P/E ratio is related to earnings growth (Chapter 6) and whether 30% perpetual earnings growth is really possible.



What is "consistency" of earnings growth?



What is an "excitement factor"?



  How does one determine an intrinsic P/E ratio?



2.   The valuation is done under one business strategy--that of AOL as a stand-alone, internet portal firm.  The analysis did not anticipate the Time Warner merger or any other alternative paths for the business.  (See box 1.4 in the text).  To value an internet stock in 1999, one needed a well-articulated story of how the "Internet revolution" would resolve itself, and what sort of company AOL would look like in the end.



3.   



Further Discussion Points



§  Circular valuations are not uncommon in the press and in equity research reports: the analyst specifies a future P/E ratio without much justification, and this drives the valuation.  Tenet 11 in Box 1.6 is violated.



§  The ability of AOL to make acquisitions like its recent takeover of Netscape will contribute to growth -- and Alger argued this.  But, if AOL pays a "fair price" for these acquisitions, it will just earn a normal return.  What if it pays too much for an overvalued internet firm?  



What if it can buy assets (like those of Time Warner) cheaply because its stock is overpriced?  This might justify buying AOL at a seemingly high price.  Introduce the discussion on creating value by issuing shares in Chapter 3.



§  The value of AOL's brand and its ability to attract and retain subscribers are crucial.



§  The competitive landscape must be evaluated.  Some argue that entry into internet commerce is easy and that competition will drive prices down.  Consumers will benefit tremendously from the internet revolution, but producers will earn just a normal return.  A 26% profit margin has to be questioned.  The 1999 net profit margin was 16%.



§  A thorough analysis would identify the main drivers of profitability and the growth.



- Analysis of the firm's strategy



- Analysis of brand name attraction



- Analysis of churn rates in subscriptions



- Analysis of potential competition



- Analysis of prospective mergers and takeovers and "synergies" that might be available



- Analysis of margins.



Postscript







David Alger, president of Fred Alger Management Inc., perished in the September 11, 2001 devastation of the World Trade Center in New York, along with many of his staff. The Alger Spectra fund was one of the top performing diversified stock fund of the 1990s.