Internet Stocks: Value and
Trading Strategy
Rob Freund
Petter Hellman
Ole Hvidsten
Jiong Shao
Rick Solano
Main Points
•
•
•
•
•
•
Value in theory
Internet shortcomings for traditional value
Modifications to theory for Internet stocks
Trading strategy
Conclusion
Questions
Value in Theory
•
•
•
•
Investors want money
Industry growth vs. age curve
Graph
New industry - growth important
Mature industry - returns important
Internet Shortcomings
• Modern valuation theory created during a
time when there was no emerging societyconvulsing technology
• Valuation theory based on earnings and net
income.
• Internet terminal values are unclear.
• Can’t use current performance to
extrapolate future performance.
Laying Odds on Success of Firm’s Value
Proposition
Total Market Capitalization of Industry
(e.g. Retail: $1.45T %, FCF Margin = 5%)
{
Expected Market Cap position of firm (PV $)
(e.g. Amazon: Market Share = 10%
MCAP = $145B)
Payoff to investors
if firm successful
Bet placed by
investors
{
Current Market Cap of firm
(e.g. Amazon MCAP as of 8-31-99 = $14.14B)
Current Value of firm using existing financial
performance baseline
(e.g. Not Applicable - no earnings)
Price of bet influenced by factors affecting expected future outcome (e.g. starting QB
breaks leg day before Superbowl) - IN THIS CASE, MARKET HAS SET 10-1
ODDS ON AMAZON CROSSING THE FINISH LINE IN THIS POSITION
Hypothesis for Future Returns
• We must find a proxy to indicate the
potential for future income.
• Potential proxy candidates:
–
–
–
–
MCAP/Sales
PSSG
PSSA
Sales growth
Trading Strategy
• Sort stocks during a particular time period and
pick top 25%
• Stock sorted on the income proxy
• Positions taken at the end of the second month
following the quarter used for analysis
• Returns calculated over three month holding
period
• Stock returns were compared to a “buy and hold”
strategy of stocks included in the H & Q Internet
Index
Results
Index
Conclusion
• Must use a proxy for earnings
• A buy and hold strategy can be beaten
• Current value is based on investor perceived
future potential
Questions?
Industry Growth vs. Time
Growth
Rate
Return
Time
Results of Various Sort-Trading Strategies
Average
Quarterly
Returns
Calendar Buy and Hold
Quarter
Strategy
1995 - Q0
1995 - Q1
-8.89%
1995 - Q2
23.47%
1995 - Q3
2.32%
1995 - Q4
-19.27%
1996 - Q1
20.42%
1996 - Q2
-28.84%
1996 - Q3
-14.75%
1996 - Q4
-9.36%
1997 - Q1
-5.36%
1997 - Q2
17.30%
1997 - Q3
3.14%
1997 - Q4
16.58%
1998 - Q1
10.19%
1998 - Q2
-27.46%
1998 - Q3
82.28%
1998 - Q4
26.25%
1999 - Q1
10.97%
1999 - Q2
2.94%
B&H
Strategy
$
1.00
$
0.91
$
1.12
$
1.15
$
0.93
$
1.12
$
0.80
$
0.68
$
0.62
$
0.58
$
0.68
$
0.70
$
0.82
$
0.91
$
0.66
$
1.20
$
1.51
$
1.68
$
1.73
Average
Quarterly
Returns
MCAP / Sales MCAP / Sales
Stategy
Strategy
$
1.00
25.98% $
1.26
36.75% $
1.72
-25.07% $
1.29
-12.54% $
1.13
20.68% $
1.36
-26.92% $
1.00
-6.22% $
0.93
-24.32% $
0.71
-9.40% $
0.64
0.81% $
0.65
14.74% $
0.74
9.76% $
0.81
15.55% $
0.94
-28.25% $
0.67
96.25% $
1.32
77.89% $
2.35
21.16% $
2.85
9.77% $
3.13
Average
Quarterly
Returns
PSSG
Strategy
PSSG
Strategy
$
1.00
$
0.82
$
1.14
$
1.41
$
1.24
$
1.37
$
1.00
$
0.82
$
0.78
$
0.71
$
0.67
$
0.57
$
0.71
$
0.88
$
0.90
$
1.61
$
1.74
$
2.19
-18.48%
40.33%
23.36%
-12.44%
11.15%
-27.49%
-17.72%
-4.82%
-8.42%
-6.11%
-14.40%
23.62%
23.38%
3.12%
78.58%
8.09%
25.88%
6.53% $
2.34
Average
Quarterly
Returns
PSSA
Strategy
PSSA
Strategy
$
1.00
$
0.82
$
1.17
$
1.44
$
1.03
$
1.08
$
0.96
$
0.60
$
0.41
$
0.47
$
0.45
$
0.42
$
0.47
$
0.53
$
0.35
$
0.54
$
0.54
$
0.65
-18.48%
43.17%
23.36%
-28.25%
5.00%
-11.46%
-37.47%
-31.59%
14.63%
-3.42%
-7.42%
11.88%
11.97%
-34.49%
54.98%
0.25%
20.90%
19.63% $
0.78
Average
Quarterly
Returns
Sls Growth
Strategy
-18.48%
43.17%
23.36%
-49.59%
5.70%
-27.49%
-19.32%
21.56%
-9.45%
3.50%
-9.15%
20.76%
29.51%
1.60%
84.57%
-9.48%
30.97%
8.57% $
Average
Total
Return
9.21%
13.30%
10.33%
4.94%
Sls Growth
Strategy
$
1.00
$
0.82
$
1.17
$
1.44
$
0.73
$
0.77
$
0.56
$
0.45
$
0.55
$
0.49
$
0.51
$
0.46
$
0.56
$
0.73
$
0.74
$
1.36
$
1.23
$
1.61
10.74%
Using a simply MCAP to Sales ratio to sort yields the highest return
1.75
MCAP to Sales and Sales Growth
Ratio
• Incorporate sales and sales growth into a
valuation parameter
• Based on PEG (price to earnings and
earnings growth)
• Formula - MCAP/(S*DS)
• As the firm/industry matures, growth
declines, so actual sales must pick up the
value slack
H & Q Internet index
Due to MCAP weighting - the index return has been significantly skewed
by a few extraordinarily successful stocks
Traditional vs. Internet
• Traditional
–
–
–
–
Players exist and stable
Market size identifiable
Can estimate terminal value because market size known
Extrapolate current performance based on short-term management
guidance
• Internet
– Terminal value unknown
– Can’t use current performance to extrapolate
• Factors determining mature market performance
– Margins
– Market Size
– Market Share