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. 45 T %, FCF Margin = 5%) Expected Market Cap position of firm (PV $) (e. g. Amazon: Market Share = 10% MCAP = $145 B) 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. 14 B) 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 Using a simply MCAP to Sales ratio to sort yields the highest return
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
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