Internet Stocks: Value and Trading Strategy

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 • New industry - growth important • Mature industry - returns important Graph

Internet Shortcomings • Modern valuation theory created during a time when there was no emerging society- convulsing 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 Current Market Cap of firm (e.g. Amazon MCAP as of 8-31-99 = $14.14B) { Bet placed by investors 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

Internet Stocks: Value and Trading Strategy