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The New Economy

The New Economy. Mental Models for Market Outperformance. Presented by : Michael Mauboussin Chief U.S. Investment Strategist (212) 325-3108. Agenda. I. Follow the Cash II. Information Rules III. How to Play Today. Part I. Follow the Cash. Follow the Cash. The ideal model.

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The New Economy

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  1. The New Economy Mental Models for Market Outperformance Presented by: Michael Mauboussin Chief U.S. Investment Strategist (212) 325-3108

  2. Agenda I. Follow the Cash II. Information Rules III. How to Play Today

  3. Part I Follow the Cash

  4. Follow the Cash The ideal model... • Understand Economics • Return on invested capital • Return on incremental invested capital • Earnings/value creation relationship • Competitive advantage period • Expectations Quantification • Project “fair” value • Understand market expectations

  5. Return on Invested Capital 5% 10% 15% 20% 8% 10% 15% 20% Earnings Growth Assume all equity financed; 10% WACC; 20-year forecast period Follow the Cash ROIC and P/E multiples 8.5x 5.7 0.1 NM 10.0x 10.0 10.0 10.0 12.0x 12.9x 15.8 18.6 23.4 29.9 38.2 52.2

  6. Follow the Cash First principles (1) Cash flow (2) Risk Value (3) Forecast horizon (CAP) These drivers are expectational in the stock market

  7. Volume • Pricing • Expenses • Leases • Tax Provision • Deferred Taxes • Tax Shield Sales Operating Margin Cash Earnings Cash Taxes Free Cash Flow minus • A/R • Inventories • A/P • Net PP&E • Operating Leases D Cash available for distribution to all claimholders Working Capital Investment Capital Expenditures Acquisitions/ Divestitures Follow the Cash Cash flow defined

  8. Old Economy New Economy Capitalized Earnings overstate cash flow Expensed Earnings and cash flow are similar Follow the Cash How investments are treated Investments

  9. Balance sheet -61 -75 26 13 Cash flow 161 175 74 87 Microsoft Yahoo! Coca-cola Wal-Mart minus D equals Cash flow/net income 1.6x 1.8x 0.7x 0.9x Note: most recent reported fiscal year; all figures scaled. Follow the Cash The evidence Net income $100 $100 $100 $100

  10. Old Economy 15% ROIC New Economy Follow the Cash The margin and capital turnover tradeoff 15% 10% Cash Earnings Margins 5% 1% 1.0 5.0 10.0 15.0 Invested Capital Turnover

  11. Follow the Cash Atom, bits and cash $245 billion in capital freed last 10 years • Working capital as a percent of sales • Fixed capital as a percent of sales ROIC 1988 9.9% 1998 9.4% M&A formalizes intangible assets • Goodwill as a percent of sales

  12. Income Statement Sales Expenses Operating Income Taxes Net Income Balance Sheet Current Assets PPE Other Total Assets Current Liabilities Equity Liabilities & Equity Cash earnings = $10 billion 975% ROIC = Invested capital = $ 1 billion Follow the Cash Microsoft - fiscal 1999 $500,000 average employee option profit (F99) ~ $500 billion market cap $81 billion ESO liability

  13. Part II Information Rules

  14. Information Rules Mental models for the new millennium • Network economics • Trumping trade-offs • Triumph of bits

  15. Information Rules Network economics Physical capital world • economies of scale • supply-side driven (manufacturing, processing capability) • positive feedback dissipates as dominance is approached Knowledge capital world • network effects • demand-side driven (eBay) • positive feedback strengthens with dominance

  16. Richness Richness Reach Reach Information Rules Trumping tradeoffs Mass customization “Don’t get stuck in the middle”

  17. Atoms Bits • Rival good • Easy to protect • Spread costs • Limited scalability • Non-rival good • Hard to protect • Upfront costs • High scalability Information Rules Triumph of bits

  18. Capital-based Knowledge-based diseconomies of scale economies of scale Average unit cost Average unit cost constant return to scale Output Output Information Rules Relationship between output and costs costs are insensitive to sales

  19. Radial Interactive Information Rules Network effects “Of networks there shall be few” -Arthur’s Law

  20. Network effects High upfront costs First-to-scale Lock-in (standard) Increasing returns Information Rules Increasing returns

  21. 0 10 - 2 10 Top 150 Internet Stocks (12/99) - 109 4 10 Proportion of sites - 6 10 108 Sites - 8 10 107 - 10 10 0 1 2 10 10 10 3 4 5 10 10 10 106 Number of users Market Capitalization ($) Zipf distribution 105 0 10 Alexa Infoseek - 2 10 104 Links - 4 10 Probability 100 101 102 103 Market Cap. Rank - 6 10 - 8 10 - 10 10 0 1 2 10 10 10 3 4 5 10 10 10 Number of pages Information Rules Topology of the Internet % sites% visits 0.1% 32% 1.0% 56% 5.0% 75% 50% 95%

  22. Information Rules What to look for • Heavily discount-or give away-new products • Link and leverage-highlights the value of real options • Think adaptation, not optimization

  23. Part III How to Play Today

  24. How to Play Today Traditional businesses - barriers to success • Culture and compensation • hierarchical structure • cash-based versus stock-based • lack of diversity • Channel conflict • pricing • varying logistics • information type • Red Queen effect • prey/predator model • benefits competed away • lower margins

  25. How to Play Today Traditional businesses - the checklist • Close to the customer • more reliable information • better capital management • tap network effects • Deconstruct the business model • where is value created? • vertical models vulnerable • managers/investors don’t know where and why value is created • Capital discipline • reinvestment rate • game theory

  26. How to Play Today Knowledge businesses • Network effects • stewards of the network • de facto standards • Necessities • infrastructure • digital rights management • Globalization • link and leverage • redefining local/national industries

  27. The New Economy Mental Models for Market Outperformance Presented by: Michael Mauboussin Chief U.S. Investment Strategist (212) 325-3108

  28. Recommended Sources • Finance: • Creating Shareholder Value, Alfred Rappaport (The Free Press, New York, 1986 & 1998) • Valuation: Measuring and Managing the Value of Companies, Tom Copeland, Tim Koller, Jack Murin (John Wiley & Sons, Inc., New York, 1995) • The Quest for Value, G. Bennett Stewart III (Harper Collins, New York, 1991) • Real Options, Martha Amram, Nalin Kulatilaka, (Harvard Business School Press, Cambridge, 1999)

  29. Recommended Sources • Strategy: • Information Rules, Carl Shapiro, Hal R. Varian (Harvard Business School Press, Cambridge, 1999) • Innovator’s Dilemma, Clayton M. Christensen (Harvard Business School Press, Cambridge, 1997) • Blown to Bits, Philip Evans, Thomas S. Wurster (Harvard Business School Press, Cambridge, 2000) • Unleashing the Killer App, Larry Downes, Chunka Mui (Harvard Business School Press, Cambridge, 1998)

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