valuation and value creation in internet-related companies

Pablo Fernández. IESE Business School Valuation and value creation in Internet-related companies

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Valuation and value creation in Internet-related companies

Pablo FernándezIESE Business School

Camino del Cerro del Aguila 328023 Madrid, Spain

Telephone 34-91-357 08 09e-mail: [email protected]

17 March 2001

This paper will analyze the evolution of a number of companies (Terra, Amazon, AmericaOnline, Microsoft, B2B companies, online brokers,…), although our focus will be the valuation ofAmazon. We compare Damodaran’s valuation by cash flow discounting ($35/share), Copeland’svaluation by scenarios and cash flow discounting ($66/share) and our valuation by simulation and cashflow discounting: $21/share

We claim that in a company such as Amazon, it is necessary to introduce uncertainties in theexpectations. We deal with uncertainty (volatility) in the hypotheses doing simulations. In ourvaluation, the likelihood of bankruptcy or voluntary reorganization is 43.43%.

It is very interesting to compare and try to differentiate what Internet may signify in the firstyears of the 21st century with the revolutionary effect on society that the railways, freeways, airlines,radio, television and the telephone had when they first appeared. We also urge the reader to analyze thehistory of companies such as Levitz, Home Shopping Network, MCI, LTCM and Boston Chicken.

Internet is no King Midas. Business ideas related with Internet must be analyzed with the samerigor as any other business initiative. On the other hand, it is fairly obvious that Internet will reduce (itis already reducing them) the margins of banks as a whole. Some banks may succeed in benefitingpartially from Internet if it manages to increase its customers by taking them from other banks.However, for the industry as a whole, Internet will bring about a decrease in their margins that will notbe matched by a parallel decrease in their costs.

A website is not necessarily a business. Selling below cost gets you lots of customers, but notmuch money.

JEL Classification: G12, G31, M21


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Valuation and value creation in Internet-related companies

The impressive escalation of the share prices of Internet-related companies during the late 90’sand their abrupt fall in 2000 render necessary a discussion of their value creation. Furthermore, most ofthese companies reported losses in 1999 and 2000, so most of their capitalization was due to investorexpectations. At the beginning of 2000, the question was: Are they companies that create a lot of valueor are they just a bubble?1 The question at the beginning of 2001 is: Has the bubble disappeared, isthere still some of it left, or is it that the market is unable to appreciate these companies’ potential?

We start with three events that prove the bubble’s existence:1. Cooper, Dimitrov and Rau (2000)2 show that the 147 companies that “internetized” their

name (they took on a name ending in .com or .net) between June 1998 and July 1999 gave a meanreturn, during the period between 15 days before changing their name to 15 days after changing theirname, that was 142% above that of similar companies. This return was 122% for Internet companiesand 203% for companies whose business had no relation with Internet.

2. In April 1999, the company dELIA*s floated 25.2% of its subsidiary iTurf (specializing inelectronic commerce). From its flotation to February 2000, the capitalization of the parent company(dELIA*s) was less than the market value of the shares it held in iTurf (according to their market price).During the first month after the subsidiary went public, the market value of the iTurf equity held by theparent company (dELIA*s) was 54% higher than the market value of dELIA*s’ entire equity. Isn’t thatsurprising?

3. Another similar case occurred when Creative Computers floated 19.9% of its subsidiary uBid(specializing in electronic commerce) in February 1998. During the first month after the subsidiary wentpublic, the market value of the uBid equity held by the parent company (Creative Computers) was 66%higher than the market value of Creative Computers’ entire equity3.

Speculative bubbles are not a new phenomenon. When the railways started building their lines,investors had tremendous expectations about these companies’ future growth, which led to a dramaticincrease in their share prices. However, what happened afterwards with the railway business showedthat the shares’ price had been overvalued: the companies’ return was much lower than expected. In the20’s, the radio caused a stock market revolution. Companies such as RCA increased their value five-fold in 1928. Between 1929 and 1932, the share price of Radio Corporation of America fell 98%, eventhough the company was profitable for many years after that.

On the other hand, it is fairly obvious that Internet will reduce (it is already reducing them) themargins of banks as a whole. Some banks may succeed in benefiting partially from Internet if itmanages to increase its customers by taking them from other banks. However, for the industry as awhole, Internet will bring about a decrease in their margins that will not be matched by a paralleldecrease in their costs.

This paper will analyze the evolution of a number of companies (Terra, Amazon, AmericaOnline, Microsoft, B2B companies, online brokers,…), although our focus will be the valuation ofAmazon.

1. Some examples of value creation and destructionAmazon.com started to sell books on the Internet in July 1995. Its shares were first traded on

the stock market in May 1997. Between May 1997 and December 1999, the value created by Amazonfor its shareholders amounted to 34.546 billion dollars (a return of 7,013%). During the same period,the stock market yield (S&P500) was 61%. However, its share price fell from $106.7 on 10 December1999 to $15.56 on 31 December 2000.

America Online was incorporated in 1985. In the year 2000, it was the world leader ininteractive services, Web brands, Internet technologies, and electronic commerce. The shareholders thatbought America Online shares when it first went public obtained a return of 7,150% from December1993 to December 2000. During the same period, the stock market yield (S&P500) was 223%.However, the equity did not rise continuously during this period: the return to equity was -67%

1 When, in January 2000, I wrote that “the analysis of what has happened with the railway business may give us someclues as to what may happen with the Internet companies. Several analyses and valuations of Internet companies are verysimilar to those that were made at the time of companies such as Boston Chicken (in voluntary reorganization), Levitz(bankrupt) and Home Shopping Network”, a number of people –executives and professors- called me reactionary,antiquated and retrograde.2 Cooper, Michael, Orlin Dimitrov and Raghavendra Rau (2000), “A rose.com by any other name”, Working Paper,Purdue University.3 The reader interested in these anomalies can see Schill and Zhou’s article (1999) titled “Pricing an emerging industry:Evidence from Internet subsidiary carve-outs”, University of California.


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between May and October 1996; -51% between March and September 1999; and –54% betweenDecember 1999 and December 2000.

Table 1. Periods of value creation and destruction for a number of companiesPeriod Increase of valueValue creation Shareholders returnStock market return

From to (Million dollars) (Million dollars) annualized total annualized total

Amazon 05-97 12-99 34,738 34,546 412% 7013% 20% 61%12-99 12-00 -31 ,442 -36,311 -85% -85% -10% -10%

Total 05-97 12-00 3,296 -1 ,765 91% 938% 11% 45%

America 12-93 05-96 8,307 6,933 152% 838% 22% 62%Online 05-96 10-96 -5 ,667 -6 ,114 -93% -67% 18% 7%

10-96 03-99 152,077 151,105 425% 5,367% 31% 92%03-99 09-99 -79 ,345 -89,189 -76% -51% 0% 0%09-99 12-99 105,434 102,861 2325% 140% 32% 8%12-99 12-00 -140,811 -171,406 -62% -64% -10% -10%

Total 12-93 12-00 39,994 -5 ,811 83% 7,150% 18% 223%

Microsoft 03-86 12-99 611,722 479,418 58% 55,000% 16% 712%12-99 12-00 -396,688 -480,275 -63% -64% -10% -10%

Total 03-86 12-00 215,035 -858 43% 19816% 14% 630%

Terra 11-99 02-00 34,920 34,798 581,522%975% 92% 20%02-00 12-00 -35 ,305 -39,509 -95% -92% -31% -27%

Total 11-99 12-00 -386 -4 ,711 -10% -11% -11% -13%

In February 2000, Microsoft was the world’s largest company in terms of stock marketcapitalization (521.7 billion dollars). The company was incorporated in 1975 and went public in March1986. Between March 1986 and December 1999, the value created by Microsoft for its shareholdersamounted to 479.418 billion dollars (a return of 55,000%). During the same period, the stock marketyield (S&P500) was 712%. However, the share price fell from $119.9 in December 1999 to $43.38 on31 December 2000 and the return to equity was –64%.

Terra went public in November 1999. The placement price was 13 euros per share. On 25February 2000, it traded at 139.75 euros, but by December 2000 its share price had fallen to 11.6euros. For a time, Terra was the second largest Spanish company, in capitalization terms (behindTelefónica). Between 17 November 1999 and 25 February 2000, the value created by Terra for itsshareholders amounted to 34.798 billion euros (a return of 975%). During the same period, the stockmarket yield (IBEX 35) was 8%. However, during the period 25 February – 31 December 2000, thevalue destroyed was 39.509 billion euros (a negative return of -92%), while the stock market fell27%.

Table 2 shows the evolution of 13 B2B companies. Their total value in December 2000 was8.9% what it had been in March.

Table 2. B2B companies. Evolution during 2000Capitalization 2000 ($ million) Public Share price in last year

Company 24/march 03/aug 31/dec offering low high 31/dec Dec/marchLow/highVerticalNet 6,547 3,676 492 11/febr/99 4.1 148.4 5.6 7.5% 2.7%FreeMarkets 6,529 1,872 665 10/dec/99 16.9 370.0 17.5 10.2% 4.6%Ventro 4,859 630 44 27/july/99 0.6 243.0 1.0 0.9% 0.2%PurchasePro.com 3,740 1,328 962 14/sept/99 9.2 87.5 14.5 25.7% 10.5%Onvia.com 2,459 614 79 01/march/99 0.8 78.0 0.9 3.2% 1.0%Neoforma 1,698 250 137 24/ener/00 0.9 78.8 0.9 8.1% 1.1%eMerge 1,248 877 135 04/febr/00 3.6 70.5 3.9 10.8% 5.1%FairMarket 1,036 134 48 14/march/00 1.1 53.5 1.7 4.6% 2.1%SciQuest.com 966 273 39 19/nov/99 1.3 91.0 1.3 4.0% 1.4%iPrint 497 124 23 08/march/00 0.5 28.5 0.8 4.5% 1.8%RoweCom 214 40 8 09/march/99 0.4 53.0 0.7 3.8% 0.8%Partsbase.com 197 74 29 22/march/00 1.7 15.0 2.0 14.5% 11.3%b2bstores.com 92 16 14 15/febr/00 1.1 19.5 1.7 15.5% 5.8%TOTAL 30 ,082 9 ,908 2 ,674 8.9% 3.7%


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2. Amazon2.1. Spectacular growth in sales and losses

On 24 November 1999, Amazon’s capitalization was $36.358 billion. On the Spanish market,only Telefónica and BSCH had a higher capitalization. This was surprising for many, because Amazonwas still losing money, and losing it in increasing quantities. However, by December 2000, itscapitalization stood at $8.1 billion. The company’s accrued losses stood at $1.748 billion by September2000.

Table 3. Amazon. Income statements and balance sheets (million dollars)($ million) 1995 1996 1997 1998 1999 Sep 2000

Sales 0.5 15.7 147.8 610.0 1,639.8 1,789.6Cost of sales 0.4 12.3 119.0 476.2 1,349.2 1,358.1Marketing and sales 0.2 6.1 40.5 133.0 413.2 408.3Other expenses 0.2 3.8 20.9 67.3 268.6 306.3Depreciation of intangibles 42.6 214.7 258.7Losses on investments 2.9 76.8 267.0Net interest 0.0 -0.2 -1.6 12.6 37.4 57.3

Net income -0 .3 -6 .2 -31 .0 -124 .5 -720 .0 -866 .1

Cost of sales/sales 80.0% 78.0% 80.5% 78.1% 82.3% 75.9%Marketing and sales/sales 39.1% 38.7% 27.4% 21.8% 25.2% 22.8%Other expenses/sales 40.1% 24.1% 14.2% 11.0% 16.4% 17.1%

Cash 0.8 0.8 1.9 25.5 133.0 647.0Temporary investments 0.2 5.4 123.5 347.9 573.0 252.0Current assets, net -0.9 -1.7 -93.2 -262.7 -299.0 -345.0Total assets 1.1 8.4 149.8 648.5 2,472.0 2,254.0

Long-term debt 0.0 0.0 76.7 348.1 1,466.0 2,083.0Shareholders’ equity 1.0 2.9 28.6 138.8 266.0 -487.0

Million shares 144.9 159.27 345.16 356.10

Asse ts sept/1999 sept/2000 Liabi l i t ies sept/1999 sept/2000

Cash 43 647 Accounts payable 237 304Temporary investments 863 252 Other short-term liabilities 121 354Stock 119 164 Long-term debt 1.462 2.083Other current assets 55 99 Shareholders’ equity 420 -487Fixed assets, net 221 352 Nominal 3 3Other investments 196 91 Share premium 1.027 1.343Intangibles 707 521 Other -51 -85Other assets 36 128 Retained earnings -559 -1.748Total assets 2.240 2.254 Total liabilities 2.240 2.254

Amazon.com started to sell books on the Internet in July 1995 with a single purpose: to use theInternet to make book-buying the fastest, easiest and most fun buying experience possible.

Jeffrey P. Bezos founded Amazon in 1994. Since its foundation, Bezos has been the company’spresident. He has also been its COO since May 1996, and was CFO from May 1996 to March 1997. InDecember 1998, Bezos and his family held 42% of Amazon’s equity.

2.2. Stock market evolution. Amazon.com went public on 15 May 1997. At the time, the pricewas $1.5/share4. On 10 December 1999, Amazon’s equity traded at $106.7/share. However, just oneyear later you could by an Amazon share for $16. Figure 1 shows the evolution of the share price andthe earnings per share.

4 The price is adjusted for the splits: 2x1 on 1/September/99, 3x1 on 4/January/99 and 2x1 on 1/June/98. In actual fact,Amazon issued 3 million shares at $18/share.


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Figure 1. Amazon. Evolution of the share price and EPS

Since it started business in 1995, this virtual bookstore was the example of electronic commercethat everyone wanted to imitate. By December 2000, it had 20 million customers in 160 countries.

Amazon dec-98 march-99 june-99 sept-99 dec-00Customers (million) 6.2 8.4 10.7 13.1 20

In December 2000 (as in the previous year), the analysts’ recommendations were optimistic,even though the earnings per share forecast for 2000 and 2001 were -$1.20 and –$0.68, respectively.

Number of analystsDate Share price Strong Buy Buy Hold Sell Strong sell

Dec 1999 98 9 8 8 0 0 Dec 2000 25.875 4 15 10 0 1

By the end of 1999, some analysts were already commenting that “Amazon’s potential may notbe as large as we think”.

Amazon, like many other companies, implemented a compensation system for executives andemployees using stock options. Table 4 shows that in December 1999, the company’s personnel had80.34 million options with an average exercise price of $27.755. In December 1999, the options wereworth approximately $8 billion, but by December 2000, their value had dropped to just above $1billion.

Table 4. Options held by employees and managers. 31 December 1999Range of Average Average Million Strike

strike Million life strike options priceprices ($) options (years) price ($) January 1, 1996 21.23 0.012

0.014 - 0.083 9.965 5.0 0.049 Options granted 31.20 0.0510.111 - 1.000 11.655 7.2 0.554 Canceled -6.34 0.0231.167 - 5.372 9.44 7.9 3.823 Exercised -6.05 0.0336.135 - 12.83 9.242 8.3 7.644 January 1, 1997 40.03 0.03812.87 - 21.30 8.207 8.7 18.426 Options granted 36.12 1.14821.33 - 57.95 12.388 12.5 50.778 Canceled -5.10 0.29758.09 - 64.88 9.294 12.4 62.425 Exercised -16.39 0.03264.94 - 87.75 8.67 9.4 72.564 January 1, 1998 54.66 0.75187.78 - 104.1 1.338 9.5 91.654 Options granted 39.55 12.734105.0 - 105.0 0.143 9.0 104.969 Canceled -7.54 4.049

Exercised -10.67 0.554Total 80.342 9.0 27.755 December 31, 1998 76.01 6.688

Options granted 31.74 63.602Canceled -11.28 3.860Exercised -16.13 19.703December 31, 1999 80.34 27.755


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2.3. Online leadership: Barnes & Noble vs. AmazonBarnes & Noble was the world’s largest bookstore chain, reporting sales amounting to 3.486

billion dollars in 1999. It sold books only in the United States and had at least one store in every majorcity. In 1999, the company had 520 Barnes & Noble bookstores and 470 bookstores that operatedunder the name of B. Dalton. Barnes & Noble had developed other businesses: it offered books fromsmall independent publishers and university papers. It also published books under the Barnes&Noblebrand which were sold exclusively in its stores and through mail order catalogs. Barnes & Noble’sgreatest asset was its name, which had special connotations for its customers: a broad selection of titles,daily discounts, and a welcoming atmosphere to buy in.

In January 1997, Barnes & Noble announced plans to be the only bookseller for the largestInternet access provider (America Online) and its intention to launch its own web site that same spring.Barnesandnoble.com started operating in March 1997 and become one of the world’s most visited sitesand the fourth largest online retailer. It offered a broad range of products and services: books, music,software, posters, and related products, similar to those that could be found at amazon.com. Barnes andNoble staked their hopes on the company’s name: its brand recognition would be the vehicle that wouldenable it to move from a small market (its bookstores) to a mass market (Internet). Referring to Barnes& Noble, Jeff Bezos said, “Quite frankly, I’m more worried about two guys in a garage.”5

In December 2000, the company’s market capitalization stood at $1.678 billion, 3 times lessthan that of Amazon. But one year before, Barnes & Noble’s market capitalization was 23 times lessthan Amazon’s. During that period, Barnes & Noble’s return was 15%, while Amazon’s was –75%.Figure 2 shows the evolution of Barnes & Noble’s share price.

The main items of Barnes & Noble’s income statement were:

($ million) january-97 january-98 january-99 january-00Sales 2,448 2,797 3,006 3,486

Net income 5 1 .2 6 4 .7 9 2 .4 124 .5

Barnesandnoble.com went public on 28 May 1999. Barnes & Noble held 40% of thiscompany’s equity. Bertelsmann held another 40%. The company’s market capitalization in December2000 stood at $215 million, with expected sales during 2000 of about $300 million. Figure 2 shows avery different story from Amazon. However, in September 2000, the company’s shareholders’ equitystood at $100 million, which included accrued losses of $42.8 million.

Figure 2. Evolution of Barnesandnoble.com’s share price since its flotation

3. Valuations of Amazon

3.1. Valuation made by an analyst using cash flow discounting: $87.3/shareOn 10 December 1999, when the price had risen to $106.7/share, the forecasts given in Table 5

enabled one analyst, by discounting the cash flows at 12%, to reach a price per share for Amazon of$87.3/share, that is, a market capitalization of $30 billion.

5 Fortune, 9 December 1996.


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Table 5. Forecasts made by an analyst for Amazon in December 1999 (million dollars)($ million) 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Sales 0.5 15.7 148 610 1,542 3,250 6,500 11,375 17,063 22,181 27,771 33,436 38,652 42,827 45,396 48,120Net income (0.3) (6.2) (31) (125) (425) (399) (322) 169 540 649 918 1,335 1,533 1,962 2,321 2,799Net income/Sales -59% -40% -21% -20% -28% -12% -5.0% 1.5% 3.2% 2.9% 3.3% 4.0% 4.0% 4.6% 5.1% 5.8%

Another way of justifying Amazon’s share price was to view the share as a call option. A calloption on Amazon’s future: an uncertain future in that the company could have many online businessesother than book selling6. With just book selling alone, it was virtually impossible to justify Amazon’sshare price of $106.7/share in December 19997.

3.2. Damodaran’s valuation by cash flow discounting: $35/shareDamodaran published a valuation of Amazon8 in March 2000 and valued its equity at 11.955

billion dollars9, that is, $35/share. Table 6 gives Damodaran’s forecasts. The valuation is a simplediscount of the FCF at the WACC. From this quantity, we must deduct the debt and the value of theoptions held by the employees to obtain the equity’s value.

One error of Table 6 is that it considers that the company starts to pay taxes in 2003, eventhough the company has accrued losses of $1.748 billion in 2000. The depreciation is also very low,considering the historic depreciation and the level of investment. On the other hand, Damodaranconsiders a debt of only $349 million and a borrowing rate of 1.2% during the first five years, rising to15% in years 9 and 10. Initial borrowing, according to the equity value obtained by Damodaran andconsidering the net debt in December 1999, is 5%. When these adjustments are entered into thevaluation, the value of the equity would be about $1 billion higher.

Table 6. Forecasts of Damodaran for Amazon (million dollars)2000 2001 2002 2003 2004 2005 2006 2007 2008 2 .009

Sales 2,793 5,586 9,776 14,663 19,062 23,866 28,735 33,217 36,805 39,013EBIT -373 -94 407 1,038 1,628 2,212 2,768 3,261 3,646 3,883Taxes 0 0 0 167 570 774 969 1,141 1,276 1359Depreciation 46 60 75 90 104 115 122 130 138 146Capital expenditure 554 907 1,345 1,572 1,438 1,572 1,599 1,489 1,226 815WCR expenditure 50 84 126 147 132 144 146 134 108 66FCF -931 -1 ,024 -989 -758 -408 -163 1 7 7 6 2 51 ,174 1 ,788Ke 12.9% 12.9% 12.9% 12.9% 12.9% 12.42% 11.94% 11.46% 10.98% 10.50%Kd 8.0% 8.0% 8.0% 8.0% 8.0% 7.8% 7.8% 7.7% 7.5% 7.0%

3.3. Copeland’s valuation by scenarios and cash flow discounting: $66/shareIn the third edition of his book,10 Copeland includes a valuation of Amazon. Copeland

recommends drawing up different scenarios for 10 years’ time. For the specific case of Amazon, hegives four scenarios for 10 years’ time, ordered from most optimistic to least optimistic. Scenario A(see Table 7) corresponds to “suppose that Amazon is the next Wall-Mart”: 15% of book sales on theAmerican market, 18% of music sales on the American market, success in the sale of new products anda good margin. Scenarios B and C are midway between A and the most pessimistic (D), which isdefined as much lower shares of the book and music markets, little success with other products and asmaller margin. The value of Amazon’s equity in 2000 is 79 billion dollars according to scenario A and3 billion according to scenario D. These valuations are obtained by cash flow discounting. The next stepis to allocate a probability to each scenario: Copeland allocates 5% to the most optimistic, 25% to themost pessimistic and 35% to the midway scenarios. With these assumptions, he obtains an equity valueof 23 billion dollars, that is, 66 dollars per share. Note that Copeland does not allocate any probabilityto a voluntary reorganization or bankruptcy for the company.

6 There were some who were saying in early 2000 that “Amazon will be the Wall-Mart of the future”. Copeland (2000)defines a possible scenario saying “suppose that Amazon is the next Wall-Mart” (page 318).7 The company’s comments on its performance in June 1999 included the following paragraphs: “Risk of new businesses.We want to expand our company by selling new or complementary products, introducing new services and new ways ofselling. This will require additional expenditure and investment. We do not expect to benefit from the advantage of beingthe first mover, as in online book selling. Any unsuccessful business may damage the reputation of the Amazon brand.”8 Damodaran, Aswath (2000), “The dark side of valuation: firms with no earnings, no history and no comparables”,Working Paper, Stern School of Business.9 Value of shareholders’ equity (14.847 billion) less value of the options held by employees (2.892 billion).10 See Chapter 15 of Copeland, T. E., T. Koller, and J. Murrin (2000), Valuation: Measuring and Managing the Value ofCompanies. Third edition. New York: Wiley.


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Table 7. Copeland’s forecasts and valuation for Amazon (billion dollars)EBITDA/ Equity value in each Likelihood Equity

books music other Total sales scenario (2000) of scenario valueScenario A 24 13 48 85 14% 79 5 % 3.9Scenario B 20 9 31 60 11% 37 35% 13.0Scenario C 16 6 19 41 8 % 15 35% 5.3Scenario D 7 5 5 17 7 % 3 25% 0.8

23.0

Sales in 2010

3.4. Our valuation by simulation and cash flow discounting: $21/shareIn this section, we give our valuation of Amazon. The basic scenario is that given in Table 8.

Table 8. Basic scenario for the valuation of Amazon (million dollars)1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Sales 1,640 2,650 5,300 9,540 15,264 22,133 29,105 35,522 40,222 43,415 45,482

Cost of sales, marketing and other expenses 2,030 2,518 5,035 9,063 14,501 21,026 27,649 33,746 38,211 41,244 43,208FCF 33 65 117 187 271 357 436 493 532 558Equity cash flow -134 -10 34 97 173 250 321 279 318 420

The hypotheses given in Table 8 can be summarized as follows:(Cost of sales + marketing + other expenses) / sales11 = 95%Growth of sales = 100% in 2001, 80% in 2002,…, 8% in 2008.Both hypotheses are optimistic if we consider the historic evolution of the (Cost of sales + marketing +other expenses) / sales ratio and growth of sales shown in Figure 3.

Figure 3. Historic growth of Amazon’s sales

-25%0%

25%50%75%

100%125%150%175%200%

II-96 III-96 IV-96 I-97 II-97 III-97 IV-97 I-98 II-98 III-98 IV-98 I-99 II-99 III-99 IV-99 I-00 II-00 III-00

Quarterly growthGrowth vs. same quarter previous year

With this data (without any type of future flexibility in costs or sales), the equity’s value iscalculated to be 2.721 billion dollars (present value of the equity cash flows discounted at 12%).

In a company such as Amazon, it is necessary to introduce uncertainties in the expectations. Weintroduce uncertainty (volatility) in the hypotheses in the following manner:(Cost of sales + marketing + other expenses) / sales = 95% with a volatility of 5% (80%-110%)Sales growth in 2001 = 100% with a volatility of 25% (25%-175%).

In order to take into account future flexibility in costs and sales, we carried out 10,000simulations. The equity value obtained is 7.368 billion dollars12. The distribution of the value of the10,000 simulations is shown in Figure 4. Observe that 4,343 of the 10,000 simulations give an equityvalue of zero. If we consider a liquidation value (or a value for the option of pulling out of thebusiness), the equity’s value would increase. For example, if we consider that the worst scenario is thatproposed by Copeland (an equity value of 3 billion), the equity’s value would increase to 8.671 billion.

However, the reader should remember that this valuation considers that the likelihood ofbankruptcy or voluntary reorganization is 43.43%.

The distribution of sales in 2009, according to the simulation, is shown in Figure 5.Table 9 shows a sensitivity analysis for the valuation.

11 During the period 1995 - 1999, this ratio has been 159%, 141%, 122%, 111%, and 123%.12 7.368 billion dollars is the mean of the 10,000 valuations performed, one in each simulation.


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Figure 4. Distribution of the value of Amazon’s equity in the year 2000. 10,000 simulations

0

100

200

300

400

500

600

0 10 20 30 40 50 60 70value of equity (billion dollars)

Simulations

4,343 simulations give a value of zero

Figure 5. Distribution of Amazon’s sales in the year 2009

0200400600800

1,0001,2001,4001,6001,800

0 20,000 40,000 60,000 80,000 100,000 120,000 140,000Sales in 2009 (million dollars)

Simulations

Table 9. Value of Amazon’s equity (million dollars). Sensitivity analysisCost of sales, marketing and other expenses / sales 70% 80% 88% 90% 92% 95% 97%Value of equity 35,426 26,816 18,399 15,523 12,311 7,386 4,741

Correlation between sales and cost volatilities -100% -70% -50% -30% 0 % 50% 100%Value of equity 12,195 10,670 9,865 8,817 7,368 5,313 3,595

Cost volatility 2 % 3 % 4 % 5 %Value of equity 5,021 6,030 6,824 7,368

Sales growth volatility 0 % 10% 20% 25% 30%Value of equity 6,518 6,693 7,049 7,368 7,691

Schwartz and Moon (2000) also give a valuation13 of Amazon by simulation. They value theequity at 4.210 billion dollars, that is, $12.42/share. In their simulation, Amazon applied for voluntaryreorganization 27.9% of the times.

3.5. Differences between our valuation and those of Copeland and DamodaranTable 10 shows the differences between our valuation and Copeland’s. In order to compare the

two valuations, we have converted the 10,000 simulations of our valuation into 5 scenarios: forexample, scenario A is the mean of the 49 simulations that gave the highest value to the shares. Themain two differences are that Copeland allocates higher probabilities to the more optimistic scenariosand no probability to voluntary reorganization.

Table 10. Difference between this valuation and Copeland’s (billion dollars)Equity value in

each scenario (2000) Copeland this valuation Copeland this valuationScenario A 79 5 % 0.49% 3.9 0.39Scenario B 37 35% 3.42% 13.0 1.27Scenario C 15 35% 34.15% 5.3 5.16Scenario D 3 25% 18.51% 0.8 0.56Scenario E 0 0 % 43.43% 0.00

23.0 7.4

Likelihood of scenario Equity value

13 Schwartz, E. and M. Moon (2000), “Rational Pricing of Internet Companies”, Working Paper, Anderson School atUCLA.


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Table 11 shows the differences between our projections and Damodaran’s. Our projections aremore optimistic than Damodaran’s regarding sales and the first years’ FCFs. However, Damodaranexpects much higher FCFs than we do after 2007. This is important because of the residual value:Damodaran’s present value is 12.168 billion higher than ours. This large difference is due to thedifference in the final year’s FCF and because Damodaran considers a residual growth of 6% while weuse 5%.

Table 11. Difference between Damodaran’s projections and this valuation (million dollars)2000 2001 2002 2003 2004 2005 2006 2007 2008 2 .009

Ventas 143 286 236 -601-3.071 -5.239 -6.787 -7.005 -6.610 -6.469FCF -964 -1.089 -1.106 -945 -679 -520 -259 132 642 1.230Ke 0,9% 0,9% 0,9% 0,9% 0,9% 0,4% -0,1% -0,5% -1,0% -1,5%Kd 0,0% 0,0% 0,0% 0,0% 0,0% -0,2% -0,3% -0,3% -0,5% -1,0%

4. America OnlineAmerica Online’s capitalization at the beginning of December 1999 was $181.1 billion. The

share price at the beginning of December 1999 was $81/share14. However, it had fallen to $34.8 by theend of 2000. The company had more than 12,000 employees.

Figure 6 shows the evolution of America Online’s share price.

Figure 6. Share price, earnings per share of America Online

Although this figure shows the significant drop in the company’s share price between March andSeptember 1999 (the share price fell from $82/share to $40/share in October), it fell even more in 1996,from $4.5/share in May to $1.5/share in October, as a consequence of the investors questioning thecompany’s business model.

The most important data from American Online’s income statement and balance sheet were:

($ million) 06-1990 06-1991 06-1992 06-1993 06-1994 06-1995 06-1996 06-1997 06-1998 06-1999 06-2000Net sales 17.3 19.5 26.6 40.0 115.7 394 1,094 1,685 3,091 4,777 6,886EBITDA 0.7 1.3 4.6 6.0 7.6 -9.18 98.61 41.48 257 851 1,788Net income 0 . 2 1 . 5 3 . 5 4 . 2 2 . 6 -38 3 0 -499 -74 7 6 2 1 ,232

Total assets 7.9 7.9 23.6 32.4 154.6 406 959 847 2,874 5,348 10,673Shareholders’ equity 2.0 3.5 18.9 23.8 98.3 218 513 131 996 3,033 6,161Debt 0.4 0.7 0.0 0.0 9.3 22 22 51 372 348 1,646

AOL was incorporated in 1985. In 2000, it was the leading company in interactive services,Web brands, Internet technologies, and electronic commerce. The company operated two onlineservices: America Online with 18 million members and CompuServe with approximately 2 millionmembers. It was also the owner of many Internet brands such as ICQ, AOL Instant Messenger, andDigital City. It also had Internet portals such as Netscape and AOL.com, communication software suchas Netscape Navigator, and the largest company in the USA in show ticket sales (AOL Movie Phone).Through its strategic alliance with Sun Microsystems, the company develops and sells electroniccommerce applications for companies that do business through Internet.

14 After 7 2x1 splits in Nov. 94, April 95, Nov. 95, March 98, Nov. 98, Feb. 99 and Nov. 99.


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In 1999, AOL’s sales had the following breakdown: subscriptions 70%; advertising, commerce,and others 21%, and business services 9%. Customers who had subscribed to the AOL service andCompuServe generated the subscriptions. The companies that advertised to AOL subscribers and usersmainly generated the sales from advertising, commerce and others. They consisted mainly of the ratescharged by the company for electronic services and product sales. The sales of business services mainlyconsisted of fees for using AOL products and technical service, consulting and training fees.

The analysts’ recommendations. In spite of the company’s high capitalization and its PER of 250at the beginning of December 1999, most of the analysts recommended buying: 25 analystsrecommended buying, 15 recommended moderate buying and only 3 recommended holding the stock.None of them recommended selling or selling moderately. In December 2000, the capitalization was114.3 billion and the PER was 92.6. Most of the analysts continued to recommend buying: 24 analystsrecommended buying, 12 recommended moderate buying, 3 recommended holding the stock, and nonerecommended selling.

5. Online brokers: ConSors, Ameritrade, E*Trade, Charles Schwab, and MerrillLynch

The course followed by the online brokers makes very interesting reading.Incorporated in 1994, by the year 2000 ConSors was the largest German discount broker in

terms of number of customer transactions and the second largest in terms of number of accounts. Thelargest discount broker (in terms of number of accounts) was Comdirekt. Table 12 shows the forecastsmade by J.P. Morgan for ConSors at the end of 1999.

Table 12. ConSors. Historic data and forecasts (million euros)1996 1997 1998 1999E 2000E 2001E

Total sales, net 4.6 17.2 60.2 128.3 205.0 287.3Earnings before tax (without marketing costs) 1.4 6.6 18.9 42.3 75.1 106.1Net income 0.0 2.5 7.0 14.9 25.1 31.4Number of accounts (thousand) 12 37 86 180 330 555Number of orders (thousand) 157 631 2,830 6,141 9,874 14,186Costs/revenues (without marketing costs) 69.5% 61.1% 67.6% 66.3% 62.7% 62.5%Operations per account 14 19 35 34 29 25Acquisition cost per customer (euro) 188 86 130 177 205 217Source: Company records and J.P. Morgan estimates

ConSors went public in April 1999 (ConSors’ largest shareholder, the Schmidt Bank, sold 25%of its shares). During the public offering, the price of its shares tripled on the Neuer Market, achieving a25% return in the first session. ConSors became the country’s fifth largest bank in terms of marketcapitalization. In August 1999, ConSors’ share capital amounted to 44 million shares and itscapitalization was 3.3 billion euros. The table below gives ConSors’ shareholding structure. TheSchmidt Bank held 70.2% of the company’s shares, ConSors customers held 9.1% and the free floatamounted to 18.6% of the total equity.

Figure 7 shows the evolution of ConSors’ share price.The company’s greatest assets were its brand recognition and its customer base. In the opinion

of JP Morgan, ConSors’ success was based on the image of a modern, innovative, competitivecompany that it conveyed to the market’s most active segment. The large number of operations percustomer is striking (35 per year in 1998).

The company’s goal was to gain a core position as a leader in financial services in Germany andtake this leadership to other European markets. ConSors’ strategy to achieve this leadership goalconsisted of extending its product range beyond mere online brokerage services, offering its customersa comprehensive, personalized service. Through Internet, its customers could not only buy shares butalso take out insurance, mortgages, etc. By this means, ConSors would increase the number offinancial assets managed in its portfolio.

Another reasons for ConSors’ success was the composition of its management team: relativelysmall (six people), young (five of them were in their 30’s), and strongly motivated with shares andoptions. The six managers (including the founders) had options on more than 132,000 shares, with anapproximate value of 9.9 million euros.

ConSors, like other European brokers, wished to follow the example of the French CompanyCortal and extend its offerings to other European and international markets. As regards its penetration ofother European countries, ConSors would have a competitive advantage compared with its possiblecompetitors if it succeeded in being the first to enter neighboring markets. With this goal in mind, inmid-1999, ConSors bought a small online broker in France, Axfin; and, on 14 December 1999 itbought Siaga, a Spanish stockbroker company.


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The American brokers had also initiated their expansion in Europe, in spite of havingencountered difficulties such as their ignorance of the European market, currencies, and language andcultural differences. To overcome these obstacles, they resorted to agreements and alliances.E*Trade, the second largest broker in terms of turnover, was present in France, Italy and theScandinavian countries. For its part, Ameritrade had an agreement with the French company Cortal, byvirtue of which Ameritrade’s customers had access to the Paris stock market through Cortal, andCortal’s customers had access to the American stock market through Ameritrade.

Figure 7. Evolution of ConSors’ share price

At the same time as Internet was opening up new markets for the banks, it also brought newperils for their business with the entry of new competitors. Indeed, Internet offered many advantagesfor the banking industry; costs could be reduced enormously while, at the same time, providing thepossibility of expanding the services offered and personalizing customer relationships.

The European banks were aware of Internet’s enormous potential. Success would be dependentupon two factors: technology and marketing. The new technologies enabled banks to significantlyreduce their costs per operation: the initial outlay required to open a bank website and its associatedrunning expenses were much lower than opening and maintaining a bank branch.

Banks in Great Britain, France, Germany, Scandinavia, and Spain were offering theircustomers all sorts of services over the Internet. However, the European banks’ volume of operationswas much lower than the US banks, although the number of investors using the Web was growingcontinuously.

The analysts considered that the German online banks and brokers were leading the field inEurope. In Germany, out of a total of 65 million accounts opened, it was possible to access about 10million online.

5.4. ConSors vs. Ameritrade, E*Trade . Taking into account that Germany has always beenconsidered a very conservative country, it may come as a surprise that the German online brokerageindustry has a lot in common with the US model:1. Relatively low fees based on the size of the order. They have not yet adopted the flat rate structure

used in America but the fees are similar to those charged by the American brokers Schwab andFidelity.

2. Marketing costs are growing rapidly, particularly those items related with brand recognition.3. Continuous creation of new products.4. Technological innovation. Strategies are adapted rapidly to new trends in the industry.


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Table 13 shows the leading online brokers’ key indicators in 1998: ConSors’ return percustomer was 45% - 75% higher than that of its American counterparts and 161% higher than that ofComdirekt.

Table 13. Key indicators of the main online brokers in 1998 (euros)ConSors comdirekt Ameritrade E*Trade

Revenues per customer 979 564 668 638Costs per customer (without marketing costs) 661 443 449 457Earnings before tax per customer 318 121 219 181Revenues per operation 28.4 28.4 29.2 35.1Costs per operation (without marketing costs) 19.2 22.3 22.3 25.1Earnings before tax per operation 9.2 6.1 6.9 10.0Operations per customer 35 20 23 18Costs/revenues (without marketing costs) 67.5% 78.5% 67.2% 71.6%Source: Company records and J.P. Morgan estimates

However, if we analyze earnings before tax per operation or the cost/revenues ratio (bothparameters exclude marketing costs), we will see that there are no significant differences between theresults obtained by ConSors, E*Trade and Ameritrade. All of this leads us to thank that the reason whyConSors’ return is better than the rest is to be found in the number of operations performed by itscustomers: the number of operations per customer and year was 35 for ConSors, 23 for 23 and 18 forE*Trade.

In 1999, J.P. Morgan valued the ConSors share at 104 euros. ConSors’ market capitalization inDecember 2000 amounted to 2.697 billion euros. Table 14 shows a number of parameters for theleading North American brokers.

Table 14. North American brokers. Main parametersDecember 31, 2000 sales /

Capitalization Net income sales employee 1 year 3 years P/BV PER dividend ROE ROAMerrill Lynch 52,950 2,618 34,879 0.626 23.4% 7.9% 3.1 17 1.0% 20.9% 0.7%Charles Schwab 36,062 589 4,713 0.365 53.0% 29.2% 8.6 53 0.2% 25.7% 1.7%Ameritrade 1,271 -14 654 0.275 107.4% 90.1% 6.0 na 0.0% 12.5% 1.0%E*Trade 2,261 19 2,201 0.583 232.4% 140.0% 1.2 123 0.0% -0.3% 0.0%

Million dollars sales growth 5 years

Figures 8 and 9 show the evolution of the share prices of E*Trade, Ameritrade, CharlesSchwab, and Merrill Lynch.

Between 16 April 1999 and December 2000, Merrill Lynch’s return to equity was 48%, whileCharles Schwab’s return to equity was –40%. In December 2000, Merrill Lynch’s capitalization was$52.95 billion and its PER was 17, while the same parameters for Charles Schwab were $36.062billion and 53.

Figure 8. Evolution of E*Trade’s (EGRP) and Ameritrade’s (AMTD) share prices


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Figure 9. Evolution of Charles Schwab’s (SCH) and Merrill Lynch’s (MER) share prices

6. MicrosoftIn February 2000, Microsoft was the company with the world’s largest market capitalization. On

2 February 2000, Microsoft’s capitalization stood at $521.7 billion, almost twice the capitalization ofthe 35 companies comprising the Spanish stock market index IBEX 35. On 2 February 2000, its sharessold for $100.8/share15, but by the end of 2000, their price had dropped to $43.38.

Bill Gates, the company’s founder and largest shareholder, was born on 28 October 1955 inSeattle (Washington). He founded Microsoft in 1975 after dropping out from Harvard.

Microsoft started business in Alburquerque, developing applications for the BASIC language.The company moved to Seattle in 1979. In 1980, IBM commissioned Microsoft to develop theoperating system for its personal computers (PC). Gates bought the QDOS (quick and dirty operatingsystem) operating system from a Seattle programmer for 50,000 dollars and renamed it MS-DOS(Microsoft disk operating system). Many other companies manufactured computers that werecompatible with IBM’s computer and MS-DOS became the standard operating system for PCs.Microsoft started to develop other programs for personal computers.

In 1985, Microsoft launched Windows, a more user-friendly version of MS-DOS that wasinspired by Apple’s operating system, Macintosh. In 1993, it launched Windows NT (new technology)to compete with the UNIX operating system in large mainframes and networks. Microsoft bought manysoftware companies and invested unwaveringly in applications development. In 1995, Microsoftentered Internet with Microsoft Network (MSN), licensed Sun’s Java language and launched theInternet Explorer.

In 1999, the company organized itself by customer groups, instead of by product lines, as it haduntil then. It also invested 5 billion dollars in AT&T and bought Visio (a company specialized indrawing programs) for 1.3 billion dollars.

Figure 10 shows the evolution of Microsoft’s share price, earnings per share and PER (thecompany closes its fiscal year on 30 June).

Table 15 shows Microsoft’s spectacular growth in sales, employees and earnings. The growthof Microsoft’s sales and earnings over the years is immediately striking. However, even more strikingis the fact that, in spite of being the company with world’s largest market capitalization, theearnings/sales ratio has also grown over time. It is difficult to account for the company’s spectaculargrowth (and growing earnings/sales with a very large size) without considering some sort of monopolyor quasi-monopoly position.

Gates’ business acumen and his superb perception of IT innovations have been fundamentalfactors in Microsoft’s success. Gates makes the strategic decisions, also playing a key role in thetechnical development of new products. For Bill Gates, it is important know the opinion of hiscustomers and employees and, consequently, he spends a large part of his time meeting with customersand contacting Microsoft employees via e-mail.Under Gates’ leadership, Microsoft’s goal has been to continuously improve software technology andmake it increasingly easier, cheaper and more fun for users to use the computer. In 1999, Microsoftinvested more than 3 billion dollars in research and development.

15 After 8 splits: 2x1 in Sept. 87, April 90, May 94, Dec. 96, Feb. 98 and March 99; and 3x2 in June 91 and June 92.


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Figure 10. Microsoft’s share price, earnings per share and PER

Table 15. Microsoft. Evolution since 1975.($ million) 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Sales 591 804 1,183 1,843 2,759 3,753 4,649 6,075 9,050 11,936 15,262 19,747 22,956Net income 124 171 279 463 708 953 1,146 1,453 2,195 3,439 4,462 7,757 9,421Earnings/sales 21% 21% 24% 25% 26% 25% 25% 24% 24% 29% 29% 39% 41%Cash and investments 183 301 449 686 1,345 2,290 3,614 4,750 6,940 8,966 13,927 17,236 23,798Total assets 493 721 1,105 1,644 2,640 3,805 5,363 7,210 10,093 14,387 22,357 38,625 50,400Shareholders’ equity 376 562 919 1,351 2,193 3,242 4,450 5,333 6,908 10,777 16,627 28,438 52,150Employees 2,793 4,037 5,635 8,226 11,542 14,430 15,017 17,801 20,561 22,232 27,055 31,575 39,170

1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987Sales ($ million) 0.016 0.022 0.38 1.36 2.39 7.52 16.0 24.5 50.1 97.5 140 198 346Employees 3 7 9 13 28 40 128 220 476 608 910 1,153 1,816

Some key dates for Microsoft4 April 1975 Incorporation of Microsoft.

12 August 1981 IBM introduces the personal computer with Microsoft’s MS-DOS 1.0 operating system13 March 1986 Public offering. 2.5 million shares at $21/share.

22 May 1990 Windows 3.0 launched.24 August 1995 Windows 95 launched.

7 December 1995 Bill Gates announces Microsoft’s commitment to support and improve Internet25 June 1998 Windows 98 launched.January 2000 Serious legal problems: would the company be split?

24 February 2000 Windows 2000 launched.

7. A final comment on the valuation of Internet companiesInternet is a very powerful tool that offers an enormous range of possibilities for companies and

users. At present, Internet is the tool that must be used by virtually all companies if they wish to prosperand grow16. Its possibilities are enormous both for commerce with individuals and for commercebetween companies.

Although this is true, one is justified in wondering whether the valuations currently made ofInternet companies and projects match foreseeable reality or are merely a bubble. 16 On this point, it is amusing to attend corporate presentations to analysts and observe the frequency with which someexecutives mention (whether or not it is relevant to the occasion) the word Internet.


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It is very interesting to compare and try to differentiate what Internet may signify in the firstyears of the 21st century with the revolutionary effect on society that the railways, freeways, airlines,radio, television and the telephone had when they first appeared. We also urge the reader to analyze thehistory of companies such as Levitz, Home Shopping Network, MCI, LTCM and Boston Chicken.

Internet is no King Midas. Business ideas related with Internet must be analyzed with the samerigor as any other business initiative. Two anecdotes are very much to the point here. The promoters ofa new company for selling gifts by Internet showed us their business plan together with a series offorecasts that covered several years. When they were asked about the rationale for their forecasts, thereply was: “These forecasts are very conservative because, for example, we are assuming that we willonly sell 0.05% of the hams that are sold in Spain”. Of course, the next question was that they justifythe sale of a single ham. The promoters of another Internet-related company also showed us anextensive business plan accompanied by balance sheet, income statement and cash flow forecasts, and avaluation. According to them, the company’s shares (and it was only a project then) were worth 60million euros. They were asking my clients for 40 million euros and, in exchange for this investment,offered them 40% of the shares. It is clear that there was a conceptual error in this approach because thecompany was worth 60 million if the outlay was actually made and zero if it was not. If there were amultitude of investors willing to invest in the company (which was not the case), the 40 million wouldentitle the investors to 67% of the equity. However, as this was not the case, the 40 million entitled theinvestors to more than 70% of the equity.

Morals:A website is not necessarily a business.Selling below cost gets you lots of customers, but not much money.

REFERENCES

Cooper, Michael, Orlin Dimitrov and Raghavendra Rau (2000), “A rose.com by any other name”,Working Paper, Purdue University.

Copeland, T. E., T. Koller, and J. Murrin (2000), Valuation: Measuring and Managing the Value ofCompanies. Third edition. New York: Wiley.

Damodaran, Aswath (2000), “The dark side of valuation: firms with no earnings, no history and nocomparables”, Working Paper, Stern School of Business.

Schill and Zhou, (1999), “Pricing an emerging industry: Evidence from Internet subsidiary carve-outs”,Working Paper, University of California.

Schwartz, E. and M. Moon (2000), “Rational Pricing of Internet Companies”, Working Paper,Anderson School at UCLA.

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