Internet Stocks: Value and Trading Strategy

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Internet Stocks Value and Trading Strategy

• Rob Freund
• Petter Hellman
• Ole Hvidsten
• Jiong Shao
• Rick Solano

2
Main Points

• Value in theory
• Internet shortcomings for traditional value
• Modifications to theory for Internet stocks
• Trading strategy
• Conclusion
• Questions

3
Value in Theory

• Investors want money
• Industry growth vs. age curve
• New industry - growth important
• Mature industry - returns important

Graph
4
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.
• Cant use current performance to extrapolate
  future performance.

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Laying Odds on Success of Firms 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
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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

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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
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Conclusion

• Must use a proxy for earnings
• A buy and hold strategy can be beaten
• Current value is based on investor perceived
  future potential

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Questions?
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Industry Growth vs. Time
Growth Rate
Return
Time
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Results of Various Sort-Trading Strategies
Using a simply MCAP to Sales ratio to sort yields
the highest return
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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/(SDS)
• As the firm/industry matures, growth declines, so
  actual sales must pick up the value slack

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H Q Internet index
Due to MCAP weighting - the index return has been
significantly skewed by a few extraordinarily
successful stocks
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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
• Cant use current performance to extrapolate
• Factors determining mature market performance
• Margins
• Market Size
• Market Share