AIMR's Financial Analyst Journal Publishes Model for Rational Pricing of Internet Companies.

Business Editors

CHARLOTTESVILLE, Va.--(BUSINESS WIRE)--July 10, 2000

Authors Schwartz and Moon Apply Their Model to Amazon.com

to Find Underlying Value

Internet stocks pose knotty problems for investors. How does a serious investor determine the underlying value of a company with no earnings and sometimes negative cash flow?

A study published in the latest issue of the Financial Analysts Journal sheds a guiding light on the difficult topic. In the article, a UCLA finance professor and a California portfolio manager outline a model to value Internet companies that not only quantifies the underlying value of the companies but directs attention to the components that are most important in the valuation.

Eduardo S. Schwartz, professor of finance at the Anderson School at the University of California, Los Angeles, and Mark Moon, vice president and portfolio manager at Fuller and Thaler Asset Management of San Mateo, Calif., conclude that even when there's a real chance that a company may go bankrupt, Internet companies earn unbelievably high valuations if two conditions exist: If the initial growth rates are sufficiently high and there is enough volatility in the growth rate over time, Internet companies can be worth their high valuations.

The Financial Analysts Journal is a bimonthly scholarly publication containing articles by leading investment professionals and academics. It helps practitioners in the investment community keep abreast of new ideas and new developments in the field of investment analysis, counseling and management. The 55-year-old journal is published by the Association for Investment Management and Research, a global, non-profit association that furthers the investment body of knowledge and establishes standards of professional conduct for its 42,000 members in 95 countries.

Schwartz and Moon's model applies two tried and true techniques for valuing securities to the pricing of Internet stocks: real-options theory and modern capital budgeting techniques, familiar tools used by analysts and corporate financial managers.

Valuing Internet Stocks Like Options Contracts Helps Gauge Underlying Value

Real-options theory, a technique for valuing highly volatile options contracts, incorporates market price volatility, the tendency of conditions to return to an average rate of return over a specific period of time, and the risk-free rate of return to find an option's underlying value.

"Internet company stocks share one major characteristic with options," explains the study's co-author, Mark Moon. "There is possible huge upside potential and the downside risk is limited to bankruptcy."

Once they found tools they felt would work, the authors expanded the option pricing calculations to 20 parameters for their model. Starting with initial revenue, loss carry-forwards, and cash balances, the model uses the initial growth rate of the company and the expected long-term growth rate of the company to find a current valuation of the company.

So how effective is the model? The authors demonstrate its application by looking at Amazon.com as an example. It's a grandaddy in Internet years, with three years of public financial data to feed into the model. At the end of 1999, revenues were $356 million per quarter, it had a loss carry-forward of $559 million and a cash balance of nearly 1 billion dollars. The initial expected rate of growth of revenues was 11% per quarter. The authors plugged in the other numbers (including the 75% cost of goods sold) and out came the answer: Amazon's underlying value is $5.5 billion. It sells for $11.9 billion in the open market.

Then Schwartz and Moon ran 100,000 simulations, changing each parameter slightly. Their first finding was not unexpected: The most important factor in the equation is the cost function. Small changes in cost of goods sold as well as other expenses varied the total valuation of Amazon immensely. For instance, decreasing the variable component of expenses, other than cost of goods sold, from 6 to just 5% chopped 22% off market cap.

The second most sensitive factor was less obvious. Characteristics of the revenue growth rate (both rate of growth and volatility of rate of growth) varied the final results by billions. A 10% increase in volatility (from 30 to 33%) a quarter increases the underlying value 15%. The flip side also proved true. A 10% decrease in the growth rate of revenues dropped Amazon's value to $4.3 billion from $5.5.

The simulations spit out another interesting set of numbers. The model calculated the chances of Amazon going bankrupt. Using the base numbers, the greatest chance that the company will run out of cash occurs six years from now; there's a 9% chance of bankruptcy in 2006, based on today's information. The good news for Amazon's shareholders is that chances then drop precipitously, running to less than 1% in 11 years, and to zero in 18 years.

Capital Budgeting Techniques Gauge Per-Share Value

To find the value of Amazon on a per-share basis, the authors applied modern capital-budgeting techniques used to find the actual number of shares of the company. Since young companies have different capital structures than more mature companies, two things must be considered in addition to the number of outstanding shares. First, investors need to take into account the number of shares that may be issued to holders of convertible bonds. Also broadly affecting the number of shares in a young companies are those likely to be issued to employees who hold stock options. Both factors increase the number of shares in the equation.

So what was the model's conclusion? When calculated on a per share basis, Amazon is worth about $12 per share. To match Amazon's current valuations, the volatility of expected rates of growth of revenues would have to increase by 182%. Or the current price makes sense if the profit margins increased from 6 to 30%. Neither is likely to happen.

Valuing Internet companies is an art in its infancy. These authors agree that as more data becomes available, the results become more reliable. But in the meantime, these tools exist to help investors determine the real values of companies in the New Economy.

Subscriptions and copies of single issues of the Financial Analysts Journal are available by contacting the Association for Investment Management and Research, at [phone] or [e-mail].

AIMR's 42,000 members are financial analysts, portfolio managers and other investment professionals in 95 countries. AIMR's membership also includes 95 local societies and chapters in 21 countries. Headquartered in Charlottesville, Virginia, USA, AIMR has a staffed office in Hong Kong and is preparing to open an office in Europe. The association is best known for administering the Chartered Financial Analyst (CFA(R)) professional-credential program. More information on AIMR and its programs and services is available at http://www.aimr.org.