Do the old rules still apply? Do we need new valuation metrics or are the old metrics flexible enough to deal with the companies that comprise the new economy? Can you value a company that has no earnings, no history and no comparable firms? These are the questions that I have heard repeatedly over the last few years. I have always believed that the fundamentals that determine value are the same, no matter what company you value and what market it is in. Increasingly, though, I have faced skeptical audiences who are unwilling to take this belief at face value and have demanded proof that America Online, Amazon or Pricleine.com can be valued using traditional models.
The genesis for this book was a paper I did on valuing Amazon.com in March 2000, where a discounted cash flow model yielded a value of $ 34 per share. Since the stock was trading at $ 80 at that time, there were many who viewed the valuation as either excessively pessimistic or as missing something. The interest in the paper led me to think about writing a book, but I expanded it to cover both new technology and old technology firms. While there are differences in estimation that arise across these firms, I believe that they have far more in common. Why technology firms? I believe that traditional valuation books and models (and I count my book on investment valuation among the culprits) have tended to concentrate on valuing manufacturing or traditional service firms. Technology firms are different. They expand by investing in research and through acquisition and not by building plant and equipment. They have astronomical growth rates in revenues, and often very little in current earnings. Their assets are often patents, technology and skilled employees. I look at how the notions of capital expenditures, operating income and working capital have to be redefined for these firms.
I begin this book by laying out the facts on the growth of technology and, in particular, new technology stocks in the equity market in the first chapter, and argue that while the principles of valuation might not shift, the focus can change as firms move through their life cycle. This is followed by an extended section (chapters 2-7) on applying traditional discounted cash flow models to value technology stocks, with an emphasis on the estimation of cash flows, growth and discount rates for these firms. In the next three chapters, I look at the use of relative valuation to value technology companies, both in terms of adapting existing multiples (such as price earnings and price to sales ratios) and developing new ones (value per web site visitor, for instance). In chapter 11, I consider an argument made by many for the large premiums paid on technology stocks, i.e., that they represent real options to expand into a potentially huge e-commerce market, and consider some questions that a skeptic should ask before buying into this argument. In chapter 12, I consider how managers of technology firms can enhance the value of their firms through better investment and financing decisions.
The book is structured around the valuations of five technology firms – Motorola, Cisco, Amazon.com, Ariba and Rediff.com. The first three are household names but represent three different points in the technology spectrum. Motorola is an old technology firm with substantial investments in existing assets. It is also a firm that has fallen on hard times in the last few years, largely as a consequence of poor investments and strategic choices. Cisco is one of the great success stories of the 1990s but a great deal of the market value of the firm reflects expectations about the future. It is also a firm that has chosen to grow through acquisitions, and has done it very well. Amazon.com is the poster child (for better or worse) for the new economy stocks that have entered the market in recent years, and the popular press has documented its ups and downs in extensive detail. Ariba and Rediff.com are more recent entrants into the new economy, with Ariba representing the promise (and peril) of the Business-to-business (B2B) internet model and Rediff the potential of an internet portal serving a market (India) that could be a huge market in the future.
One of the limitations of valuing real companies is that your mistakes are there on the printed page for all to see over time but that prospect does not bother me. At the risk of giving away the punch line, I do find discounted cash flow values for all five companies – Motorola ($32.39), Cisco ($44.92), Amazon.com ($34.37), Ariba ($72.13) and Rediff.com ($19.05). For what it is worth, at the time that I did the valuations in June 2000, I did find Amazon to be overvalued at $ 48 per share and Cisco to be overvalued at $64.88. Motorola at $34.25 per share and Ariba, at $75 per share were fairly valued, and Rediff.com was significantly undervalued at $10 per share. By the time that I finished the book, Amazon had dropped in value to $ 30 per share and Cisco was trading at $ 51. Motorola had gone from being fairly valued to under valued, Ariba saw its stock price double and Rediff remained under valued. I have no doubt that you will disagree with me on some of the inputs I have used, and the values that you assign these firms will be different from mine. What I would emphasize, therefore, is not the values that I arrive at for these firms, but the process by which I get there.
Finally, I want this book to be useful to a wide audience: individual investors who hold technology stocks in their portfolios, equity research analysis, venture capitalists and managers at technology firms. There are portions of the book that I must confess are not easy reading but I have tried as much as I can to provide an intuitive rationale for everything that I do. Technology firms, notwithstanding the back and forth of markets, are here to stay and valuing them is something we all need to grapple with. I hope you find this book useful in that endeavor.