At present, the main concentration of the business culture is on eCommerce, which has led to debates among experts about its impact on businesses and whether it is a temporary phenomenon. These discussions also examine strategies for effectively navigating a rapidly changing business landscape driven by constant generation of ideas. Nevertheless, it is indisputable that companies committed to eCommerce have significantly higher stock prices and market capitalizations. Interestingly, some stock prices in this sector remain unexplainably high even without any profits.
In this paper, we aim to conduct a thought experiment to collect and distribute information on the stock prices of eCommerce companies. Moreover, we will endeavor to present solutions and explanations for the ongoing market trends concerning these companies.
Discussion of the different types of eCommerce business models
When it comes to eCommerce, having a frame of reference is crucial. It is fascinating to examine the common models in this field. Generally, there are two well-known business models for eCommerce: B2B (Business to Business) and B2C (Business to Consumer). The main question about these models is whether they bring about a revolutionary approach to business by introducing a new model or if they simply facilitate an existing and mature business model.
The prevalence of B2B and B2C eCommerce may differ based on the model being considered. B2B eCommerce is much more widespread, with about five times the prevalence of B2C eCommerce. The following discussion will offer insights into these models and address the mentioned question.
To summarize, it is important to establish whether B2B serves as a novel business model or merely aids existing models. Historical analysis reveals that B2B eCommerce has been present for several years. Essentially, B2B eCommerce encompasses different supply chain management practices and is referred to using contemporary terminology.
Supply chain management has evolved since the Industrial Revolution, leveraging communication technologies like the telegraph, telephone, computer, software, LANs and WANs, EDI, and currently the Internet and eCommerce to enhance speed and efficiency.
Although B2B eCommerce does not change most business models used for intra-business commerce, it speeds up the process by delivering information more quickly, timely, and accurately. On the other hand, there could be potential in B2C to go beyond just facilitating traditional procedures.
The emergence of B2C has created a novel competitive landscape where the Internet plays a crucial role in swiftly disseminating and exchanging information on a vast scale. This presents advantages for both consumers and businesses, providing them with convenient access to information. B2C eCommerce offers consumers the following beneficial attributes:
- Consumers can access product and service information quickly and efficiently
- Browsing, ordering and purchasing are virtual and therefore expedited
- Informational asymmetries are broken down and markets are more efficient and competitive
- Time saving allows more time for leisure activities
The positive attributes of B2C eCommerce for businesses are as follows:
- Companies can gather information about their customers easily
- Based on better consumer profiles and information systems, companies can engage in market micro-segmentation
- Costs can be reduced due to less brick and mortar rental and construction expenses, less SG&A, fewer print ads, more focused marketing efforts, better defined advertising, and potentially lower inventory holding costs based on augmented demand predictability
- Companies can reach more and more potential customers because the customer’s ability to purchase is not bounded by geographical parameters associated with traditional business models such as brick and mortar
On the downside, eCommerce has drawbacks for both consumers and business owners. When customers provide their information, they sacrifice a level of anonymity which can be exploited by businesses in questionable ways. Additionally, consumers may feel overwhelmed by the sheer amount of information they are exposed to.
From a business standpoint, having the customer access to information can be somewhat risky. When customers have complete information, it leads to intense competition. Intense competition results in low or negligible margins, which leads to very small profits and earnings. This is particularly true for products that are considered commodities. In order to succeed in eCommerce, businesses need to establish themselves as an eChain solution to effectively compete with bundled goods and establish relationships.
Despite the negative aspects that B2C eCommerce businesses may have, they are the ones that have received attention from the media and the public. Notably, companies like Amazon and eBay have achieved huge market capitalizations even though they earn very little or no profits. This makes B2C an interesting topic to investigate in terms of stock pricing. The rest of this paper will concentrate on answering why certain factors contribute to the high stock prices and market capitalizations of B2C eCommerce companies with limited profitability.
When examining the valuation of eCommerce stocks, it is crucial to consider the financial and economic models employed by investment banks in Wall Street. This article aims to present several conventional models that offer insights into the present valuations of eCommerce companies. Additionally, studying these models could aid in developing a novel model.
Standard DCF (Discounted Cash Flow) Model
The standard DCF is the most widely used valuation model for determining a reasonable market capitalization of a company. It calculates the net present value by discounting future cash flows at a reasonable rate. This value is then divided by the number of shares to determine the stock price.
When analyzing eCommerce companies, two main factors to consider are cash flows and the discount rate. The components of cash flows include dividends, plowback ratio, and earnings. While dividends and plowback ratio have little relevance in the case of eCommerce companies, earnings play a crucial role.
When evaluating a company’s stock price, it is interesting to contemplate the future earnings needed by the company, which are determined by cash flows. The analysis offers two options for valuing companies like Amazon: either making optimistic assumptions about the future of the eCommerce industry or ignoring traditional limitations on the discount rate not being negative. However, it is advisable to assess each option.
Experts suggest that in order to justify their current market capitalization, companies like Amazon would need to experience an exceptional growth rate of up to 200% per year over the next twenty years. This could result in Amazon’s market share ranging from three to ten percent of the Gross National Product (GNP) within two decades.
In contrast, some analysts argue that if Amazon was able to capture 30% of a $230 billion market and maintain a five percent profit margin, its market capitalization would be valued at $150 billion. Therefore, Amazon’s current market capitalization of approximately $15 billion is seen as a significant opportunity.
The discount rates are important in determining the adjustment of cash flows as they indicate expected rates of return and risk measurements. Breally and Myers state that these rates represent the compensation investors need for delaying payment. Normally, this value is less than one, showing that a dollar today has less value than a dollar in the future. Additionally, it should be noted that the discount rate is usually positive rather than negative.
Examining the implications of a discount rate less than zero is fascinating. This assumption becomes relevant when using a DCF model for companies with negative earnings. Consequently, dividing cash flows by a negative discount rate when earnings are negative results in a positive number. A negative discount factor indicates that an investor is willing to pay for the opportunity for a company to utilize their money, similar to paying an entrance fee to enter a casino. However, both situations have similarities: as a gambler, there is virtually unlimited potential for gains, but typically the house or insiders come out on top. In the next section on day trading, we will delve deeper into this matter.
Peter Lynch has introduced the PEG Model, a valuable tool for assessing growth stocks. This model proposes that a stock’s price should be proportional to its long-term growth rate, as measured by the P/E (price-to-earnings ratio). By using simple algebra, we can calculate the stock’s price by multiplying its growth rate (G) and earnings (E): P = G * E.
The model generally performs effectively, but it relies on positive future growth and earnings to produce accurate values. When earnings become extremely low, the P/E ratio becomes infinitely high. Likewise, zero earnings would result in a price of zero according to the model. However, many users of the model assume a positive gross margin in the future to determine a price or P/S (Price to Sales) ratio.
Two other commonly used models in valuation attempts are the P/S and P/BV ratios. These models are quite intricate and are typically studied in advanced Finance classes. Hence, they will not be discussed in this context. According to financial models, it seems apparent that eCommerce stocks are being overvalued. The reason behind this phenomenon is quite intriguing and various experts propose different hypotheses. Perkins and Perkins term this overvaluation as the “Internet Bubble”.
The stock market and the Internet game have active participants who contribute to overvaluation. These participants, such as day traders, venture capitalists, investment bankers, and large institutional investors, inflate valuations through their actions.
Venture capitalists are rapidly bringing companies public nowadays, despite their lack of profitability. They also wield significant control over the market through negotiating deals between clients to enhance the strength of the companies in their portfolio, which is commonly known as a keiretsu.
Investment banks are generally willing to participate in the market. In the current booming market, bankers are assured their usual seven percent share for a certain investment. Additionally, the bankers collaborate with big institutional investors to engage in flipping. Flipping entails buying a stock before it is introduced to the secondary market and swiftly selling it after it yields a reasonable return. Through this approach, institutional investors ensure good return on investment for their portfolios, while the bankers maintain investor satisfaction, enabling them to charge substantial transaction fees.
Day traders, who are the general consumer that trades stock in the secondary market via a technologically enabled process such as using a computer and an Internet connection, make up the most perilous group in the eCommerce game. Currently, more than ever, roughly 50% of American households have a stake in the market. Unfortunately, a large majority of these individuals have exposed themselves to dangerous leveraged positions to “play” the market. This includes actions such as taking out second mortgages, trading on margin, or investing a significant portion of their portfolio that would not typically be allocated to high-risk stocks.
Macroeconomists argue that investment is important and beneficial for the economy, but this does not apply to pure speculation. Day traders engage in speculation by relying on limited information, often obtained from investment chat rooms or other day traders. Consequently, herd mentalities develop, leading to stocks being traded irrationally rather than based on solid financial data. Ultimately, stock prices become artificially inflated due to unrealistic consumer optimism.
This form of speculation is similar to betting and gambling. Day traders pay premiums on stocks to engage in speculation, which is akin to gambling. Additionally, day traders often display addictive behaviors resembling those of gamblers.
The combination of various groups and facts, alongside a potentially unhealthy optimism, work together to perpetuate and worsen the “Internet Bubble.” It is crucial to assess the healthiness of this optimism concerning the Internet. It is clear that those who have made significant investments believe that this optimism is grounded in logical assumptions. These assumptions form the basis for the argument that eCommerce stocks are appropriately valued or possibly undervalued.
Adequate or Under Valuation Arguments
Assessing the fair value of an eCommerce stock requires considering the company’s assets. These assets are not limited to traditional accounting balance sheet items like inventory and property, plant, and equipment. In the digital era, there are other crucial assets, particularly information. Baruch Lev, the Phillip Bardes Professor of Accounting and Finance at NYU’s Stern School of Business, emphasizes the significance of knowledge assets, stating that their potential depends on the market’s size.
Furthermore, Mr. Lev categorizes intangible assets into four main groups: assets linked to product development, assets associated with a company’s brand that allow it to sell products at higher prices than competitors, structural assets or improved business models, and monopolies or sustainable competitive advantage. According to this definition, first mover advantages possess long-term value, obtaining market share holds value, customers and their information are valuable, as are strategies that result in a new business model or sustainable advantage.
It is reasonable to say that the B2C eCommerce industry is currently packed with competition. There are numerous “.com” companies vying for market share, making it unrealistic to expect all of them to thrive. This suggests the presence of an “Internet Bubble.” Nevertheless, it could be argued that certain eCommerce companies are not overvalued considering their assets and a few other crucial assumptions. Given the crowded nature of the eCommerce landscape, it is likely that a significant majority of these companies will not succeed.
At the beginning of the 20th century, there were more than 100 car companies in the United States. However, currently, there are less than 20 in the world and this number continues to decrease. Similarly, the eCommerce industry will also see a reduction in competitors. As a result, the established conglomerates that gained an early advantage, built a strong customer base, created secure information-driven strategies, and established an efficient eChain environment will ultimately enjoy the advantages of their positions.
In terms of future earning and cash flow, those positions hold significant value. If there is consolidation in the market and the Internet continues to thrive, it is not unrealistic to anticipate Amazon gaining a 30% share in a $230 billion industry. Likewise, other eCommerce companies that dominate their niche in a consolidated market will also be able to support their current stock prices.
The use of technology has exponentially increased in the Western World and is steadily expanding globally. If the Internet reaches its full potential, there is a significant chance to attract vast customer bases worldwide. Owning eCommerce stocks today is akin to investing in the future of the Internet. While there is a possibility of incurring losses, the potential for unlimited gains also exists. So, the crucial considerations are: do you have faith in the potential of the Internet, and are you willing to take the associated risk?
According to a priest I once heard at my college, the only certainties in life are the existence of a higher power and the acknowledgment of our own limitations. This quote skillfully captures the inherent uncertainty of life, even for those who do not subscribe to a belief in a divine being. In the context of the Internet and stock market evaluations, the only definite belief I can hold is the existence of the Internet itself. Additionally, I deeply regret not purchasing Amazon shares during its initial public offering.
Reference
- Breally, Richard and Stewart Myers, Principles of Corporate Finance 4th Edition, New York: McGraw Hill (1991).
- Clemons, E.K. Alternative Futures for Customer Focused Electronic Commerce, OPIM 666, The Wharton School (November 1999).
- Ip, Greg Market on a High Wire, WSJ, (January 18, 2000).
- Korper, Steffano and Juanita Ellis, The E Commerce Book Building the E-Empire, New York: Academic Press, (1999).
- LEK Consulting Presentation on eCommerce Stock Valuations, Given at the Wharton School (October 1999).
- No Safety Net, The Economist, (August 14, 1999).
- Perkins, Anthony and Michael, The Internet Bubble, New York: Harper Collins Publishers, (1999).
- Voetmann, Torben Valuation By Multiples Part I, FNCE 728, The Wharton School (November 1999).
- Webber, Alan M. New Math for a New Economy, Fast Company, (January:February 2000).
