eCommerce Companies and Stock Valuations
A hot topic in today’s business culture is eCommerce. Experts argue about whether eCommerce will change business, whether or not it is a fad, and what viable strategies there are in a business world that is changing at the speed of idea generation. One thing that nobody argues about is the fact that eCommerce oriented companies have stock prices and market capitalizations that are enormous. Based on losses rather than earnings, some of these stock prices are inexplicable.
This paper is a thought experiment that attempts to gather and disseminate data regarding these stock prices. Additionally, the paper will attempt to propose solutions and reasons for the current market trends relative to eCommerce companies.
2. Discussion of the eCommerce business models
When discussing eCommerce, it is good to have a frame of reference. As a result, it is interesting to review the common models associated with the field of study.
Generally, there are two widely recognized business models regarding eCommerce.
These models include the B2B (Business to Business) model and the B2C (Business to Consumer) model. The fundamental question regarding these models is: is the specific model in question a revolutionary way of doing business, and hence a new business model; or is the specific model in question a facilitation of a mature business model.
Depending on which model you are discussing you may get different answers. The B2B model is much more common. B2B eCommerce is roughly five times more prevalent than B2C eCommerce . Following is a discussion of the models, and answers to the above question.
To reiterate, it is important to decide whether or not B2B is a fundamentally new business model, or a facilitation of existing business models. It is easy to answer this question when one looks at history. The fundamentals of B2B eCommerce have actually been around for decades. B2B eCommerce is the new en vogue term for supply chain management in the majority of forms in which it is implemented.
In reality, supply chain management has been around since the Industrial Revolution. It has just become expedited with the advent of communications technology: the telegraph, the telephone, the computer, easily designed software, LANs and WANs, EDI, and now the Internet and eCommerce .
B2B eCommerce does not change the majority of business models developed for intra-business commerce. It simply facilitates the process by offering information more quickly, more timely, and more accurately. However, there may be an opportunity with B2C to do more than just facilitate old processes.
The advent of B2C has created a new competitive landscape. The strength of the Internet is dispersion and dissemination of information on a large expedited scale. Consumers can access information quickly and so can organizations and businesses. B2C eCommerce has the following positive attributes for consumers:
·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
B2C eCommerce has the following positive attributes for businesses:
·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
However, there are negatives aspects of eCommerce for both the consumer and the business proprietor. The customer gives up a certain amount of anonymity when he/she allows information to be collected about him/her. This information can be used for questionable and leveraged positions by businesses. A consumer may experience information overflow. From a business perspective, the availability of information to the customer is dangerous to a certain extent. Perfect information implies perfect competition. Perfect competition implies low or non-existent margins, and therefore minute profits and earnings. This is especially true of commodity-oriented products. Successful eCommerce oriented businesses need to position themselves as an eChain solution in order to compete on bundled goods and relationships.
Although there is downside potential for B2C eCommerce businesses, these are the companies that have caught the eye of the media and the public. With companies like Amazon and eBay earning little or no profits, but deriving huge market capitalizations; it makes B2C interesting to study from a stock-pricing standpoint. The rest of this paper is dedicated to answering that question: what drives large stock prices and market capitalizations for B2C eCommerce companies that have made little or no profits.
In terms of understanding the pricing of eCommerce stocks it is important to review classical financial and economic models. Every investment bank on Wall Street has its own method for valuing publicly traded entities. The following sections are a general overview of some of the models that are traditionally used. Evaluating these models will help to determine the reason for the strange valuations of today’s eCommerce companies. Additionally, reviewing the models may help to propose a new model.
3.1 Standard DCF (Discounted Cash Flow) Model
Perhaps the most widely used valuation model is the standard DCF. Essentially, this model uses the net present value of future cash flows to determine a reasonable market capitalization for a company, and then divides that number by the number of shares to derive a stock price. The net present value of the cash flows is computed by determining the cash flows and discounting them at some reasonable rate.
In essence, there are two critical variables in this model: cash flows and the discount rate. There are numerous things to consider regarding cash flows, which include dividends, plowback ratio, and earnings. For the purposes of reviewing eCommerce companies, dividends and plowback ratio have negligible relevance in the analysis at this point of the eCommerce evolution. However, earnings are fairly critical.
Fundamentally, it is interesting to consider what future earnings a company needs to have to justify its stock price, which is a function of cash flows. Based on that analysis, one of two things occurs in the valuation model relative to companies like Amazon: you have to make wild assumptions about the future economics of the eCommerce space, or you need to violate traditional non-negativity constraints imposed on the discount rate. However, it is reasonable to evaluate each option.
Some experts have estimated that Amazon and companies like it would need to grow at phenomenal rates in the future to achieve a cash flow that would justify its current market capitalization. This estimation is as high as 200% growth every year in the next twenty years . This puts Amazon’s market share at anywhere from three to ten percent of GNP in twenty years . Other analysts argue that a future 30% share of a $230 billion market, with a five percent profit margin values Amazon’s market capitalization at $150 billion . Based on this analysis, Amazon is trading at a bargain with a roughly $15 billion market capitalization.
Discount rates are even more interesting. The discount rate is the rate at which cash flows are adjusted. These rates reflect expected rates of return and risk measurements. Defined by Breally and Myers, “The rate of return is the reward that investors demand for accepting delayed payment.” Usually, this number is not greater than one because this would imply that a dollar today would be worth less than a dollar in the future. Additionally, the discount rate is not normally less than zero.
It is interesting to evaluate what a discount rate less than zero implies. In order to use a DCF model for companies with negative earnings, this is an assumption that could be applicable. Thus, negative earnings, and therefore cash flows divided by a negative discount rate yields a positive number. A negative discount factor implies that an investor is willing to pay for the right for a company to take its money. This is analogous to paying a cover charge to enter a casino. However, there are similarities to both: as a gambler you have almost unlimited upside potential, but generally the house or insider always wins. In the later section briefly discussing day trading, we will explore this issue further.
Peter Lynch has recently popularized the PEG Model. This model is especially efficient for valuing growth stocks. The basic theory assumes that a stock should trade at a price where the stocks P/E (price to earnings ratio) is roughly equal to its long-term growth rate . Using simple algebra, the price of the stock should be a function of the growth rate times earnings: P = G * E.
The model tends to work well. However, to calculate a reasonable value, it is necessary to have positive values for growth and earnings in the future. As earnings approach zero, the P/E ratio is equal to infinity. Coordinately, zero earnings would imply a price of zero based on the model. Although, most users of the model assume a positive gross margin at some point in the future and back into a price or P/S (Price to Sales) ratio.
Two other popular models used in valuation attempts include P/S and P/BV ratios. These models are fairly complex, and the subject of upper level Finance classes. As a result, they will not be discussed here.
Based on financial models, it would appear obvious that eCommerce stocks are overvalued. It is interesting to ask why. Different experts propose different hypotheses. Perkins and Perkins refer to this overvaluation as the “Internet Bubble”.
The reasons for overvaluation seem to come from the active participants in the stock market and the Internet game. These players include day traders, venture capitalists, investment bankers, and large institutional investors. All of these groups pump up valuations via their actions.
Venture capitalists are quick to take companies public these days due to huge upside potential for their portfolios. Often times, those companies have not made a profit. Additionally, the venture capitalists exert great influence over the market by engaging in deal making between clients in an effort to augment the strength of the firms in their portfolio. Often that stable of firms is referred to as a keiretsu .
Investment banks are generally willing to play the game as well. With the recently hot market, bankers are guaranteed their standard seven percent cut for a sure bet. The bankers also collude with the large institutional investors to engage in flipping. Flipping is the art of purchasing a stock before its introduction into the secondary market, and then quickly selling it after it has made a reasonable return. In this manner, institutional investors guarantee good ROI for their portfolios, and the bankers keep the investors happy enough to charge them large transaction fees.
Day traders comprise the most dangerous constituency of the eCommerce game. Day traders are the general consumer that trades stock in the secondary market via a technologically enabled process, which usually includes a computer and a connection to the Internet. Currently, roughly 50% of American households have a stake in the market. This is higher than ever. Unfortunately, a large majority of these individuals have put themselves in dangerous leveraged positions in order to “play” the market. Some have taken out second mortgages, traded on margin, or used a large portion of their portfolio that would not normally be invested in stocks with such a high-risk profile.
Although macroeconomists make the argument that investment is healthy and necessary for the economy, the fact is not true of pure speculation. Day traders tend to speculate on stocks based on their limited information. Often, they get their information from investment chat rooms or other day traders. As a result, herd mentalities form and stocks are traded based on irrationality as opposed to sound financial data. In the final analysis, stock prices become overvalued based on unrealistic consumer optimism.
This form of speculation is akin to betting. As noted in the DCF model discussion, it is possible that the day traders activities are akin to gambling. They pay the premiums on the stock for the right to speculate. Day traders seem to exhibit addictive behavior patterns similar to gamblers.
All of these groups and facts combined with what may be an unhealthy optimism perpetuate and exacerbate the “Internet Bubble.” It is critical to decide whether the optimism about the Internet is unhealthy. Obviously, individuals that have invested heavily believe that the optimism is based on reasonable assumptions. These assumptions are the basis for the argument that the eCommerce stocks are adequately valued or undervalued.
5. Adequate or Under Valuation Arguments
In terms of assessing whether or not an eCommerce stock is fairly valued it is important to look at the company’s assets. Assets in this case are not defined necessarily as pure accounting balance sheet assets. With the advent of the Internet there are other assets that are critical other than inventory and property, plant, and equipment. In the information age, information is king. Baruch Lev, the Phillip Bardes Professor or Accounting and Finance at NYU’s Stern School of Business states: “The only limit to your ability to leverage a knowledge asset is the size of the market.”
Furthermore, Mr. Lev defines four broad categories of intangible assets that are increasingly more valuable: assets associated with product development, assets associated with company brand which let a company sell its products at a higher price than its competitors, structural assets or better business models, and monopolies or sustainable competitive advantage . Based on that definition, first mover advantages have some long-term value, the capture of market share has value, customers and information about them has value, and so do strategies that lead to a new business model or a sustainable advantage.
It is probably reasonable to assert that the B2C eCommerce space is currently crowded. There are so many “.com’s” competing for market share these days that it is unreasonable to believe that all of them will survive. This implies a certain amount of “Internet Bubble.” It is possible, however, that some of the eCommerce-oriented companies are not overvalued based on the above analysis of assets and a few other key assumptions. Based on the crowded state of eCommerce it is reasonable to assume that a large majority of these companies will fail.
At the turn of the century there were over a 100 car companies in the United States. Today there are less than 20 in the world, and that number is shrinking yearly. The eCommerce industry will condense its competitors also. When that happens, the large conglomerates that obtained the first mover advantage, cultivated a large consumer base, developed defensible information based strategies, and provided an eChain environment will be left to reap the benefits of their positions.
Those positions will be very valuable from a future earning and cash flow perspective. If consolidation occurs, and the Internet continues to flourish; it is not unreasonable to expect Amazon to capture 30% of a $230 billion industry. Similarly, the other eCommerce oriented companies that are number one or two in their niche in a consolidated market will be able to justify current stock prices.
The use of technology has exploded in the Western World and it continues to grow around the rest of the world. If the Internet continues to reach its potential, it is very reasonable to assume that there is an opportunity to capture large customer bases around the world. Owning eCommerce stocks today is similar to buying a call option on the future of the Internet. It is possible to lose a set amount of money, but there may also be unlimited gain. The questions are: do you believe in the potential of the Internet, and is it a risk that you are willing to take?
As a priest once said at my undergraduate university, “There are only two things that I know in this world: there is a god, and I am not him.” This quote nicely illustrates the ambiguity of life, even if you do not believe in a higher power. Relative to the Internet and the valuation of stocks, the only thing that I can conclusively believe is that there is an Internet, and I wish that I had bought Amazon when it went through its IPO.
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4.Korper, Steffano and Juanita Ellis, The E Commerce Book Building the E-Empire, New York: Academic Press, (1999).
5.LEK Consulting Presentation on eCommerce Stock Valuations, Given at the Wharton School (October 1999).
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