honey, love the one you're with"
--Stephen Stills, Love the One You're With
As Wall Street begins to grapple with the lingering effects of a seven-year bull market, the financial crisis in Asia, and the undeniable shortfall in second-quarter earnings, the ground underneath our feet just doesn't seem as strong as it once did. For those of you investing in Internet stocks, gauging the solidity of the earth below is even more difficult given the daunting distance from the bottom of your shoes to the actual surface of the earth. Perhaps everything is fine--at press time, Internet stocks were quite resilient. However, if recent market skittishness has caused you to reassess, make sure that you're not overly exposed to the risks of the "proxy" valuation.
Any financial academician will tell you that the only proper way to value a stock is to predict the long-term cash flows of a company, discount those amounts back to the present, and then divide by the number of shares. As this is much easier said than done, many practitioners often shortcut the process using tools that serve as a "good enough" proxy for cash flow. One good example is the price-to-earnings ratio. It's not a perfect measure of cash flow, and there are many loopholes, but as John Maynard Keynes said, "I would rather be vaguely right than precisely wrong."
In certain emerging markets, particularly ones that are capital-intensive, the cost of market entry is so high that even market leaders lose money for several years before eventually turning profitable. This presents a bit of a dilemma for the typical investor, as his or her standard proxy tools are irrelevant because the variables used for computing valuation--earnings, earnings growth, cash flow per share--all may be nonexistent. Rather than throw in the towel, innovative investors must turn to new proxies based on variables that are indeed measurable. Simply make some assumptions that tie the proxy back to standard valuation tools, and you are on your way.
The cable television and cellular telephone industries owe a great deal to the proxy valuation. The cash flow required to build these communication infrastructures was so high that most of the market players performed quite poorly when evaluated using standard valuation tools. However, many optimistic investors "knew" that these companies eventually would reach economies of scale that would then lead to profitability. Therefore, with no earnings to measure, these investors grabbed hold of any variable they could.
In the cable television era, the variable that was most commonly used was "homes passed." Divide the market value of the average cable company by the average number of homes that potentially could subscribe to the service in order to calculate the value per home passed. This proved to be a useful tool for valuing cable franchises, and one always could rationalize the value by calculating a rough estimate of what the lifetime value of a single customer actually should be. Two other variables that proved popular in both cable and cellular were price per subscriber and Earnings Before Interest, Taxes, Depreciation, and Amortization--also known as EBITDA (more on this later).
The Internet is going through a similar stage. Investors, who are rightly optimistic about the future and potential of the Internet, are anxious to invest in companies that are clearly many years away from profitability (perhaps many, many years). Not to be shut out for lack of a valuation tool, these investors have created proxies that are tied to the variables we happen to be able to measure. Some popular ones include market capitalization per subscriber, market cap per unique visitor, market cap to page view, and the most popular of all--market cap to revenues.
While abstract proxy valuation tools are indeed risky, there is no reason to belittle those that use them. Keep in mind that, even while these tools are inaccurate, they still offer a distinct advantage over the alternative of holding one's finger in the air. In addition, the advanced risk that is apparent in these situations typically is offset by a greater potential upside. Columbus never would have discovered America if he had waited around for someone to invent the Global Positioning Satellite. Many investors in the cable and cellular industries were handsomely rewarded for betting big and betting early, and the same reality already has been proven to hold true on the Internet.