first majestic silver

Introducing the PWE Ratio— Price to Wildest Expectations

March 4, 1999

It explains the ridiculous rise in Internet stock prices.

"If it's magic, then why can't it be everlasting?"
—Stevie Wonder, "If it's Magic,"-1975

Internet stocks were certainly magic in 1998. One major Internet stock index tripled last year. But even this trick paled in comparison to the levitation shown by well-known Internet stock like Yahoo and Yahoo ended 1998 ten times above its 1998 low. And by year-end, Amazon .com sold for 13 time its January 1998 price.

Dozens of new companies came public to join the fun. Jaded investors once considered IPO to mean, "It's Probably Over-priced." In 1998, the Internet IPO became synonymous with "Instant Profits Obtainable." But is this the kind of magic that's everlasting? Hardly.

Amazing Faith

There's certainly no denying the growth of the Internet and Internet-related advertising and commerce. There will be 320 million Internet users worldwide by 2002, compared to less than 70-million in 1997. Worldwide transactions on the Internet are predicted to reach $426 billion, up from $12billion. It is based on such grand expectations—coupled with the current vogue-ish investment strategy of buying high and selling higher—that has driven Internet stocks to magical levels. But these stocks are prices as if the Wildest Expectations has already been realized.

Consider at north of $100 per share. Despite its success in generating on-line sales, it generates only one sixth the sales of Barnes & Noble, an old fashioned company with real stores and real earnings to go with them. Yet the virtual bookseller has a market cap eight times that of the real one. In fat, owners of are so infested with optimism that they believe their stock is worth almost five times as much as Barnes & Nobles and Borders combined. But selling books and music is a slow growth business. By definition Amazon's success must come from stealing market share from other retailers. Based on its valuation, even if ran the country's two biggest booksellers out of business, it would still be an expensive stock.

Barnes & Noble and Borders together generate about $5.3 billion in sales. Barnes & Noble earns a scant 1.9 percent net profit margin, but we'll assume that the Internet's magic lets Amazon net 5 percent. That would give Amazon the ability to earn $5 a share. Slap on a generous P/E (for a retailer) of 20, and you have a stock worth $100. But Amazon already sells for $330—that is, it is already trading at a 66PWE. That is, 66 times earnings of the wildest expectations. Amazon is ridiculously overpriced.

Even if Amazonians are eventually rewarded with actual earnings, it's unlikely these numbers will march in a straight line toward the moon. For one thing, Internet advertising will become more expensive. Throw in increased competition from companies like Barnes & Noble and Borders—not to mention the ability of any mom and pop shop to open for business with a computer and an HTML decoder ring—and you have a recipe for disappointment. But Amazon .com is a stock with no room for disappointment. Even a whiff of bad news could take this stock down dozens, maybe hundreds of points. Yes, Amazon has huge potential. But it's priced as if it had already reached it.

And what about Yahoo? Of all the gold to mine on the Internet, surely portals are the biggest nuggets. Yahoo is even scheduled to make money this year and next. But advertising revenues don't simply materialize. Advertisers will have to woo business from other media. Judging from the 1998 television season, I'd say the network advertisers are the most open to alternatives. So let's assume Yahoo convinces every CBS customer to take a walk on the virtual side, thereby capturing ever dollar of the company's sales from all sources. That would take Yahoo from a company generating $200 million in revenues to one cranking out $6.6 billion annually.

Even under this rather optimistic scenario, Yahoo is already selling at more than 3 times the estimated $6.6 billion in sales. In other words, investors have already taken Yahoo from upstart to empire. If Yahoo stumbles between now and the time it runs CBS out of business investors will drop the stock like a bad sitcom. Another way to look at Yahoo is to assume it not only runs CBS out of business, but that it can be run as profitably as Disney. Even if it can pull that off in, say, a week or so, Yahoo would still sell at PWE of 39. Yet investors remain confident that a banner when no one is clicking?

Computers are able not only to determine how many people see a particular banner, they can figure out how often it is clicked. These Net-monitors even know whether or not a purchase is made from a particular advertising gimmick. So far it seems banners get clicked only about 1 percent of the time. The 'looker to book' ratio—or percentage of people who buy something—is single digits. And the ability to accurately measure the effectiveness of Internet advertising combined with the proliferation of web sites could actually drive down what Yahoo can charge for ad space.

But what about a company like AOL with a real base of subscribers and advertising revenue to boot? These guys the optimists argue, are a real company. In fact they are a little like a virtual cable company with their tow pronged source of revenue. So here, finally, is an Internet stock that can be considered a bargain. That is, the stock is a bargain if you assume that AOL can generate as much revenue as the entire cable television industry—be as profitable as Disney—and pull all this off by next week. If it could do that it would sell a PWE of 20.

Or we can value AOL another way. Let's say worldwide Internet traffic jumps to 320 million users as predicted. Let's also assume AOL persuades 13% of these users to subscribe to its service. Let's further assume the company continues to average $245 in total revenue/subscriber. Even if AOL can pull that off, the company would still sell for 5 times sales, a valuation + times that of A.H. Belo by the way is a company with 17 television stations, 7 newspapers, 3 cable news channels and earns a 6% net profit margin on its $1.4 billion in revenues.

Here's another angle. Let's say AOL starts dropping its shiny CDs from helicopters and garners half of the 320 million Internet surfers while continuing to collect $245 per subscriber. We'll further assume AOL is not only making money but is as profitable as Disney. In this most perfect of worlds, AOL would still sell at PWE of 18. The only speculative fervor that can approach this Net nuttiness in recent years is the biotech mania of the early 1990s. Investors rushed into these stocks of the future, but most wound up terribly disappointed.

Today's modern day fallen star, of course, is Netscape. In 1996 the innovative browser company sold at twenty times 'forward' sales. The company was not only profitable, it was a near monopoly. Even today, the company boast the country's 5th most popular web-site. Yet when AOL offered to buy Netscape with its own hyper-inflated common stock it proposed a price roughly half of its valuation of three years ago. And management was happy to sell. If Yahoo was suddenly priced at a similar valuation to AOL's offer price it would sell for 1/10th of today's price.

In 1934 President Franklin Delano Roosevelt devalued the dollar by raising the price of gold to $35 per ounce.
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