By Madhu Suthanan

A traditional stock analyst always blames an optimistic market for valuing the Internet stocks at very high levels, without paying heed to their poor fundamentals. While another lot holds that the Internet stocks are valued on the basis of inherent strength. The fight may be ongoing with no end result. Whichever way, these stocks know only one way - upwards - they have been moving up as if there is no tomorrow.

But, such high prices leads to the belief that these stocks are overvalued. The traditionalists support this view on the basis of the P/E multiple. Almost all Internet stocks currently have negative returns while some don’t even have revenues. And, the projections made don’t have any precedence to justify them. These factors lead to the perception of high valuation.

There maybe some pricing inefficiencies like in any other market. But the scarcity value has clearly played a significant part in the pricing of Internet equities. However, at the most basic level of valuation, there are only two ways of describing the value of any company (or any financial asset): discounted future cash flows and demand-supply position in the market.

A discounted cash flow (DCF) analysis calculates a company’s market capitalisation in terms of the net present value (NPV) of its future cash flows. In other words, a company can be valued by estimating the after tax cash flows that it will generate over a given period, and then determining the value of those flows today, taking into account the time value of those revenues.

Valuation methodologies like the price-earning ratios, price-revenue ratios, multiples applied to projected forward earnings, price/members or users, technology values, patent position values, marketshares, market sizes, multiple of losses, etc., are just derivatives of the DCF mechanism.

The bazaar method
The supply and demand analysis defines the value of a company’s equity and what the market is willing to pay at a given moment in time. It can be termed to be the meeting point of the marginal buyer and the marginal seller.

As stated earlier, absence of profits and in some cases absence of revenues has made the market view the Internet stocks outside the confines of the DCF analysis. In this situation, it is often instructive to analyse a company’s valuation in the context of the valuations of other companies in its peer group.

When the industry matures, the current valuation on the basis of the demand-supply scenario should change to the DCF methodology. Till then, the valuations will be based on the demand-supply scenario rather than the DCF theory.

The expectation of unabated growth of the Internet business in the foreseeable future is materialising. For most Internet companies, that growth translates into an essentially unconstrained ability to improve revenues over the next 3-5 years into the 2002-2004 time frame. At the same time, the market expects to see a shift in the investment community’s focus away from revenue growth and towards long-term operating margins. The market then will begin to more closely examine the strength of the underlying business models upon which these companies have been built. Once this happens, the market will be comfortable with the traditional investment methodologies on the basis of discounted cash flows.

The traditional scrutiny
To start with, the valuation mechanism for publicly traded Internet companies will be based on the application of price/sales multiples to the revenue projections for each company. The methodology represents a derivative approach (and is built upon the structure of) a present value/discounted cash flow analysis.

For high growth/high-margin companies, the application of price-to-revenue valuation methodology is entirely appropriate within this section. Moreover, the investors are generally aware that these companies trade at valuations that assumes continuation of the existing strong growth rates and the transition to highly profitable operations. In the international scenario, especially the US, the valuations have expanded dramatically since late 1997.

As stated earlier DCF valuations are based on the NPV calculations. The NPV calculation incorporates four key assumptions:
Risk adjusted discount rate -- approximates the rate of return which investors should expect to generate for an investment with a similar perceived level of risk.

After tax cash flows - Cash flow generated after deducting all appropriate costs, taxes, and interest payments.

Duration -- The assumed period of analysis, which should be consistent with an investor’s long-term investment horizon.

Terminal value -- The sale or market value of a company if it were offered for sale at the end of the final year of the duration of analysis.

Practically, the above theory can be explained as follows:
Let us consider a company like India.com that owns a portal site by the same name. Its projected after tax cash flows which should accrue for to shareholders of the company are Rs 1 crore, Rs 10 crore and Rs 20 crore over the next three years, respectively. Currently, almost all Internet-based companies have limited cash flows because of the heavy spending on advertisements and the activity of taking over other companies.

We could also assume that the company could well be sold for 20 times its final year cash flow, at Rs 400 crore. This, assuming that the investors expect a return of at least a 20 per cent discount to India.com’s future cash flows.

Interestingly, investors ask for a very high discount rate due to the inherent high level of risk involved in these companies. According to a wholesale investor, the discount rate that he prefers for his Internet related investments is usually double or triple his other investments.

NPV of cash flows from India.com = Rs1/(1+0.2)+Rs10/(1+0.2)^3+Rs20/(1+0.2)^3+Rs400/(1+0.2)^3 = Rs250.8 crore.

If there are 10 million shares of India.com outstanding (on a fully diluted basis), then each share could be valued at Rs 25 today.

If the current market price is lower, then the shares are undervalued and a buy signal could be given.

On the other hand, if the market price is more than the calculated one then, the shares are overvalued and a sell signal could be given. If the market price is the same as that of the calculated one then quantitatively the share is properly priced.