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Understanding Internet Valuations: An E-Business Imperative

It is the dawn of a new era.A wonderful
technology promises to revolutionize
processes and communications,indeed
everyday life.However,businesses are
facing tremendous difficulties in trying
to value strategies and options regarding
this technology.Many are perplexed
about investment requirements.Others
have concerns regarding the cannibalization
of current business models.
This describes our current experience
with the Internet.Could this just as
easily describe the emergence of the
telephone or the introduction of the
steam engine?
Companies in the Internet business
or firms integrating e-business into
their strategy face similar decisions
as their predecessors when societychanging
technologies challenged
their markets. Strategies that create
value need to be identified and selected.
Investment decisions have to be made.
Companies considering strategic
initiatives need to appropriately value
the alternatives.
As the Internet evolves,companies
are being formed with innovative
products and services on a daily basis.
This has led to the complex question
of how one should value these new
companies or the e-business portions of
existing companies.This is an unavoidable
issue for executives.For example,
exchange-of-shares transactions are
common among Internet companies
and assessing the intrinsic value of those
shares is critical. Also,valuing and
Our objective in producing this
newsletter series is to present topics that
you have expressed an interest in and
that illustrate the benefits of applying
Shareholder Value to your strategic
and operating functions. If there is a
Shareholder Value topic that you would
like to see discussed, please contact
Leon Schor at 1-800-929-4535 ext.
9565 or by e-mail at L_Schor@lek.com.
If you would like to receive a complete
set of our SVA Newsletter series or
if others in your organization would
like to receive our publication, please
feel free to contact Leon.
continue on page 2
L.E.K. Consulting llc
comparing alternative strategies and
investments is a management challenge.
However, it should be comforting
to note that while the Internet may
seem overwhelming,many existing
valuation tools can be applied in the
cyber-world just as they have for
more traditional companies.
In past SVA newsletters,L.E.K.
has tackled topics such as valuation and
market signals analysis and discussed
our belief that the value of a company,
or of any underlying asset,is best calculated
by discounting its expected cash
flows.This analysis can be performed
even for Internet companies that have
limited revenue and negative operating
profit.The bulk of their earnings and
cash flow is expected in the future
when more customers are on-line,
when greater on-line advertising occurs,
or when more business is transacted.
The reality is that all Internet companies
must eventually offer goods or services
that result in revenues,operating profits
and cash flows.
Frameworks for Analysis
Consider two types of Internet
business models:
E-commerce company
This type of company has a novel business
model that involves selling goods
over the Internet.It possesses significant
first-mover advantage and has the ability
to create barriers to entry and build
a significant brand.The result is the
company has the capability to grow
revenues faster than competitors.It can
potentially build economies of scale
in its purchasing, pick and pack, or
customer service functions resulting
in greater margins than competitors. A
valuation of an e-commerce company
can be quantified using assumptions for
revenue growth,margins,and required
investment based on its strategic plans.
Internet portal company
This type of company relies upon several
sources of revenue including advertising
and transaction fees.To quantify
the value of this company,one must
make assumptions for this portal’s
different sources of revenue,margins,
and required investment.The portal
is building a recognized and valuable
brand name and providing well organized
and proprietary content that can
drive more traffic.Results can be greater
advertising and transaction revenues.
To create value, the investments made
to build brand equity, distinguish its
content, and to improve the site’s
navigation must result in:
– Greater revenues
– Improved margins
– Less future investment
The key in both of these types
of companies is that their value is still
a function of the expected future cash flows
and the level of risk associated with success
or failure.The difficulty is forecasting
reasonable performance scenarios.
Therefore,it is instructive to look at
existing Internet companies to see what
underlying assumptions would justify
their current market valuations.In other
words,what are the implicit assumptions
regarding an Internet company’s
future performance that would justify
its current valuation? Is the valuation
based on the current business that these
companies are operating in today or is
the value based upon the opportunity
to expand well beyond into new
products,services and global markets?
Valuing Amazon.com,
eBay and Yahoo!
To analyze the assumptions behind
the current valuations,L.E.K.chose
three benchmark firms with different
business models. First,we looked at
Amazon.com,the on-line retailer of
books,CDs,movies and other goods.
Second,we analyzed eBay,the on-line
auction house.Finally,we examined
Yahoo!, the popular portal company
that recently acquired GeoCities and
L.E.K.used a similar methodology
for each company:
• Gather historical data to determine
the past and current performance
of the company, its cash and debt
position, and its current market
• Calculate a weighted average
cost of capital using the capital asset
pricing model (CAPM).
• ReviewWall Street analyst reports
that focus on the performance
projected over the next few years.
• When devoid of specific information,
make reasonable assumptions
for other parameters such as tax
rates and investment requirements.
• Using the collected data, create a
valuation model that would back
solve for future variables such as
revenue,margins,and investment
using the current market valuation
as a given.For this study,L.E.K.
applied a 15 year forecast period
ending in the year 2013.
Each company’s results reveal
compelling insights as to the cash flow
forecast assumptions that are implicit
in today’s market valuations.
L.E.K. Consulting llc
A 33.8% growth rate implies that
Amazon.com will achieve revenues of
nearly $71 billion in 2013.This figure
is almost equal to the expected U.S.
market for books, recorded music,
and video tapes/discs combined ($87
billion) in 2013.Since the Internet
has no geographical boundaries,what
about the global marketplace? The U.S.
is roughly one third of the worldwide
market for these products (lower for
recorded music,higher for books).This
implies that Amazon.com would need
to capture between 20% and 40% of
worldwide sales for these products or
add many new types of products to
achieve the revenue levels required
to justify its valuation.
Can Amazon.com build barriers
to entry that will allow growth at this
pace for 15 years? One threat to its
current business will be music sales that
use advances in digital compression
technology to distribute music over the
Internet.While Amazon.com could
enter this business, it is important to
note that sales would trade-off with
existing revenues from CDs and tapes.
Additionally, other competitors such
as MP3.com,EMusic.
Lycos have already gotten
a jump in this area.
recently launched an
online auction site.
While this new endeavor
will generate additional
revenues, it faces a
formidable competitor
in eBay, which has a
significant first-mover
advantage. Additionally,
as we will see in the eBay discussion,
auction merchandise sales only generate
commissions of approximately 6% to
the host website.The gross auction sales
required to generate significant net
revenues will be enormous. An acquirer
of Amazon.com or an investor in its
shares must therefore have a high level
of confidence that large,additional
revenue sources will be added in the
future to achieve these lofty revenue
levels.While still early,Amazon.com
appears to be building a track record
that indicates it can find these new
revenue sources. Among its recent
investments are drugstore.com,
pets.com,and HomeGrocer.com.
Beyond the need to find additional
revenue sources,Amazon.com must
maintain its margins over time.Current
expectations for operating margins
are in the range of 10%.As the figure
below demonstrates, small decreases
in operating margins will drastically
increase the 2013 revenues required
to justify the current market value.In
the competitive world of the Internet,
where a lower priced purchase is just
As of market opening May 21,1999,
Amazon.com had a market capitalization
of $20.8 billion based on a stock
price of $129 per share,a significant
drop from its high earlier in the year.
L.E.K.used four different investment
analyst reports for forecasts of such
items as cost-of-goods-sold, product
development,sales and marketing
expense,and G&A.The average of
these reports was taken to determine
the near-term inputs for the valuation
with assumptions made for fixed and
working capital investments.
In this model,we assumed a 3%
growth in perpetuity of operating profits
from the end of the 15 year forecast
period.To define the required revenue
growth for Amazon.com,we forecasted
costs at a percentage of revenues and
backsolved for a revenue growth rate
that would justify its current valuation.
Consistent with analyst forecasts,we
used operating margins that grew to
6% by the year 2002.We then assumed
a steady state operating margin of
10% for the period 2003 to 2013.
L.E.K.’s results find that
Amazon.com will need to grow revenues
at a compound annual growth
rate of 33.8% for 15 years to support
its current valuation.This alone is quite
a feat and implies a faster growth rate
than Intel (22.9%),and Microsoft
(32.9%) had over the past five years.
Highly successful non-Internet retailers
such as Wal-Mart and Home Depot
have experienced 5-year periods with
annual revenue growth rates over
40%.However,as these companies have
matured,they have not been able to sustain
these growth rates for an extended
period of time such as 15 years.
Amazon.com Operating
Margin/Required Revenue
10 15
Operating Margin
2003–2013 (%)

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