The Metrics For Evaluating Internet Companies

Pundits supposedly in the know regularly decry valuations of Internet stocks. They have a well-worn lexicon handy with thumbed pages that include “bubble,” “overvalued,” “hype.” But in 1994 when the first pundit jumped up and said the Internet was a fad and a bubble because the price-to-earnings (P/E) of AOL at that time was off the charts according to the industrial era P/E ratios, I had to delve deeper into the emerging phenomenon called the Internet.

What I found was I needed real tools, real metrics to evaluate really new ways of doing business. And many didn’t exist.

What resulted in the following five years since then has been a toolbox of metrics, some of which I had to invent, to properly evaluate these new animals called “Web” or “Internet” companies. Because this new fangled thing was unlike anything that had plopped on the planet before.

First an analogy. Think for a second of the emergence of the automobile and you begin to see how the old ways of thinking cloud the new. When “cars” first were invented they replaced the “horseless carriage,” hence how “cars” came to be called “cars” (from carriage).

Another term introduced to describe a car was “horse power.” Anyone who drives a car or talks to a car salesperson today hears how much “horse power” the car has.

Yet the term is empty. How many car buyers today know what one horse’s power is?

How many have ever ridden a horse? Is it meaningful to gauge a car with expressions such as “it has 250 horse power?” 250 horses cannot be ridden at once so why use it as a term to describe an entirely new way of travel? And few know what a horse’s power is anyway today.

Let’s cut the horse talk with Internet companies also. We are at a crossroads in the evolution of industry.

The next 100 years will be defined by new views, new ways of evaluating opportunities, by a new lexicon and new set of metrics thundering up and down Main Street, Wall Street and Web Street.

It’s already here and now and has been for quite some time, something I’ve been opening daily in an effort to understand the Pandora’s box called the Internet.

With a “traditional” non-Internet company the metrics are in place. For example, in a prior life as a media financial analyst I valued broadcast stocks on a discounted cash flow basis or multiple of EBITDA cash flow. Ditto newspaper stocks.

Or I valued firms in the PC space such as Apple, Sun or IBM on P/E basis. For despite being “technology” firms each is and was in the business of moving plastic boxes with silicon inside around the planet. Hard goods, hard distribution.

With the Internet there are no walls. The entire telecommunications infrastructure worldwide — a multi-trillion dollar investment made in the past 100 years — is effectively’s (NASDAQ:AMZN) store. Amazon’s cost to use it? next to zero.

How big can AOL get? Well, there’s phone lines everywhere, connecting millions of people who are not connected today in anyway. Earthlink, Mindspring same thing. The 50 companies in ISDEX all leverage this platform, all are financing their way into the future (or trying to).

The 50 stocks in ISDEX, by the way, represent 95% of the market capitalization of what I define as the Internet stock universe. At approximately $400 billion the ISDEX stocks are a blip on the overall ebb and flow of the world’s stock exchanges. Old-line thinking prevents value from being identified, evaluated and realized or perceived.

Why? The world is looking at Internet companies and using old ways of thinking, drubbing up modern-day equivalents of “horse power” to try and label the shift. Or observers who haven’t spent any time really analyzing the Internet call the sector “hype” or “bubble.”

Yes, speculation, hype, confusion, puzzlement, and more all exist in this space. But instead of coming at a new era with old metrics or your grandfather’s diction, I’m sharing with you the set of tools that I have used for five years now to begin to make sense of the new ways of doing business and ultimately valuing the Internet industry.

The categories are usually self explanatory. Some day they may be standardized across the board and especially on Wall Street, where ratios matter more than most places. A few of these are popular now but weren’t when they debuted in Internet Stock Report in 1996 (noted by *).

Let me open my toolbox (again, since some of you have seen this but now it’s updated) and show how metrics can be applied to draw out valuations and effienciencies of being an Internet business. (If any of this helps you let me know or pass this along to a friend):

Harmon’s Internet Valuation Metrics

Market capitalization/users* A reference for comparables and peers, an indicator of overall
value per reach; see WEBDEX each week for this
Market cap/page views* Indicates what a basic page view is valued at by investors
Market cap/ad views* Page views generating revenue rather than sitting blank
Private market value What private deals go for either in merger or in bidding
Customer acquisition cost What it costs to gain a new subscriber or buyer; valuable in
evaluating ISPs, etailers, auctioneers, wholesalers, manufacturers that sell on the Web
Valuation/customer acquisition cost* Useful when comparing peers to see which may be valued at a
relative discount based on customer growth efficiencies
Enterprise value Subtract cash and add debt to market cap to determine core
value of the company; particularly useful in valuing potential takeover targets
Revenue multiple (or market cap/revenue) Primary method for valuing Internet stocks since most firms
are not earnings positive. Or if they are, the P/E is often off the charts still
EBITDA cash flow multiple The way mature media companies are valued such as Time Warner,
Disney or TCI. Usually EBITDA cash flow
Revenue per subscriber Primary way to value ISPs such as PSINet, Earthlink,
Mindspring or AOL
Lifetime value of an e-buyer* This is the metric we think will be key very soon in valuing
Internet companies, especially, CDnow, Egghead, ONSALE and etailers (and it
Effective deal value What a deal went for after factoring cash and debt or other
considerations that affect the outcome of the offer
Market cap/POP* A ratio for comparing ISPs that have points of presence
Market cap or PMV to to potential market share Helpful in determing future revenue, cash flow and earnings to
see if the firm is under or overvalued to its potential
Market cap/total Internet users* The value of a firm’s reach globally per user
Revenue/direct e-marketing* Shows yield of campaign efficiency, useful for direct sellers
such as
Market cap/Websteader* Useful for valuing community of free home page providers such
as GeoCities, or Lycos’ Tripod/Angelfire
Revenue/Websteader* Measures yield on community sites, how effective
Websteads generate revenue for community firms
Price/discounted earnings Project earnings and discount back to current stock price;
especially useful for firms with losses today; Netscape’s IPO was priced this way at 50x
projected EPS two years ahead
Sales/employee How lean and mean a company operates; 1 engineer to 10
lightbulbs or 10 engineers and 1 lightbulb?
Revenue/bandwidth cost* Useful to determine how effectively management deploys its
bandwidth to generate revenue; applies to all Web firms but especially those involved in
Revenue/reach* How much revenue is generated compared to the firm’s
percentage reach points on the Web; divide by total reach percentage points

* = ratios we invented
during the past 5 years of analyzing the emerging Internet as an investment vehicle

(c) 1999
LLC – home of the ISDEX

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Accolades for Internet Stock Report:

"Fresh and provocative" -CBS
Marketwatch, who named
Steve Harmon one of the top Internet stock analysts and only independent
one honored

"I am a huge fan of Steve Harmon’s analysis"
-Kleiner Perkins’ John Doerr

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