Valuation of Internet stocks: Real options and earnings visibility an international perspective
The value of Internet stocks is a function of growth. As the industry reaches the mature growth stage, the source of value shifts from growth to earnings. The lack of earnings visibility is the major reason for recent devaluation of Internet firms. With 51 % of US. population on-line, investors expect steady earnings from emerged industry leaders. However, a clear vision of earnings growth is blurred with managerial lack of business savvy. In international perspective, with only 4.3% of the World population on-line, there is an opportunity of growth for firms with defined international vision and experienced management team.
Understanding the valuation of Internet stocks is an important matter not only to investors seeking investment advice, but also to managers of Internet firms as a guide in the strategic planning process. The traditional discounted cash flow (DCF) valuation models, emphasizing on cash flows (earnings) as primary value driver, tend to undervalue Internet stocks characterized with low current earnings and high uncertainty in predicting future earnings. On the other hand, the family of option pricing models, emphasizing growth opportunities as the source of value and de-emphasizing the negative profitability, tend to overvalue the shares of Internet firms. The investment opportunities approach to valuation of growth stocks, defining the value of a firm as a sum of the value of current operations and the value of growth, considers both. However, it does not specify the relative importance of each component. How important are earnings in valuation of Internet stocks at different stages of growth? What are the-managerial implications?
Although this issue has received attention from financial media, the academic community seems to be puzzled with the theoretical explanation of the advanced valuation method that combines several fundamentally different valuation models into a reliable yardstick to measure the value of Internet stocks. This paper revisits the investment opportunities approach to valuation of Miller and Modigliani (1961) and the option pricing theory of Black and Scholes (1973), in an attempt to find ideas to fill the gap in the theoretical valuation literature and to provide directions for future empirical research.
The investment opportunities approach to valuation of stocks is appropriate from the stand-point of investor proposing to buy and manage a business with an opportunity to invest capital in new assets at a rate of return higher than normal, according to Miller and Modigliani (1961). The value of such a business is a function of: a) the opportunity for abnormal returns, b) investments in new assets, c) earnings from current operations, and d) the normal rate of return. Exhibit I illustrates the Internet stock valuation process using the investment opportunity approach.
Opportunity for abnormal returns
Managers are optimistic that a firm has the opportunity to invest capital at a rate of return higher than normal, and confident in their ability to take advantage of that opportunity. From the investor point of view, in-line with semi-strong version of Efficient Market Hypothesis, it is not possible to consistently make abnormal returns based on all publicly available information, including the historical price behavior. Therefore, the traditional valuation models have ignored the value of growth, assuming that rho* =rho, reducing the investment opportunities approach to a traditional net present value model, illustrated in equation (1).
However, from the managerial point of view, the opportunity for abnormal returns exists for firms that develop a dominant technology or bring a superior product/service to the market. Boer (1998) provides a guideline (see Exhibit 2) that is helpful to determine whether new technology will create value in the future. With polarization of linkages heavily in favor of developer of new technology, it is safe to conclude that the opportunity for abnormal returns exists.
Investments in R&D and marketing
To position a firm as the leader in an industry, managers invest heavily in R&D and marketing. As investments increase (I |/ ), the value of growth increases, but so does the risk (uncertainty). However, the increase in uncertainty increases the opportunity for abnormal returns ( rho* |/ ), also increasing the value of growth. In other words, the Internet firm than invests more in R&D and marketing is more likely to develop a dominant technology and a brand name, thereby becoming the industry leader. This encouraged management to “burn cash” and overspend beyond traditional financial levels. Tokic  shows that selected sample of Internet firms spent on average 75% of revenue on R&D and marketing expenses in fiscal 1999/2000 year. Shama  criticizes the management of Internet firms for lack of vision and business savvy.
Importance of Earnings
Overspending on R&D and marketing puts burden on profitability. While short-term negative profitability reduces the value of a firm, according to investment opportunities approach, prolonged period of losses may result in bankruptcy. Lack of earnings is the major reason for recent numerous NASDQ de-listings and bankruptcies in the Internet sector. Therefore, earnings are important variables in valuation of Internet stocks. The question is when do earnings become more important to investors than the value of growth? As the opportunity for abnormal returns decreases, the investments should decrease, resulting in higher earnings. When the opportunity for growth completely disappears (rho = rho*), earnings become the only value driver, according to the NPV model in equation (1). The option-pricing model compliments the investment opportunities approach in illustrating this relationship.
Option Pricing Theory
Several authors propose (Boer 1998, Jagle 1999) the advanced valuation method for Internet stocks, based on option pricing theory. An option is a financial security giving the right to buy or sell an asset, subject to certain conditions, within a specified period of time. An investor optimistic about the future prospects of a company buys a call option with the right to buy the shares of that company at the exercise price within the time period, as specified in the option contract. As soon as the stock price increases over the sum of the exercise price and the option price, the call option is “in-the-money”. An investor exercises the option, and sells the shares at the then market price, profiting from the difference between the exercise price plus the option price and the prevailing market price of the shares. For example, if eBay stock price increases to $40 before the expiration date in April, an investor gets the option to buy eBay at $30 (strike) and sell it for $40 (then market price), making $1 profits when the value of call option $9 is deducted, as illustrated in Exhibit 3.
Since call option is a financial security, an investor can sell it before it expires, just like any other financial asset. According to the option-pricing theory by Black and Scholes (1973), the option value is a function of the current market value of shares, the exercise price specified in the contract, the length of exercise time period, the underlying volatility and the risk free rate.
Daily movements in the stock price affect the value of a call option. An increase in the stock price increases the value of a call option, signaling higher probability that the option will be in the money before the expiration date, which increases the demand for call.
Call options with higher exercise price have lower values. As the exercise price of the eBay calls expiring in April increases from $30 to $40 to $45, the value of a call decreases from $9 to $3.50 to $1.88, respectively, as illustrated in Table 3. If the exercise price is much higher than the stock price, the value of a call will be close to zero, because the option is almost sure to expire without being exercised.
The value of option declines as maturity date approaches, providing that stock price does not change, reducing the chance of exercising that option. Ebay calls with the exercise price of $30 expiring in April are worth less than eBay calls with the same exercise price expiring in July, as illustrated in Exhibit 3.
The increase in the underlying stock price volatility (dispersion around the mean price) positively affects the value of a call option. An investor predicts a sharp short-term movement in the stock price, which is possible only with the high degree of operational uncertainty. Options on shares of companies with predictable operations and low or no innovations have lower values because the probability of profitable exercise is lower.
Application of Option Pricing Theory to Valuation of Internet Stocks
The valuation of Internet stocks using the option-pricing theory is applicable from the standpoint of manager-shareholder. Rather than acquiring the right to buy the shares, the manager acquires the right to manage the firm with the opportunity to grow by entering the new market or developing the new product. Just like the call option investor, the manager is optimistic about the future prospects of the company.
The right to enter the new market represents the managerial real option. Myers  explains that the real option itself has value if a firm undertakes an initially negative NPV project just to position itself in a growing industry. Managers reserve the option to either proceed with the project development in stage two, or to abolish the project, depending on earnings visibility. Undertaking several projects at the same time creates the real option tree, where each stage of product development is assigned a probability and potential profitability. There are three major problems with the application of real option pricing to Internet stocks: 1) Internet firms have a portfolio of negative NPV projects, therefore a serious problem of negative short-term profitability; 2) real option pricing method fails to recognize that negative earnings decrease the value, overvaluating Internet stocks; 3) assigning the probabilities to each stage of product development is a highly subjective task.
Market size and earnings
Investors in call options expect that the current market price of underlying shares will increase in the future. Similarly, managers of Internet firms, that enter the new market undertaking negative NPV projects due to small market size, expect that the market size will grow in the future, reversing the value of projects. Since the market size may be small in the initial growth stage, the firm is not expected to have profits. However, as the market grows, selected industry leaders are expected to convert the value of the real option to position the company in the new market into steady profits. Similar to exercise price of a call option, ag market size increases, the value of real option to enter the market decreases, while the importance of earnings increases.
Volatility – R&D and marketing
The volatility, usually measured as the standard deviation of daily stock price, is a proxy for risk or uncertainty. In order to position the firm as a leader in a technology-intensive industry, the manager invests heavily in several R&D projects at the same time, reserving the option to abandon some projects and to continue developing other projects, based on earnings visibility as previously illustrated. Also, in order to develop the brand name and to take advantage of economies of scale, managers invest in marketing of R&D projects and already established products. The intangible nature of R&D and marketing assets and the uncertainty of future success of these investments increase the volatility (risk) of a firm, positively affecting the value. In other words, Internet firms with higher uncertainty have higher values, which is a relationship fundamental to option pricing theory. However, maximizing the value by maximizing the uncertainty is a dangerous strategy because it treats earnings as a distraction, seriously overvaluing the Internet shares.
Valuation Issues – An International Perspective
The investment opportunities approach and the (real) option-pricing model both assume that managers are optimistic about future prospects of a firm, and confident in their ability to manage the firm successfully to take advantage of opportunity, buying the firm to maximize personal wealth. In support, Schultz (2001) finds that managerial ownership in Internet firms is higher than in other firms, owners-managers are generally optimistic about the future of the firm and they are less likely to diversify personal portfolio than managers from other firms. Both models also agree that increased investments, causing the higher uncertainty (risk), positively affect the value of growth, opposite to traditional NPV models.
When to convert the value of option to cash (earnings)?
Similarly, as the market size reaches the mature growth stage, firms that entered the market at initial growth stage are expected to produce earnings. The proxy for market size of Internet related industry is the number of people on-line. Over the last few years the number of people in U.S. using the Internet for daily activities has increased rapidly to 51% of total population (see Exhibit 4). The same period was characterized with high number of Internet IPO’s and sky-high values of Internet shares. Many questioned if the Internet stocks were irrationally overpriced in late 1990’s. According to the option pricing theory, industry as a whole was not overpriced because firms entered a promising market at initial growth stage. Naturally, some firms would disappear due to mergers of bankruptcies, but emerging leaders were expected to eventually convert the real option value into steady profits, once the market reached a more mature growth stage.
As the U.S. market size grew to 51% of population on-line, the value of real option to enter already mature market for new firms disappeared, reducing the possibilities for new Internet IPO’s. As for already established industry leaders, such as Amazon.com, the source of value shifts from the value of growth to the net present value of earnings, according to the investment opportunities approach. However, Internet firms were not able to convert the value of real option into steady earnings, causing sharp decline in Internet stock prices and possibly U.S. recession. A more serious problem than lack of current profitability is the lack of earnings visibility. In other words investors are not able to forecast the increase in earnings growth, once the opportunity for abnormal returns disappears.
However, expanding the market definition to the World population can imply a tremendous growth opportunity since only 4.3% of World population, excluding the U.S., is on-line. (see Exhibit 4). Particularly high growth rates in market size are estimated in Asian countries (see Exhibit 5). U.S. Internet firms with a clear mission to expand internationally may still have the opportunity for abnormal returns and may realize the value of real option by investing internationally. Investors may evaluate the possibility to invest in emerged international Internet companies with a competitive advantage over U.S. firms in specific geographical area.
The real option pricing model and the investment opportunities approach assume that managers have sufficient business skills to take advantage of growth opportunity. Coincidently, a series of studies criticized the management of Internet firms for lack of vision and business savvy. In abundance of technical skills, young and in-experienced Internet executives ignored the traditional strategic planning and financial management rules, failing to convert the value growth opportunity into earnings.
In international context, as the percentage of World population on-line increases, individual Internet firms must develop growth strategies by matching the firm-specific strengths with the opportunity, focusing on traditional marketing/management/finance rules. The R&D expenses, as a percentage of revenue, must be reduced to sponsor a limited number of R&D projects developing a product/service with high earnings visibility. The price of that product must be competitive, below the retail-store prices. The marketing expenses, as a percentage of revenue, must be reduced to target the specific market segment, and increased proportionally as target market grows. The distribution and the payment method may be the most critical issues in international context. Possible solutions include development of international distribution centers or acquisition of local firms. Reduction of operational expenses and increased efficiency will increase earnings, which many reasonably call “the bottom line”.
Understanding the importance of earnings visibility in valuation of growth shares, managers of U.S. Internet firms have an option to enter international markets in initial growth stage reasonably expecting abnormal returns as market matures. The earnings visibility depends not only on firm-specific issues, but also on international communications infrastructure, which may take longer than expected to fully develop. But according to option pricing models, longer time horizons increase the value of an option. Internet firms with clear international vision and experienced management team have the highest probability to maximize the shareholders’ wealth.
The value of Internet stocks depends on the ability to grow, which is the opportunity to produce higher than normal rate of return. Once the industry reaches the mature growth stage, the source of value for individual firms shifts from growth to earnings. The reason for recent devaluation of Internet firms is not only the lack of earnings, but also the lack of earnings, but also the lack of earnings visibility. With 51% of U.S. population on-line, investors expect emerged industry leaders to produce steady earnings. However, a clear vision of earnings growth is blurred with managerial lack of business savvy. In the international perspective, there is a growth opportunity for firms with defined international vision and experienced management team.
With the continuous innovations in high-tech industry and opportunities for global expansion, it is likely that many firms will have the opportunity for growth in the future. Therefore, valuation of growth stocks remains a critical issue for investors. The future empirical research should focus on topics such as the option-like feature of managerial decision process and its’ impact on firm value, and the timing of the market size growth with earnings visibility.
Damir Tokic is affiliated with the University of Texas – Pan American and the New Finance Research Institute.
Copyright Credit Research Foundation Fourth Quarter 2001
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