Internet Stocks: Value and Trading Strategy Rob Freund Petter Hellman Ole Hvidsten Jiong Shao Rick Solano

Main Points Value in theory Internet shortcomings for traditional value Modifications to theory for Internet stocks Trading strategy Conclusion Questions

Value in Theory Investors want money Industry growth vs. age curve New industry - growth important Mature industry - returns important Graph

Internet Shortcomings Modern valuation theory created during a time when there was no emerging society- convulsing technology Valuation theory based on earnings and net income. Internet terminal values are unclear. Can’t use current performance to extrapolate future performance.

Laying Odds on Success of Firm’s Value Proposition Total Market Capitalization of Industry (e.g. Retail: $1.45T %, FCF Margin = 5%) Expected Market Cap position of firm (PV $) (e.g. Amazon: Market Share = 10% MCAP = $145B) Current Market Cap of firm (e.g. Amazon MCAP as of = $14.14B) Current Value of firm using existing financial performance baseline (e.g. Not Applicable - no earnings) { Bet placed by investors { Payoff to investors if firm successful Price of bet influenced by factors affecting expected future outcome (e.g. starting QB breaks leg day before Superbowl) - IN THIS CASE, MARKET HAS SET 10-1 ODDS ON AMAZON CROSSING THE FINISH LINE IN THIS POSITION

Hypothesis for Future Returns We must find a proxy to indicate the potential for future income. Potential proxy candidates: –MCAP/Sales –PSSG –PSSA –Sales growth

Trading Strategy Sort stocks during a particular time period and pick top 25% Stock sorted on the income proxy Positions taken at the end of the second month following the quarter used for analysis Returns calculated over three month holding period Stock returns were compared to a “buy and hold” strategy of stocks included in the H & Q Internet Index ResultsIndex

Conclusion Must use a proxy for earnings A buy and hold strategy can be beaten Current value is based on investor perceived future potential

Questions?

Industry Growth vs. Time Time Growth Rate Return

Results of Various Sort-Trading Strategies Using a simply MCAP to Sales ratio to sort yields the highest return

MCAP to Sales and Sales Growth Ratio Incorporate sales and sales growth into a valuation parameter Based on PEG (price to earnings and earnings growth) Formula - MCAP/(S*  S) As the firm/industry matures, growth declines, so actual sales must pick up the value slack

H & Q Internet index Due to MCAP weighting - the index return has been significantly skewed by a few extraordinarily successful stocks

Traditional vs. Internet Traditional –Players exist and stable –Market size identifiable –Can estimate terminal value because market size known –Extrapolate current performance based on short-term management guidance Internet –Terminal value unknown –Can’t use current performance to extrapolate Factors determining mature market performance –Margins –Market Size –Market Share