Henry Payne ’84
Tech stocks ride on Amazon wave

Do your due diligence on Amazon.com, and you’ll come across a startling statistic. Its price to earnings ratio, your source will say, is Not Applicable. The short explanation for this dismissal of one of financial analysts’ mainstay valuation measures it that Amazon.com has no earnings – thus, no P/E ratio. The long explanation is that Amazon.com and the many other nonprofitable Internet companies have completely upended the way the stock markets and financial analysts value stocks, bucking off traditional valuation measures like a feisty rodeo bull.

Historically, the P/E ratio has been one of the key factors in determining the value of an individual stock. One rule of thumb was that if a company’s earnings growth rate – ho much a company’s earnings were expected to grow annually – exceeded its P/E ratio, then the stock was undervalued, and therefore a wise investment. But for technology companies that have no earnings – and even for those that do, whose earnings rates can’t possibly keep up with their astronomical stock prices – that measure doesn’t hold up anymore.

Instead, enthusiastic analysts – those driving what Federal Reserve Board chairman Alan Greenspan famously described as the market’s irrational exuberance – are proclaiming a brave new economy, an economy in which traditional gauges of value don’t apply. It’s all about potential, they cry. Invest in the future.

However, investors might do better to look at the past. In an article for the January 2 New Your Times headlined “Humbling Lessons From Parties Past,” Princeton’s Burton Malkiel *64, Chemical Bank Chairman’s professor of economics and author of A Random Walk Down Wall Street wrote, “The rules of valuation have not changed. Stocks are only worth the present value of the cash flows they are able to generate for the benefit of their shareholders.”

He went on to remind new economy proponents of the similar booms in markets of the not-too-distant past: the electronics rage of 1960-61; 1972’s “Nifty Fifty” – growth stocks such as IBM and Hewlett-Packard that were called “one-decision” stocks because the only decision was whether to buy (you were never to worry about selling_; and the bio-technology fever that infected speculators during the early 1980s. All of these high-flyers crashed to earth when investors decided that real profits – and traditional valuation measures – mattered after all.

Still, says Yacine Ait-Sahalia, economics professor and director of the university’s Bendheim Center for Finance, “People enamored of the Internet are not necessarily fools. There is some reality behind what is happening.” There are compelling financial reasons, he says, why the Internet does make sense as an investment, and why investors should be looking at technology stocks. The Internet is providing “major cost savings across the economy,” and improving efficiencies in business. One example he gives is online trading: Whereas in the past a discount broker might execute a trade for $100, today online brokers offer the same service for less than $10. But, Ait-Sahalia says, what happens is that “people get carried away too far, as indeed they have.”

There are a few signs that the frenzy is beginning to subside. “The market is maturing,” Ait-Sahalia says. The NASDAQ market, where most technology stocks are traded, went through incredible fluctuations during the first quarter of 2000 as investors swung wildly from new technologies to old-economy stalwarts; the eventual result was a technical correction for NASDAQ in the waning days of March. Investors are being encouraged to put their money in profitable companies that support the infrastructure of the Internet, such as Cisco Systems, Sun Microsystems, microchip manufacturers, and telecommunications companies; share prices of consumer-driven “e-tailers” such as Amazon have languished; and formerly dedicated online companies are searching for grounded partners, most notably AOL and TimeWarner.

Finally, Amazon.com’s Jeff Bezos ’86, who frequently refers to his company as “famously unprofitable” and has generally avoided making predictions as to when he might abandon his “the more we sell, the more we lose” business model, is starting to talk about the bottom line. In his annual report he announced that Amazon’s book division had, in fact, made money in the last quarter of 1999, and that he expected its music segment also to turn a profit in 2000.

“No company cares more about long-term profitability than Amazon.com, or long-term returns on invested capital,” Bezos declared on national television in January. The question is: Will the long term be too late?

This was published in the April 19, 2000 issue of PAW.