Practical Magic, or How to Value a Net Stock

Also, repricing rumblings and the six steps to getting a Net clue.
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Investors in Net stocks hunt endlessly, it seems, for valuation metrics. Well, not all. Many undoubtedly subscribe to the theory humorously espoused by

Roger B. McNamee

, the tech-stock pundit who also does some investing on the side. Net stocks, jokes McNamee, are cheap at 50, fairly valued at 150 and inexpensive again at 200 because they're about to split four-for-one.

One tech investor who's digging just a little deeper is Charles A. Morris, who succeeded McNamee in 1991 as portfolio manager of

(PRSCX) - Get Report

T. Rowe Price's Science & Technology Fund, now a $5.8-billion heavyweight.

Morris, like every other big tech investor, plays the Net. But he notes investors should try not to think about "Net" stocks. Instead, "the Internet is spread out all over the place," says Morris, correctly calling

Amazon

(AMZN) - Get Report

a retailer,

Yahoo!

(YHOO)

a media company and

PSINet

(PSIX)

a telecommunications service provider.

The distinctions are important, because they lead to a demystification of all things Internet. Morris, who goes by Chip, then applies some math to his labeling game in an effort to get a "practical P/E," or price-earnings ratio, for Net-oriented stocks.

Morris's metric takes a company's price-sales ratio and divides that by its targeted net margin. The effect is to hone a simple price-sales metric by awarding more value to potentially more profitable companies, regardless of their revenues. The model, says Morris, allows investors to compare high-flying Net stocks not only to each other but also to leaders in the rest of the tech sector and other industries.

Let's see how it works in practice, using back-of-the-envelope calculations for Amazon to ease understanding.

With Amazon trading around 150 and, with 157 million shares fully diluted, the stock currently is worth roughly 17 times estimated 1999 revenues of $1.4 billion. Assuming net margins over time of 6% -- a big assumption considering Amazon isn't profitable -- the company would have a "practical P/E" of 283.

Assuming an average annual earnings growth rate of 60% for Amazon, and assuming that -- as a leader -- it deserves a multiple-to-earnings-growth rate of about 2.3 -- which is a level common to other leading companies in and out of technology -- Morris figures Amazon is worth 138 times earnings, or about half its current valuation.

"At some point in the not-so-distant future there has to be a reconnect with economic value," says Morris, who adds that he'd buy Amazon's shares for somewhat more than half their level but not at the current price.

There are some caveats to keep in mind when considering words of wisdom from a fund manager like Morris. First, T. Rowe Price has so much money to manage that it typically makes only very large investments. That means Morris won't even consider stakes in small companies that don't have the potential for big payouts. Second, smart guys like Morris have been predicting "rationality" would hit Net stocks for as long as the sector has existed. Remember late last year when the former Internet analyst at

Merrill Lynch

, Jonathan Cohen, guessed Amazon would fall to a split-adjusted 17 and the current Merrill maven,

Henry Blodget

, guessed it would go to a split-adjusted 133?

The difference could be that now investors are becoming less and less willing to cut profitless Net wonders some slack.

Then again...

It's not exactly like death, but...

Watching offline companies ponder their fates in the Internet age is a painful process. It's so painful that Bradford C. Koenig, who honchos technology investment banking for

Goldman Sachs

in Menlo Park, Calif. (and who wasn't personally involved with Tuesday's Goldman-led IPO of

TheStreet.com

(TSCM)

), likens the realization process to the well-known stages of facing one's final fate.

Think of any big, slow company -- many are Koenig's clients, grasping for a Net clue -- when reading his morbid but accurate five stages of Net awareness with paraphrased commentary:

1. Ridicule: "What a lousy way to make money!"

2. Bemusement: "How interesting that everyone's paying so much attention to such a small operation."

3. Recognition: "Wow, they're growing quickly."

4. Fear: "That 18-month-old company is taking share from us!"

5. Panic: "I'll be out of a job if I don't get a Net strategy soon."

"There's not a CEO in the country and probably the world who's not completely focused on how the Internet will transform their business," says Koenig, who asserts that only after "panic" does a big company move on to the crucial Stage No. 6: Action.

Wishful thinking?

Alfred J. Castino, CFO of

PeopleSoft

(PSFT)

, knows about repricing stock options. The Pleasanton, Calif.-based maker of software for big companies repriced its employees' options on Dec. 14 at 22 after the company's stock plunged from a high of 52 1/8 earlier in the year. That's why

NationsBanc Montgomery Securities

analyst Robert Austrian invited Castino to participate in a telephonic panel for clients about new accounting standards that will make it more difficult for companies to play the repricing game.

Castino took umbrage, however, at the suggestion that the new standards -- still being pondered by the

Financial Accounting Standards Board

-- will affect PeopleSoft. (Readers of fine print might want to check out the FASB's draft

proposal.)

"We certainly hope to never be in a situation where we have to reprice again," said Castino.

Happy thoughts, to be sure. But PeopleSoft's shares kept falling after the repricing, hitting a low of 11 1/2 three weeks ago and closing Tuesday at 14 5/16.

Castino argued -- as do all senior executives at tech companies in this pickle -- that the repricing is necessary to retain employees. But the employees who exchanged high-priced options for new ones also agreed to push out their vesting period by six months and not to exercise any repriced options for the same period.

The FASB wants to penalize companies that reprice by forcing them to reduce earnings by the amount employees profit from repriced options, a fair proposal. The companies themselves will continue to whine that repricing is crucial in Silicon Valley because employees otherwise will leave for greener pastures.

But if repricing is always the solution, one that's not available to shareholders, doesn't that turn options into an entitlement rather than an incentive?

Adam Lashinsky's column appears Mondays, Wednesdays and Fridays. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. Lashinsky writes a monthly column for Fortune called the Wired Investor, and is a frequent commentator on public radio's Marketplace program. He welcomes your feedback at

alashinsky@thestreet.com.