For all the talk of Bubble 2.0, the Internet has investment characteristics that investors normally have to wait decades to see: phenomenal growth in front of it, and deep-value characteristics.

When is a company a deep value?

  • A great balance sheet: Cash on the books and no debt, so that you know there is zero chance the company will have financial troubles anytime soon.
  • Strong cash flow: Hypothetically, if a company has a market capitalization of $100 million and earnings of $10 million, that's a 10% earnings yield. Compare that earnings yield with other comparable investments (for instance, a Treasury bill at 4%) and you can determine which is the better investment. Part of the calculation involves determining if those cash flows are stable. Will the company consistently earn 10%? If the company is growing, then you've got the best of every world -- it's like a bond, where the coupon is actually increasing over time.
  • Right now, there are several deep-value plays in the Internet world; I've written about some of them in my Internet Review newsletter.

    RealNetworks

    RealNetworks ( RNWK) posted earnings Thursday night that failed to impress the market. Let's take a step back and look at the fundamentals.

    The company announced it will have $800 million in cash at the end of the fourth quarter. It will have $100 million in debt, so that's $700 million in net cash. The company also will have about $250 million coming to it as a result of its antitrust settlement with Microsoft ( MSFT). Those payments will be made over the 15 months following the fourth quarter. So now we're at $950 million net cash. That's $5.33 a share in cash, leaving the company with an enterprise value of $340 million, or $2 a share.

    Prior to the settlement, analysts were projecting earnings of 11 cents a share, which would amount to an EBITDA (earnings before interest, taxes, depreciation and amortization) of roughly 16 cents, giving RealNetworks a multiple of enterprise value divided by EBITDA of 12, or an earnings yield of about 8%. Note that 11 cents per share is significantly below its run rate of 24 cents a share.

    How stable is that earnings yield? With Microsoft now an ally and income having grown for the past five quarters, it's a fair bet that it's stable and growing. For the fourth quarter, RealNetworks forecast revenue of $81 million to $85 million. Analysts were hoping for $87.5 million, but RealNetworks said that the benefits from the Microsoft relationship won't really kick in until 2006. This is the reason the stock fell.

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