FREE ESSAY ON ECOMMERCE COMPANIES AND STOCK VALUATIONS

ECOMMERCE COMPANIES AND STOCK VALUATIONS

eCommerce Companies and Stock Valuations
1. Introduction
A hot topic in today's business culture is eCommerce. Experts argue about whether
eCommerce will change business, whether or not it is a fad, and what viable strategies
there are in a business world that is changing at the speed of idea generation. One thing
that nobody argues about is the fact that eCommerce oriented companies have stock prices
and market capitalizations that are enormous. Based on losses rather than earnings, some
of these stock prices are inexplicable.
This paper is a thought experiment that attempts to gather and disseminate data regarding
these stock prices. Additionally, the paper will attempt to propose solutions and reasons
for the current market trends relative to eCommerce companies.
2. Discussion of the eCommerce business models
When discussing eCommerce, it is good to have a frame of reference. As a result, it is
interesting to review the common models associated with the field of study. 
Generally, there are two widely recognized business models regarding eCommerce. These
models include the B2B (Business to Business) model and the B2C (Business to Consumer)
model. The fundamental question regarding these models is: is the specific model in
question a revolutionary way of doing business, and hence a new business model; or is the
specific model in question a facilitation of a mature business model.
Depending on which model you are discussing you may get different answers. The B2B model
is much more common. B2B eCommerce is roughly five times more prevalent than B2C
eCommerce . Following is a discussion of the models, and answers to the above question.
2.1 B2B (Business to Business) 
To reiterate, it is important to decide whether or not B2B is a fundamentally new
business model, or a facilitation of existing business models. It is easy to answer this
question when one looks at history. The fundamentals of B2B eCommerce have actually been
around for decades. B2B eCommerce is the new en vogue term for supply chain management in
the majority of forms in which it is implemented. 
In reality, supply chain management has been around since the Industrial Revolution. It
has just become expedited with the advent of communications technology: the telegraph,
the telephone, the computer, easily designed software, LANs and WANs, EDI, and now the
Internet and eCommerce .
B2B eCommerce does not change the majority of business models developed for
intra-business commerce. It simply facilitates the process by offering information more
quickly, more timely, and more accurately. However, there may be an opportunity with B2C
to do more than just facilitate old processes.
2.2 B2C (Business to Consumer) 
The advent of B2C has created a new competitive landscape. The strength of the Internet
is dispersion and dissemination of information on a large expedited scale. Consumers can
access information quickly and so can organizations and businesses. B2C eCommerce has the
following positive attributes for consumers:
? Consumers can access product and service information quickly and efficiently
? Browsing, ordering and purchasing are virtual and therefore expedited
? Informational asymmetries are broken down and markets are more efficient and
competitive
? Time saving allows more time for leisure activities
B2C eCommerce has the following positive attributes for businesses:
? Companies can gather information about their customers easily
? Based on better consumer profiles and information systems, companies can engage in
market micro-segmentation
? Costs can be reduced due to less brick and mortar rental and construction expenses,
less SG&A, fewer print ads, more focused marketing efforts, better defined advertising,
and potentially lower inventory holding costs based on augmented demand predictability
? Companies can reach more and more potential customers because the customer's ability to
purchase is not bounded by geographical parameters associated with traditional business
models such as brick and mortar
However, there are negatives aspects of eCommerce for both the consumer and the business
proprietor. The customer gives up a certain amount of anonymity when he/she allows
information to be collected about him/her. This information can be used for questionable
and leveraged positions by businesses. A consumer may experience information overflow.
From a business perspective, the availability of information to the customer is dangerous
to a certain extent. Perfect information implies perfect competition. Perfect competition
implies low or non-existent margins, and therefore minute profits and earnings. This is
especially true of commodity-oriented products. Successful eCommerce oriented businesses
need to position themselves as an eChain solution in order to compete on bundled goods
and relationships.
Although there is downside potential for B2C eCommerce businesses, these are the
companies that have caught the eye of the media and the public. With companies like
Amazon and eBay earning little or no profits, but deriving huge market capitalizations;
it makes B2C interesting to study from a stock-pricing standpoint. The rest of this paper
is dedicated to answering that question: what drives large stock prices and market
capitalizations for B2C eCommerce companies that have made little or no profits.
3. Pricing options
In terms of understanding the pricing of eCommerce stocks it is important to review
classical financial and economic models. Every investment bank on Wall Street has its own
method for valuing publicly traded entities. The following sections are a general
overview of some of the models that are traditionally used. Evaluating these models will
help to determine the reason for the strange valuations of today's eCommerce companies.
Additionally, reviewing the models may help to propose a new model.
3.1 Standard DCF (Discounted Cash Flow) Model
Perhaps the most widely used valuation model is the standard DCF. Essentially, this model
uses the net present value of future cash flows to determine a reasonable market
capitalization for a company, and then divides that number by the number of shares to
derive a stock price. The net present value of the cash flows is computed by determining
the cash flows and discounting them at some reasonable rate. 
In essence, there are two critical variables in this model: cash flows and the discount
rate. There are numerous things to consider regarding cash flows, which include
dividends, plowback ratio, and earnings. For the purposes of reviewing eCommerce
companies, dividends and plowback ratio have negligible relevance in the analysis at this
point of the eCommerce evolution. However, earnings are fairly critical.
Fundamentally, it is interesting to consider what future earnings a company needs to have
to justify its stock price, which is a function of cash flows. Based on that analysis,
one of two things occurs in the valuation model relative to companies like Amazon: you
have to make wild assumptions about the future economics of the eCommerce space, or you
need to violate traditional non-negativity constraints imposed on the discount rate.
However, it is reasonable to evaluate each option.
Some experts have estimated that Amazon and companies like it would need to grow at
phenomenal rates in the future to achieve a cash flow that would justify its current
market capitalization. This estimation is as high as 200% growth every year in the next
twenty years . This puts Amazon's market share at anywhere from three to ten percent of
GNP in twenty years . Other analysts argue that a future 30% share of a $230 billion
market, with a five percent profit margin values Amazon's market capitalization at $150
billion . Based on this analysis, Amazon is trading at a bargain with a roughly $15
billion market capitalization. 
Discount rates are even more interesting. The discount rate is the rate at which cash
flows are adjusted. These rates reflect expected rates of return and risk measurements.
Defined by Breally and Myers, "The rate of return is the reward that investors demand for
accepting delayed payment." Usually, this number is not greater than one because this
would imply that a dollar today would be worth less than a dollar in the future.
Additionally, the discount rate is not normally less than zero.
It is interesting to evaluate what a discount rate less than zero implies. In order to
use a DCF model for companies with negative earnings, this is an assumption that could be
applicable. Thus, negative earnings, and therefore cash flows divided by a negative
discount rate yields a positive number. A negative discount factor implies that an
investor is willing to pay for the right for a company to take its money. This is
analogous to paying a cover charge to enter a casino. However, there are similarities to
both: as a gambler you have almost unlimited upside potential, but generally the house or
insider always wins. In the later section briefly discussing day trading, we will explore
this issue further.
3.2 PEG (P/E=Growth Rate) Model
Peter Lynch has recently popularized the PEG Model. This model is especially efficient
for valuing growth stocks. The basic theory assumes that a stock should trade at a price
where the stocks P/E (price to earnings ratio) is roughly equal to its long-term growth
rate . Using simple algebra, the price of the stock should be a function of the growth
rate times earnings: P = G * E. 
The model tends to work well. However, to calculate a reasonable value, it is necessary
to have positive values for growth and earnings in the future. As earnings approach zero,
the P/E ratio is equal to infinity. Coordinately, zero earnings would imply a price of
zero based on the model. Although, most users of the model assume a positive gross margin
at some point in the future and back into a price or P/S (Price to Sales) ratio.
Two other popular models used in valuation attempts include P/S and P/BV ratios. These
models are fairly complex, and the subject of upper level Finance classes. As a result,
they will not be discussed here.
4. Overvaluation Arguments
Based on financial models, it would appear obvious that eCommerce stocks are overvalued.
It is interesting to ask why. Different experts propose different hypotheses. Perkins and
Perkins refer to this overvaluation as the "Internet Bubble".
The reasons for overvaluation seem to come from the active participants in the stock
market and the Internet game. These players include day traders, venture capitalists,
investment bankers, and large institutional investors. All of these groups pump up
valuations via their actions.
Venture capitalists are quick to take companies public these days due to huge upside
potential for their portfolios. Often times, those companies have not made a profit.
Additionally, the venture capitalists exert great influence over the market by engaging
in deal making between clients in an effort to augment the strength of the firms in their
portfolio. Often that stable of firms is referred to as a keiretsu .
Investment banks are generally willing to play the game as well. With the recently hot
market, bankers are guaranteed their standard seven percent cut for a sure bet. The
bankers also collude with the large institutional investors to engage in flipping.
Flipping is the art of purchasing a stock before its introduction into the secondary
market, and then quickly selling it after it has made a reasonable return. In this
manner, institutional investors guarantee good ROI for their portfolios, and the bankers
keep the investors happy enough to charge them large transaction fees.
Day traders comprise the most dangerous constituency of the eCommerce game. Day traders
are the general consumer that trades stock in the secondary market via a technologically
enabled process, which usually includes a computer and a connection to the Internet.
Currently, roughly 50% of American households have a stake in the market. This is higher
than ever. Unfortunately, a large majority of these individuals have put themselves in
dangerous leveraged positions in order to "play" the market. Some have taken out second
mortgages, traded on margin, or used a large portion of their portfolio that would not
normally be invested in stocks with such a high-risk profile.
Although macroeconomists make the argument that investment is healthy and necessary for
the economy, the fact is not true of pure speculation. Day traders tend to speculate on
stocks based on their limited information. Often, they get their information from
investment chat rooms or other day traders. As a result, herd mentalities form and stocks
are traded based on irrationality as opposed to sound financial data. In the final
analysis, stock prices become overvalued based on unrealistic consumer optimism.
This form of speculation is akin to betting. As noted in the DCF model discussion, it is
possible that the day traders activities are akin to gambling. They pay the premiums on
the stock for the right to speculate. Day traders seem to exhibit addictive behavior
patterns similar to gamblers. 
All of these groups and facts combined with what may be an unhealthy optimism perpetuate
and exacerbate the "Internet Bubble." It is critical to decide whether the optimism about
the Internet is unhealthy. Obviously, individuals that have invested heavily believe that
the optimism is based on reasonable assumptions. These assumptions are the basis for the
argument that the eCommerce stocks are adequately valued or undervalued.
5. Adequate or Under Valuation Arguments
In terms of assessing whether or not an eCommerce stock is fairly valued it is important
to look at the company's assets. Assets in this case are not defined necessarily as pure
accounting balance sheet assets. With the advent of the Internet there are other assets
that are critical other than inventory and property, plant, and equipment. In the
information age, information is king. Baruch Lev, the Phillip Bardes Professor or
Accounting and Finance at NYU's Stern School of Business states: "The only limit to your
ability to leverage a knowledge asset is the size of the market."
Furthermore, Mr. Lev defines four broad categories of intangible assets that are
increasingly more valuable: assets associated with product development, assets associated
with company brand which let a company sell its products at a higher price than its
competitors, structural assets or better business models, and monopolies or sustainable
competitive advantage . Based on that definition, first mover advantages have some
long-term value, the capture of market share has value, customers and information about
them has value, and so do strategies that lead to a new business model or a sustainable
advantage.
It is probably reasonable to assert that the B2C eCommerce space is currently crowded.
There are so many ".com's" competing for market share these days that it is unreasonable
to believe that all of them will survive. This implies a certain amount of "Internet
Bubble." It is possible, however, that some of the eCommerce-oriented companies are not
overvalued based on the above analysis of assets and a few other key assumptions. Based
on the crowded state of eCommerce it is reasonable to assume that a large majority of
these companies will fail.
At the turn of the century there were over a 100 car companies in the United States.
Today there are less than 20 in the world, and that number is shrinking yearly. The
eCommerce industry will condense its competitors also. When that happens, the large
conglomerates that obtained the first mover advantage, cultivated a large consumer base,
developed defensible information based strategies, and provided an eChain environment
will be left to reap the benefits of their positions.
Those positions will be very valuable from a future earning and cash flow perspective. If
consolidation occurs, and the Internet continues to flourish; it is not unreasonable to
expect Amazon to capture 30% of a $230 billion industry. Similarly, the other eCommerce
oriented companies that are number one or two in their niche in a consolidated market
will be able to justify current stock prices.
The use of technology has exploded in the Western World and it continues to grow around
the rest of the world. If the Internet continues to reach its potential, it is very
reasonable to assume that there is an opportunity to capture large customer bases around
the world. Owning eCommerce stocks today is similar to buying a call option on the future
of the Internet. It is possible to lose a set amount of money, but there may also be
unlimited gain. The questions are: do you believe in the potential of the Internet, and
is it a risk that you are willing to take?
6. Conclusions
As a priest once said at my undergraduate university, "There are only two things that I
know in this world: there is a god, and I am not him." This quote nicely illustrates the
ambiguity of life, even if you do not believe in a higher power. Relative to the Internet
and the valuation of stocks, the only thing that I can conclusively believe is that there
is an Internet, and I wish that I had bought Amazon when it went through its IPO.
Bibliography
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