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Facebook, Inc.'s current PE ratio of ~80x creates questions around valuation methodologies. Other internet companies have higher PE ratios, with LinkedIn Corporation's ratio close to 700x and Amazon.com Inc.'s ratio being around 175x. These companies also have significant valuation multiples relative to free cash flow. The following table shows select internet companies and their valuation multiples:

Valuation Multiples for Internet Companies
 Ticker Name Recent Price (\$) Trailing EPS Trailing PE Forward EPS (\$/share) Forward PE GOOG Google Inc. 591.53 32.99 18 50.60 12 AMZN Amazon.com, Inc. 212.89 1.21 176 2.50 85 NFLX Netflix, Inc. 70.22 2.95 24 2.16 33 EBAY eBay Inc. 40.35 2.54 16 2.73 15 YHOO Yahoo! Inc. 15.36 0.88 17 1.12 14 LNKD LINKEDIN CORP 98.52 0.15 675 1.22 81 FB Facebook Inc. 31.91 0.39 82 0.65 49 ZNGA Zynga, Inc. 6.61 <0 NA 0.37 18

Source: Yahoo Finance

Even on a forward PE basis, this shows most of these companies to have high PE ratios. Valuation multiples reflect two things: An assumed discount rate and growth assumptions. The discount rate should reflect two things: An underlying rate, usually the 10-year Treasury bond, and some premium to reflect the risk of the company's underlying cash flows. Growth is an easier concept to understand. While it might vary from one year to another, it still represents a single underlying number. This article will provide a closer look at discount rates.

One common finance approach to determine the discount rate is the capital asset pricing model (CAPM). The CAPM inputs are the risk free rate, beta, and market risk premium. The most critical variable is beta. While the market risk premium is subject to debate, it should reflect a constant value. There are additional textbook approaches that use multi-factor models. One can also select arbitrary hurdle rates that reflect more intuitive assessments of risk. The essence of the discount is understanding and quantifying the measure of risk.

Beta provides an Analytical Approach

Beta is composed of two components: The ratio of volatility between the security and the market and the correlation between security and market returns. For example, a company could have high volatility and low beta if it has a low correlation to the market. The following table shows several leading internet companies and their betas.

Beta of Select Internet Companies
 Ticker Correlation 48 months Volatility 48 months Ratio Implied Beta SPY 100% 5.7% 1.0 1.0 GOOG 60% 8.8% 1.5 0.9 AMZN 44% 10.8% 1.9 0.8 NFLX 21% 19.2% 3.3 0.7 EBAY 76% 11.1% 1.9 1.5 YHOO 57% 8.8% 1.5 0.9
Source: Yahoo Finance for monthly split and dividend adjusted prices. Author calculations. Insufficient history is available for FB, ZNGA, and LNKD.

The first observation is that most of these internet companies, with the exception of EBAY, have relatively modest betas. This is due to low correlations, not low volatilities. NFLX has extremely high volatility - largely due to its sharp run up and then decline over the past 18 months. Google Inc. and Yahoo have lower volatilities, but they are still higher than the market's volatility of 5.7%.

Beta is a historical measure and can change over time. A large change in beta probably suggests that significant new information about a company has been revealed and it would necessitate a reassessment if one has a position in that company. This would apply in the case of NFLX.

Since it is a historical measure, it raises the question of whether the recent historical risk profile is similar to the expected risk profile going forward. It is always important to understand how a derived metric is calculated so you can make your own assessment as to how you should use it when making an investment decision.

While capital asset pricing models using betas are not ideal, they do provide a structured approach to quantifying discount rates. Another approach is to run the cash flow assumptions in reverse and ask the question of what discount rate is necessary to achieve a fair valuation. From that point, one can make a subjective decision as to whether it too low, meaning the stock is over-valued, or unreasonably high, meaning the stock is under-valued. The beta itself does not offer any guidance to a stocks relative valuation.

Qualitative approaches

Another approach to understanding risk is through a qualitative assessment. One can look at a company and identify major risks, technology, regulatory, competitive, availability of substitutes, etc and score those ratings on a scale from 1 to 10. The scales should be clearly defined with descriptions as well as example companies. The critical issue is not the scale but rather having done a thorough and rigorous review of the risks present for the company.

Conclusion

From my personal perspective, having reviewed valuations for these companies, I think FB and AMZN are overvalued and GOOG is moderately valued. In terms of risk, I see substantial risks for NFLX. I also see potential regulatory and business model risk for FB. While LNKD provides some clear business value in terms of connecting professionals and has multiple potential revenue streams, including subscription fees, there is still a question around valuation. Even its forward PE ratio is high.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.

Disclosure: I am long SPY.