We all know that investing can be a very complex and, in many cases, even daunting experience. When it comes to Internet stocks, there is certainly an inescapably huge investment opportunity. However, there is a lot to be said about valuing each company. By default, we associate all technology stocks with inventions and innovations, while investors expect high R&D costs and steady stream of progress.
While progress increases the likelihood of survival in this highly competitive, technology-savvy environment, we shouldn't forget about fundamentals. Knowing a company's numbers and growth statistics inside and out helps to filter out companies that are trading for way more than they're worth.
A good example of a successful investment is Google (NASDAQ:GOOG). Trading at $757.84 a share (down 2.13% from its historical high of $774.38 a share), Google has made a truckload of money being the biggest search engine and online advertising platform. In addition to its online presence, Google has acquired a stake of the mobile market along with a couple of "here and there" investments. We all know that early Google investors did a great job picking the right investment that, if held until today, has turned into 791%-plus in capital gains.
Click to enlarge image.
When it comes to picking a better investment alternative with fewer dollars per share for the same level of financial performance, it's not rocket science. At $85/share on Aug. 18, 2004, Google was valued at a P/E ratio of 80, which is a pretty high price margin for a company producing $0.25/share in net income. However, given that LinkedIn's (NYSE:LNKD) P/E ratio is around 848 these days, Google was a "slick deal."
In fact, many investors would not even look at Google's P/E ratio since, back in 2004, each dollar of investment into Google barely generated a couple of cents in profits. Alternatively, they will look at the growth potential given that Google has constantly been increasing its revenues, resulting in 240% revenue growth in the first year post-IPO. One of Google's largest early investors, Fidelity Investments, owned about 5.6 million shares, valued at $124.6/share as of September 2004, that have turned into $2.86 billion today.
So how can we find a "gold mine" while it's still covered in mud? Some value investors would suggest you should look at a company's fundamentals, such as P/B, debt/equity, FCF, and DCF. However, most of these valuation criteria will never work for growth stocks -- especially in the Internet space.
Price to Book
With the P/B ratio, we're looking at how much investors are willing to shell out for every dollar in a company's assets. Since applications of the P/B ratio in real-world analysis suggest elimination of intangible assets, this index is useless in analyzing Internet stocks.
Debt to Equity
Since it's pretty unusual for Internet companies to be heavily leveraged with debt, the debt/equity ratio will not likely support or reject any investment ideas. Although this indicator will not lead to any investment decisions, being aware of the above-industry debt/equity numbers will still help to eliminate bad investments.
Given that in most cases the amount of a company's earnings is almost never equal to the cash the company brings, free cash flow is a way to look at how much money the company is left with after all capital investments. However, given that most Internet growth stocks reinvest all their cash flow back into R&D and market acquisition, free cash flow will not necessarily point out the gold mine.
Discounted Cash Flow
One of the most common "retro" valuation tactics is looking at DCF. However, DCF requires positive revenues, while every other Internet company goes public with a negative track record.
This brings us to the conclusion that investing in Internet companies -- unlike other, more "asset-backed" firms -- is pure gambling. We can certainly look at a successful track record of monetization, either at the company or in its management, but the likelihood of continuous development is still uncertain.