VALUATION PERSPECTIVE

8/20/2004

Will They All Cross the Chasm?

Valuation Perspective
The report analyzes the
markets expectations for
the future financial
performance of companies.
It also compares historical
financial performance to
different future performance
scenarios.

Google, eBay, and Yahoo Share Lofty Valuations

If GOOG, YHOO and EBAY achieve the revenue growth

implied by their valuations, their combined revenues would

represent nearly 5% of GDP.

It seems that the market is rewarding GOOG, YHOO and

EBAY with expectations for market dominance and the
strong economic profits that could result.

There is a chasm between the economic futures implied by

their stock prices and their economic histories.

To justify $100 per share, GOOG must grow revenues at

30% and achieve a 25% economic profit margin for 15 years.

To justify $28 per share, YHOO must grow revenues at 30%

and achieve a -2.8% economic profit margin for 22 years.

Contributors

To justify $80 per share, EBAY must grow revenues at 30%

David Trainer

For each of these companies, reported profits meaningfully

kiran.akkineni@newconstructs.com
615-599-4462

Note
This document is available to clients
in the Research area of our site
www.newconstructs.com.

Along with aggressive revenue growth expectations, GOOG,

YHOO and EBAYs valuations imply formidable
improvement in economic earnings.

Figure 1: Combined Revenue of GOOG, YHOO and EBAY Equal 5% of GDP

5%

Priced for Perfection & Market Dominance

4%
3%
2%
1%
0%

1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028

Kiran Akkineni

overstate economic profits.

% of GDP

david.trainer@newconstructs.com
615-599-4462

and achieve a 7.6% economic profit margin for 21 years.

Combined Revenue of GOOG, EBAY and YHOO as % of GDP

Sources: New Constructs, LLC

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VALUATION PERSPECTIVE

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8/20/2004

Will GOOG, EBAY & YHOO Dominate Their Markets?

To consider GOOG, EBAY, and YHOO good long-term investments, an
investor would have to believe that Google, eBay, and Yahoo will achieve
market dominance, and as a group represent nearly 5% of GDP 25 years
from now. This observation assumes that each of them maintains the 30%
compounded annual revenue growth rate embedded in their valuations
and that GDP grows 6.5%, equal to its historical average growth rate since
1929.
Is it possible for all three
companies to achieve
market dominance given the
overlap of their businesses?

While it is not very likely that any one of these companies will achieve the
financial performance and resulting market dominance implied by their
stock prices, it is even less likely that all three of them will achieve such
domination simultaneously. In fact, it may be considered impossible for all
three to achieve market dominance given the overlap and potential
overlap in some of their businesses.
Figure 2: Combined Revenue as % of GDP versus WMT

5%
4%

What Is Left For Other Companies?

WMT Revenue CAGR = 9.5%

3%
2%
GOOG, YHOO & EBAY Revenue CAGR = 30%

1%

1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028

0%

GOOG, YHOO & EBAY as % of GDP

WMT as % of GDP

Sources: New Constructs, LLC

Few companies in the

history of business have
been able to grow revenues
at 30% for 15 years.

In our opinion, the expected market values for Google, Yahoo and eBay
imply future financial performances that are potentially too optimistic. For
example, each stock assumes future profitability (economic profit margins)
meaningfully better than what the company has done in the past. And
each companys valuation requires at least 15 years of annual revenue
growth at 30% to justify its valuation. Few companies in the history of
business have been able to grow revenues at 30% for 15 years.

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VALUATION PERSPECTIVE

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8/20/2004

Can GOOG, EBAY & YHOO Cross the Chasm?

There is a wide chasm between the economic futures implied by these
companies stock prices and their economic histories. Figures 3, 4 and 5
compare the required future financial performances to actual historical
performances.
Figure 3: Historical Versus Future Performance Needed to Justify Valuation
Google
Performance Hurdles
Stock Price
1. Revenue Growth
2. Economic Profit Margin (Avg)*
3. GAP (Growth Appreciation Period)

Historical Performance
2002
2003
n/a
n/a
n/a
176.5%
28.0%
-22.7%
n/a
n/a

Required
Future Performance
Current Price

$100.00
30.0%
25.0%
15 yrs

*Economic Profit Margin = ROIC minus WACC.

Note: The values in this table represent the performance averaged over the respective times frames.
Sources: New Constructs, LLC and Company Filings

Crossing the financial chasm between historical and future performance

means that Google must grow revenues at 30% and maintain a 25%
Economic Profit Margin for 15 years. A 25% economic profit margin
represents a big improvement over 2003s performance. 2002s
performance is bolstered by inappropriately low stock option expense for
which the company took a special charge of $229 million in 2003. For
comparison, Googles economic earnings were $54.9 million in 2002.
Accordingly, a more Conservative interpretation of Googles 2002
financials would results in a much lower economic profit margin for 2002.
Figure 4: Historical Versus Future Performance Needed to Justify Valuation
Yahoo!
Performance Hurdles
Stock Price
1. Revenue Growth
2. Economic Profit Margin (Avg)*
3. GAP (Growth Appreciation Period)

Historical Performance
5 Yr Avg
3 Yr Avg
2003
$32.55
$13.19
$22.52
29.8%
52.7%
75.5%
-17.8%
-16.2%
-12.5%
n/a
n/a
n/a

Required
Future Performance
Current Price

$28.00
30.0%
-2.8%
22

*Economic Profit Margin = ROIC minus WACC.

Note: The values in this table represent the performance averaged over the respective times frames.
Sources: New Constructs, LLC and Company Filings

Crossing the financial chasm between historical and future performance

means that Yahoo must grow revenues at 30% and maintain a -2.8%
Economic Profit Margin for 22 years. A -2.8% economic profit margin
represents a big improvement over Yahoos historical economic profit
margins.

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VALUATION PERSPECTIVE

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8/20/2004
Figure 5: Historical Versus Future Performance Needed to Justify Valuation
eBay
Performance Hurdles
Stock Price
1. Revenue Growth
2. Economic Profit Margin (Avg)*
3. GAP (Growth Appreciation Period)

Historical Performance
5 Yr Avg
3 Yr Avg
2003
$35.95
$43.99
$64.61
76.2%
70.0%
78.3%
-50.1%
-13.8%
-4.5%
n/a
n/a
n/a

Required
Future Performance
Current Price

$80.00
30.0%
7.6%
21

*Economic Profit Margin = ROIC minus WACC.

Note: The values in this table represent the performance averaged over the respective times frames.
Sources: New Constructs, LLC and Company Filings

Crossing the financial chasm between historical and future performance

means that eBay must grow revenues at 30% and maintain a 7.6%
Economic Profit Margin for 21 years. A 7.6% economic profit margin
represents a big improvement over eBays historical economic profit
margins.

Few companies have

generated such revenue
growth while driving major
improvements in profitability
at the same time.

In our opinion, the expected market values for Google, Yahoo and eBay
imply future financial performances that are potentially too optimistic. For
example, each stock assumes future profitability (economic profit margins)
meaningfully better than what the company has done in the past. And
each companys valuation requires at least 15 years of annual revenue
growth at 30% to justify its valuation. Few companies in the history of
business have been able to grow revenues at 30% for 15 years. Even
fewer, if any, companies have generated such revenue growth while
driving major improvements in profitability at the same time.
For an analysis using different assumptions for Revenue Growth,
Economic Profit Margin or Growth Appreciation Period for any of these
companies, please contact the author.

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VALUATION PERSPECTIVE

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8/20/2004

Reported Profits Overstate Economic Profits

New Constructs rectifies

accounting distortions in
GAAP financial statements.

Google, eBay, and Yahoo's economic profits, as measured by New

Constructs, are significantly lower than their reported GAAP profits. See
Figure 6 for a list of the adjustments we make to a company's reported
GAAP profits in order to arrive at a better measure of a firm's economic
earnings.
Figure 6: Accounting Issues that Distort GAAP Profit Reports

Employee Stock Options

Pension Over/Under Funding
Excess Cash
Restructuring charges
Pooling Goodwill
Minority Interests

Off-Balance-Sheet Financing
LIFO Reserve
Unrealized Gains/Losses
Goodwill amortization
Unconsolidated Subsidiaries
Capitalized Expenses

Sources: New Constructs, LLC

Figure 7 shows the difference between Googles accounting profits and its
economic profits. The trend in profitability does not looks good for Google.
Figure 8 provides further insight into why this trend is in place.
Figure 7: Insight Into All the Costs Required To Run the Business

$150.0

Google
Reported versus Economic Profits

$ in millions

$100.0
$50.0
$0.0

2002

-$50.0

2003

-$100.0
-$150.0

Economic Profit

Net Income-GAAP

Sources: New Constructs, LLC

Cash is king. When

reported earnings and
economic cash flow
diverge, the market
follows cash.

In the case of Google, the largest adjustment relates to a deduction made

for Employee Stock Options (ESO) issued by the company, as shown in
Figure 8. We consider the stock option expense that Google reports to be
too conservative because it defers much of the cost related to option
grants in any given year over the next 5 years. We replace Googles
reported stock option expenses with our own numbers that reflect the cost
of all of the options granted in a given year. Our approach gives investors
are more realistic perspective on the annual costs Google incurs to retain
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Tools for Better Investment Performance

VALUATION PERSPECTIVE
8/20/2004

and compensate its employees. Under Googles reporting method, future

reported option expenses will be boosted by the recognition of the cost of
options granted in prior years. Rather than defer the cost of compensation
incurred in the present, our methodology captures the full cost of options
in the year they are granted.
Figure 8: Insight Into All the Costs Required To Run the Business

Sources: New Constructs LLC and Company filings

Note: In 2003, the impact of the ESO Expense on Economic Profits is mitigated by our exclusion of
non-operating expenses reported by Google, which depressed GAAP Profits but not our calculation of
Economic Profits.

In 2003, our ESO adjustment is partially offset because our economic

earnings calculation also excludes non-operating, one-time expenses that
depressed GAAP Profit. Specifically, we remove a $229 million nonrecurring, expense recorded for the adjustment to options that were issued
with below-market strike prices. Off-balance sheet financing is the second
largest adjustment we make to more accurately present Googles
profitability. This adjustment increases the reported capital by 20% in 2002
and 2003. (For a complete reconciliation between Google's reported and
economic profit, and further explanation of the full range of our economic
adjustments, please contact the author).
The cost of capital, in particular the cost of Equity Capital, is an important
cost of doing business that Financial Statements overlook. This cost
captures how much capital management needs to generate earnings or
profits. Naturally, the more profits generated from a smaller amount of
capital the better for investors. Many investors, including Warren Buffett,
consider a measurement of the capital required to generate profits an
integral component any profitability analysis. This cost capital is generally
calculated as a percentage based on a blended average of the cost of
borrowing and the cost of equity capital. Most corporate finance texts refer
to this cost as the Weighted-Average Cost of Capital (WACC). To
calculate the dollar value of the cost of capital, one multiplies WACC by all
the capital invested in the business.
Figures 9 and 10 highlight the differences between the reported and
economic profits for Yahoo and eBay.

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VALUATION PERSPECTIVE

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8/20/2004
Figure 9: Insight Into All the Costs Required To Run the Business

$ in millions

Yahoo
Reported versus Economic Profits
$250.0
$0.0
-$250.0
-$500.0
-$750.0

1999

2000

2001

2002

2003

-$1,000.0
-$1,250.0
-$1,500.0
-$1,750.0
-$2,000.0

Economic Profit

Net Income-GAAP

Sources: New Constructs, LLC

The differences between Yahoos reported and economic profits are

explained primarily by two factors: unrecognized stock option expenses
and the cost of equity capital employed by the business. Over the past five
years, Yahoo has incurred over $2.1 billion (after-taxes) in unrecognized
stock option expenses. Yahoo has over $11 billion of capital invested in
the business. Yahoos reported earnings do not recognize the fact that the
company needs this capital to generate its revenues and earnings. It is
worth noting that Yahoos balance sheet does not recognize $8 billion of
this capital because the company accounted for certain acquisitions via
the pooling method. When comparing the companys NOPAT (Net
Operating Profit After-Tax) to the amount of capital invested in the
business, Yahoos ROIC (Return on Invested Capital) falls well below its
WACC (Weighted-Average Cost of Capital).
Figure 10: Insight Into All the Costs Required To Run the Business

eBay
Reported versus Economic Profits
$600.0

$ in millions

$400.0
$200.0
$0.0
-$200.0

1999

2000

2001

2002

2003

-$400.0
-$600.0
-$800.0

Economic Profit
Sources: New Constructs, LLC

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Net Income-GAAP

VALUATION PERSPECTIVE

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8/20/2004

The differences between eBays reported and economic profits are

explained primarily by two factors: unrecognized stock options expenses
and the cost of equity capital employed by the business. Over the past five
years, eBay has incurred nearly $1.4 billion (after-taxes) in unrecognized
stock option expenses. eBay has over $5 billion of capital invested in the
business. eBays reported earnings do not recognize the fact that the
company needs this capital to generate its revenues and earnings. It is
worth noting that eBays balance sheet does not recognize nearly $600
million of this capital because of off-balance sheet financings and
amortized goodwill. When comparing the companys NOPAT (Net
Operating Profit After-Tax) to the amount of capital invested in the
business, eBays ROIC (Return on Invested Capital) falls well below its
WACC (Weighted-Average Cost of Capital).

Conclusion
In our opinion, the expected market values for Google, eBay, and Yahoo
imply future financial performances that are potentially too optimistic. For
example, each potential market value scenario assumes profitability
(economic profit margins) at or better than what the company has done in
the past. And each scenario requires 15 years of annual revenue growth
at 30% to justify its valuation. Few companies in the history of business
have been able to grow revenues at 30% for fifteen years. Even fewer
have been able to improve profitability at the rate that the respective
valuations imply while they generate 30% revenue growth for 15 20
years.
New Constructs does not purport to have an ability to predict the future.
On the other hand, we empower clients to assess the market predictions
reflected in stock prices with greater accuracy and speed.

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New Constructs Profile

New ConstructsTM is a specialty equity research firm. Our main activity is
delivering to clients an integrated research platform that maximizes the
analytical value of financial data. This platform offers clients a suite of
interactive analytical tools, along with traditional equity research and raw
data services. All of our products are customizable. Our primary goal is to
empower clients to achieve better investment performance.
Our main products are MaxValTM, MaxStrategyTM and MaxDataTM. These
research tools are delivered via www.newconstructs.com. MaxVal is a
DCF-based, equity valuation model that allows clients to define their own
forecasts and forecast drivers. MaxStrategy is a stock screening/ranking
tool that enables clients to analyze stocks based on many metrics, several
unique to our platform. Both MaxVal & MaxStrategy are integrated with
MaxData, our proprietary financial database. Unlike many other research
firms, we do not buy our raw material - corporate financial data - from
commercial vendors. Rather, we source it ourselves to create MaxData.
The key advantage provided by MaxData is that it delivers data drawn
directly from SEC filings, including the Notes to the Financial Statements.
We can cost-effectively deliver any reported data point. We believe our
capabilities in this area are unmatched.
MaxData provides a scalable approach to the time-consuming task of
collecting and modeling data. It enables our research analysts to gather
and analyze corporate filings more efficiently and accurately than any
manual process. MaxData can implement any valuation methodology
requested by clients. For example, our MaxVal models provide both a
high-integrity economic analysis as well as a traditional GAAP accounting
analysis.
The result is a research platform that empowers better investment
performance.
Our clients are professional investors, research firms, consulting firms and
publicly listed corporations. We also partner with colleges and business
schools. Our products may also be of interest to active individual
investors.
For further information, contact:
David Trainer
david.trainer@newconstructs.com

(615) 599-4462

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DISCLAIMER
The information and opinions presented in this report are provided to you for information purposes only and
are not to be used or considered as an offer or solicitation of an offer to buy or sell securities or other financial
instruments. New Constructs, LLC, and/or its subsidiaries or affiliates (collectively, New Constructs) have
not taken any steps to ensure that the securities referred to in this report are suitable for any particular
investor and nothing in this report constitutes investment, legal, accounting or tax advice. This report includes
general information that does not take into account your individual circumstance, financial situation or needs,
nor does it represent a personal recommendation to you. The investments or services contained or referred
to in this report may not be suitable for you and it is recommended that you consult an independent
investment advisor if you are in doubt about any such investments or investment services.
Information and opinions presented in this report have been obtained or derived from sources believed by
New Constructs to be reliable, but New Constructs makes no representation as to their accuracy, authority,
usefulness, reliability, timeliness or completeness. New Constructs accepts no liability for loss arising from
the use of the information presented in this report, and New Constructs makes no warranty as to results that
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Ownership Policy prevents any of its employees from having an ownership position in a covered company
that is equal to or greater than 1% of its outstanding stock.
Copyright New Constructs, LLC 2003, 2004. All rights reserved.

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