Discounted cash flow has been the Holy Grail of traditional valuation. Anyone can understand that logic. You project a company’s cash flows out into the future, discount them at the appropriate rate, and come up with a valuation. The DCF model makes intuitive sense. It’s the application of that model that becomes difficult. And when you’re talking about Internet companies, implementing the DCF model becomes virtually impossible. I like to say that Internet valuations are based on discounted cash flows, but in a warped sort of way. One of my colleagues did an analysis last fall that applied DCF logic to the valuations of a bunch of tech companies. She found that for a fast-growing company such as Nextel, 63% of its current value comes from cash flows that are forecast to emerge after 2008. For priceline.com, an Internet pure play, that figure was 96%! In other words, 96% of priceline’s current market value is based on cash flows that are supposed to materialize after 2008. That is absolutely amazing. We can’t figure out what’s going to happen 2 years from now with these companies, so when we try to look as far as 8 or 10 years from now, it’s just massive guesswork. That is a crucial driver of volatility. Tech companies live and die by big, incremental margins. A small top-line shortfall causes tremendous damage down through the bottom line, as each element of the business model starts to rock like a rickety old ladder. And we have plenty of shortfalls. We analyzed 1999 earnings estimates for tech companies in the S&P 500. Some 47% of those companies missed their initial estimates by 20% or more in either direction. In other words, if analysts had been projecting profits of $1 a share, half of the time the results would be either more than $1.20 or less than 80 cents.
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