“It’s fair to say that most of the people I know have accounts at AOL and my students spend a fair amount of time in AOL chat rooms. But a friend of mine did the mental gymnastics and estimated that AOL [$167 on Monday] would need to fall to $50 for P/E=100 on estimated 2001 earnings! I have no doubt that AOL will still be standing in 20 years, but there’s got to be a limit to its subscriber growth (and thus to their profit growth), no? It’s not a consumer non-durable like Gillette or Coca Cola, and it doesn’t recreate a market cycle like Microsoft or Intel. So, Andy, can you (or one of your other readers) defend the current valuation for AOL?”Elliott Wong

Say in 10 years there are 1 billion users on the net and AOL has managed to be such an indispensable community that everybody chooses to use it. Or well, one in two — 500 million people. Is that impossible? Surely half the people who use personal finance software choose Quicken, half the people who use word processors choose Microsoft Word — no?

And say they figure out a way to extract $50/year in after-tax profit from each of us, through fees, ads and commerce. That’s $25 billion in profit. Give it a 25 multiple, and you have a $625 billion market cap, versus today’s measly $150+ billion.

And (while we’re doing preposterous math), say you don’t have to discount the numbers to account for the 10-year wait, because that $50-a-year in after-tax profit will actually increase at your discount rate.

So . . . it’s selling today for a quarter of its true value!

(Do I buy this? No! But you asked.)

If you use these same extremely if not wildly aggressive assumptions, and figured the $50 profit would be the real number in 10 years, then you do have to discount the value of that $625 billion market cap. What’s $625 billion ten-years-from-now worth today? The answer, if you expect to be “paid” 15% a year for taking risks like this (or else why not just accept 5% from a bank?), is $155 billion, or about where it was Monday.

If you think you should get 20% a year to take so much risk, then the market cap today should be about $100 billion, and it’s $50 billion too dear.

If you think internet access will essentially be free and AOL will be one of dozens of companies competing like crazy for everyone’s business and that it will be earning “just” $10 billion after tax in 10 years, then it is wildly overpriced.

And if profits even that small — $10 billion a year — should prove elusive a decade hence, then paying $150 billion for the company today will, with hindsight, have been nuts.

But it’s also possible (I suppose) that AOL and a few others will rule the world like no other companies, and only a few empires, before them. In which case these stocks are cheap.

 

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