Dave Barry on Internet Millions

HoppQ writes " Somewhat relatd to the hype of IPOs, Dave Barry writes about how everyone (ie. "not you") is getting rich on the Internet. "

Comments

Apply logic to RedHat...

[tilly]

Unfortunately Dave's comments remind me of the RedHat IPO. Don't get me wrong! RedHat is clearly a company in the right place at the right time. Unlike most "dot com" companies it has a business model that I believe in. Current revenues 10 million/year, doubling each year for 5 years. What is not to like?

The problem is that it is a company in a rapidly growing market with what looks to me to be a fixed horizon. Let us calculate what happens if RedHat has its way and does pretty darned well. 5 years from now suppose that the OS is a commodity market, and RedHat or derivatives thereof is being installed on 100 million computers per year. Let us suppose that they are actually making 5 dollars of revenue per computer (remember, nothing stops people from installing many times for the price of one CD). That is 500 million dollars of revenue/year. (If they double for 5 years in a row they would be at 320 million, so this is a reasonable ball-park.) Assuming that they get a 10% profit margin (about right for a commodity market with low barriers of entry - which is what Linux is trying to be), that is an earnings of 50 million/year.

Long-term in the stock market a sustainable P/E ratio has proven to be about 20 or so. So everything has gone well for RedHat, in 5 years the Linux market stabilizes and they might be justified in having a market cap of 1 billion dollars. That is pretty darned good for a company that last year just about broke even on 10 million in revenue!

However currently 10% of the company is being traded, and that comes to 6 million shares. So the current market-cap is 60,000,000 x 85.25 = 5,115,000,000. That is just over 5 times what I just estimated to be a reasonable market cap in 5 years if all goes reasonably well for the company.

Folks, the investment bankers who calculated $14 as being a reasonable IPO price are not idiots. (Their market cap would be $840 million, which is probably not coincidentally in the same range that my ballpark figures above gave.) They worked out what they thought was a reasonable price for where the company was going. Unless I miss my calculation some people are going to be burned eventually.

Sure, I like RedHat as well. I think that it is going to do really well as a company (although they have to improve their support a lot to meet their goals). But I don't like it as a long-term investment at $85/share!

Sincerely,
Ben Tilly

Disagree all you like then...

[tilly]

The market-cap is defined as it is defined. In one sense you are right, the price of stocks depends upon supply and demand, just like everything else. But in a very real sense you are wrong, commodities and stocks are very different items.

The value of a commodity, like cheese or diamonds, depends upon supply and demand. There is no direct connection where there is a "real" price for that commodity. This is not true of stocks that you buy for the long-term. In the long run there is indeed an intrinsic value to a stock, and that value is the present value to you of the potential future returns. Those future returns come from the dividends and the resale value. In normal markets (which 400 years of experience in many countries say will always come back BTW) you cannot depend on the resale value, and so the value really depends on expectations about dividends. And the potential for that is driven by the (future) size of the company.

Therefore when an experienced investor buys stock for the long-term at a given price, that is an implicit prediction about what that company will do. And the implicit prediction is not hard to determine, it is that the future size of the company will be (order of magnitude) similar to the market cap.

This all applies, of course, to long-term investing. By contrast day-traders and speculators who buy for the short-term are making predictions about the irrationality of other people. In the short term anything can happen and usually does. :-)

Cheers,
Ben Tilly

PS In the long-term you cannot depend upon the rest of RHAT remaining forever off of the market...