1. 185 Negative Earnings: Why they are a problem In the valuations that we have looked at so far, we have had positive earnings in the base year to which we could apply growth rates to get expected earnings in future periods. When earnings are negative, you cannot start with that number in the base year and expect to grow yourself out of the problem. The key to valuation, when earnings are negative, is to work with the numbers until the earnings become positive. Exactly how this is done will depend upon why the earnings are negative in the first place. In fact, this applies even if your earnings are positive but lower than normal.

2. 186 A Framework for Dealing with Negative Earnings

3. 187 Amazon.com: The Facts Amazon.com retails books online. It started operations in 1995 and increased revenues from $0.5 million to $ 15.7 million in 1996. In the first 3 quarters of 1997 it had revenues of $ 82 millions and expects to end 1997 with revenues of $ 150 million. The company has never been profitable. It lost $ 5.8 million in 1996 and expects to lose 5 times as much in 1997. Its earnings before interest and taxes for 1997 are expected to be – $ 30 million.

4. 188 Amazon.com: The Facts It did an initial public offering in May 1997 at $ 18 per share. There are 23.859 million shares outstanding. The firm has no debt outstanding. The firm is expected to have depreciation of $ 2.50 million and capital expenditures of $ 7.5 million in 1997.

5. 189 Amazon.com: Model Discussion In valuing Amazon, there are several factors to consider. –The firm has negative earnings and EBIT currently. The negative earnings are not due to poor management or an abnormal year, but can be attributed to the fact that this firm is still young, has made significant investments in establishing a presence in the web retail market and has low revenues. Furthermore, there is not much financial history to base the valuation on.

6. 190 Amazon.com: Model Discussion In valuing Amazon, there are several factors to consider. –There are more established book sellers (like Barnes and Noble, Border’s books) who are publicly traded, but they sell through traditional outlets. These book sellers have some debt (about 15%) in their capital structure and operating margins of approximately 8%. We will assume that Amazon.com will move towards these averages in the long term.

7. 191 Amazon.com: Model Discussion In valuing Amazon, there are several factors to consider. –There are Internet based firms (Netscape, Yahoo..) which are publicly traded. Though they have not been listed very long, the average beta for these firms is 1.80. Amazon is assumed to have a similar beta. To value Amazon, we will use a FCFF Model, with year-specific margins

8. 192 Amazon.com: Inputs YearGrowth inCOGS asGrowth inWC as % of Revenues% of RevCap ExDeprecnRevenues 1150.00%120%100%150%5% 2100.00%110%75%100%5% 375.00%105%50%75%5% 450.00%100%40%50%5% 540.00%98%33%40%5% 633.20%97%26%33%5% 726.40%96%20%26%5% 819.60%95%13%20%5% 912.80%94%6%13%5% 106.00%92%6%6%5%

9. 193 Amazon.com: Explaining the Inputs Revenue growth is anticipated to remain strong but become lower (in percentage terms) as the firm becomes larger. In steady state, revenue is expected to grow 6%. The operating margin in 1998 will be similar to the margin in 1997 (i.e., -20%). Over the next 10 years, the margin will approach the average for book retailers (Barnes and Noble, Border Books) Cap Ex will lead revenue growth by one year. (Next year’s revenue growth will be this year’s cap ex growth). Depreciation will grow with revenues.

10. 194 Amazon.com: Explaining the Inputs Non-cash working capital as a percent of revenues will be 5%. This is lower than the average for other book retailers (about 8- 10%), because we assume that a web-based book seller can maintain lower inventories.

11. 195 Amazon.com: Cash Flows

12. 196 Amazon.com: Costs of Capital and Terminal Value Cost of Capital for next 10 years –Cost of Equity =15.90% –Equity/(Debt+Equity ) =100.00% –Cost of Capital =15.90% Cost of Capital after year 10: –Cost of Equity in Stable Phase =11.50% –Equity/ (Equity + Debt) =85.00% –AT Cost of Debt in Stable Phase = 8% (1-.36) =5.12% –Debt/ (Equity + Debt) =15.00% –Cost of Capital in Stable Phase =10.54%

13. 197 Amazon.com: Costs of Capital and Terminal Value Terminal Value of Firm –Value of Firm = 253.49/(.1054-.06) = $5,580 million

14. 198 Amazon.com: Valuation YearFCFFTerminal ValuePV 1($72)($62) 2($89)($66) 3($102)($65) 4($76)($42) 5($61)($29) 6($46)($19) 7($13)($5) 8$5 $1 9$70 $18 10$135 $5,580 $1,307

15. 199 Amazon.com: Valuation Value of Firm$1,038 - Value of Debt$ 0 Value of Equity$1,038 Value per Share =$43.52

16. 200 Amazon.com: The Value Drivers

17. 201 Amazon.com: The Value Drivers

18. 202 Amazon.com: The Value Drivers