Thursday, May 18, 2006

Ebay: A dollar for 50¢?

Ebay’s current price has sparked me to consider a few things. First, am I “correct” on eBay? My general thesis on the company is that it is an undervalued market leader. The other question that comes to mind stems from the first one. If I am correct, why am I correct and the market wrong? It certainly isn’t that I possess some supernatural intellect or clairvoyance. (Trust me.) All I know is that I have looked at eBay’s operating performance numbers and to me the numbers just don’t spell 30 bucks per share.

What numbers am I referring to? Well primarily I’m referring to eBay’s free-cash-flow (FCF) figures. Recognizing that there is a plethora of ways to arrive at FCF and keeping in mind that exact numbers give a false sense of preciseness, I estimate that eBay produces about $1.4 billion in FCF. And over the last few years the company has been able to grow those figures at extraordinary rates – by at least 40% and by as much as 90%.

Using the discounted cash flow (DCF) method, I arrived at an estimated intrinsic value for eBay of about $60 per share. Of course, this method of valuation is very sensitive to the assumptions made. To come up with my estimate, I assumed a discount rate of 9% which is my optimistic view of what the market itself will return over the next decade or so. I also assumed that eBay’s FCF growth rate would substantially decrease over the next 10 years - falling from 25% in the early years to 12.5% in the later years. And then I assumed a terminal growth rate of 3%, about the historic rate of inflation. With those factors, all of which I think are reasonable, I came up with an estimated value of $60. So the market must be missing something…possibly. Click chart for larger view.

But what if I’m wrong and the market is correct? Perhaps I’m missing something. One way or another the market is saying that eBay will not be able to perform in the future as it has in the past. The market seems to be saying that some external (or internal) force will do one or a combination of several things. The forces will depress eBay’s margins or retard its sales growth or cause it to have to substantially increase its capital expenditures.

I think one thing the market is saying is that it doesn’t like eBay’s purchase of Skype for $2.6 billion. I agree with the market here. I like the company, I just don’t like the price eBay paid for it. That said I doubt that any failure in Skype will be enough to sink eBay. The market may also be saying that the Google-monster will surely do eBay in. I doubt that pressure from competitors like Google or Yahoo will be significant enough to substantially hurt the company. Not in the long run anyway. And certainly not enough to justify the $30 price tag eBay now sports.

In my own analysis, I assume that eBay’s FCF growth falls off a proverbial cliff and I still came up with a value that is at least twice the current market price. In other words, I think eBay represents the dollar being sold by Mr. Market for 50¢. Yet exploring the reasons Mr. Market is selling eBay so cheaply are worth some thought.


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