SAN FRANCISCO (CNN/Money) -
Historically speaking, October is usually a pretty rough month on the market. For tech investors, however -- especially those stalwart believers with big positions in Internet companies -- this October couldn't have come at a better time. By one account, Internet stocks rose on average 37 percent that month.
And the growth, though slowed in some cases, continues thus far in November. Yahoo! (YHOO: up $0.21 to $18.21, Research, Estimates) finished October at $14.92 and is north of $17 today. eBay (EBAY: up $1.14 to $68.50, Research, Estimates) continues its tear through the market, gaining $4.40 since the month began. And Amazon (AMZN: up $0.58 to $23.48, Research, Estimates) gained $3.06 in the last two and a half weeks, closing at $22.42 on Monday.
So is it time to stop worrying and learn to love the Internet all over again? No. Tech investors can still find undervalued stocks on the market, but not all the undervalued stocks are poised to make a comeback. So how can you tell which ones are? And what metrics can individual investors use to accurately gauge an Internet company's operating worth? I turned to some sector analysts for advice.
During the bubble years, of course, the metrics by which stocks were rated got a little higgledy-piggledy. Instead of looking at measures such as cash flow, free cash flow, and price-to-earnings ratio, investors were bombarded with data about eyeballs, stickiness, and market caps. No more. "We're not looking at any cute metrics anymore," says Safa Rashtchy, a technology analyst with U.S. Bancorp Piper Jaffray.
Free cash flow is one metric that Rashtchy and other analysts are returning to. To determine a company's free cash flow, you take the Ebitda (earnings before interest, taxes, depreciation, and amortization) figure, deduct the taxes, add back the interest, deduct working capital (the basic amount needed to run the company), and deduct capital expenditures.
As Warren Buffet once said, "Cash is king," and free cash flow is a pure measure of the amount of cash a company is making, without room for loopholes or footnotes. When I asked four analysts what metric they use to measure a company, free cash flow topped each of their lists.
Another factor pushing the e-stocks higher is that investors are finally getting an idea of Internet companies' fixed costs -- things like inventory, office space, and payroll. For the first few years of these companies' existence, costs varied wildly.
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"Fixed costs are becoming more apparent in the numbers," says Jeetil Patel, an analyst with Deutsche Bank Alex Brown. "Investors have been negative and waiting to see evidence in the past, and we're finally seeing evidence that costs are becoming fixed while revenues are growing."
The analysts are bullish on the Internet commerce sector, and point to companies that haven't yet met their fair value price targets -- including Dell (DELL: down $0.32 to $28.89, Research, Estimates), Electronic Arts (ERTS: up $1.56 to $67.11, Research, Estimates), IBM (IBM: up $2.64 to $84.25, Research, Estimates), TMP Worldwide, USA Interactive (USAI: up $1.03 to $29.16, Research, Estimates), and Yahoo!.
Rashtchy, however, says he's worried that the valuations of other leaders have gotten -- yes -- too high. (When was the last time you heard that from an analyst?) The fundamentals of the companies are strong, he argues, "but I think eBay and even Amazon have reached pretty high valuations that can't be supported even with their growth rate."
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