AOL+TWX=??? Do the math, and you might wonder if this company's long-term annual return to investors can beat a Treasury bond's.

(FORTUNE Magazine) – Frankly," wrote a J.P. Morgan securities analyst just after the AOL Time Warner merger was announced, "it is difficult to project the true potential of this new entity, but we know it is big." That statement might not get far in a logic class, but it rather nicely captures the widespread confusion about the payoff in this deal. The murkiness won't be dispelled soon. Even at Internet speed, it will take some time for the world to judge whether AOL overpaid in offering 1.5 shares of its stock for each Time Warner share, or whether Time Warner sold its impressive assets too cheaply, or whether this is truly a marriage made in heaven.

In this article, later on, we will ourselves take a stab at figuring out what this company may do for investors. But first recognize that "big" indisputably is the word for the deal by one basic measure. Even after the merger announcement had knocked AOL down in price, a pro forma AOL Time Warner had a market value of around $290 billion. That's not Microsoft, which leads the nation at about $585 billion. But it puts the new company about fifth on the market-value list, ahead of such heavyweights as IBM and Citigroup.

There's another word that applies to this transaction in a vital way: "small." In the torrent of early analysis about the merger, it was amazing how little anyone talked about earnings--real, bottom-line earnings. That could be, of course, because they are almost too measly to find. For its fiscal year, ended last June, AOL had earnings of $762 million, and for the 12 months ended in December, earnings were about $1 billion. Time Warner's 1999 results have yet to be reported, but its full-year net should be around $1.3 billion. So run a total and you have bottom-line profits for 1999 of roughly $2.3 billion. On that basis, the combined company is selling at well over 100 times earnings.

But the $2.3 billion figure is also something of a fooler: It includes very large nonrecurring gains at both companies and also, at Time Warner, some dollars slated for preferred dividends. If these items were subtracted, to get an ongoing profit figure for common shareholders, the two companies together would have bottom-line profits of under $1 billion. That makes the price/earnings multiple climb to 300.

But, hey, who cares? In both the Internet and media worlds, people seldom talk bottom-line earnings. Instead, they talk bigger figures, bearing strange, made-up names that begin with the letter "e." Here it seems that AOL and Time Warner do not speak precisely the same language. AOL reports EBITDA (e-bit-dah), which stands for earnings before interest, taxes, depreciation, and amortization. Time Warner reports EBITA (e-bit-tah), which states earnings before that same list of interest, taxes, and amortization but acknowledges that depreciation--the year-by-year bookkeeping recognition of capital expenditures made earlier--is a real cost that ought to be subtracted before getting to anything called "earnings."

In this duel of "Ebs," something is clearly going to have to give when the two companies merge (assuming they make it to the altar). And here, in fact, is their plan: Jerry Levin, CEO of Time Warner--and the CEO-to-be of AOL Time Warner--says that the merged company will go along with AOL's practice and will report EBITDA. Hmmm: That means the very real and ever-present cost of depreciation--rising out of Time Warner's big spending, for example, on its cable systems--is to be ignored in getting to "earnings." The result, of course, is the highest figure you can get in choosing between the Ebs, which is convenient when you are trying to rationalize a big valuation.

In this article--we are now getting to what the merger may do for investors--FORTUNE will not focus on either of the Ebs, or on bottom-line earnings, for that matter, but will instead get down to a profit figure that a true investor trying to size up a company would indisputably want to know. This figure is profits after depreciation, interest, and taxes--items that are inescapable costs--but before amortization of goodwill, which is a bookkeeping cost that may completely lack economic reality.

By our estimate, AOL and Time Warner had about $4.2 billion of these profits last year. This figure reflects a full bookkeeping charge for taxes, though neither company actually pays much in cash taxes right now. AOL, in fact, ran up so many losses in its early years that it has $7 billion in tax-loss carry-forwards, with these set to expire from 2001 to 2019. They will keep the tax collector away in AOL Time Warner's early years. But this company has enormous growth in mind, and it should, in pretty quick order, be paying significant taxes. If that turns out to be an inaccurate prediction, the company won't have flourished: A big company that doesn't ever pay taxes is almost never a good business.

The key questions are how fast profits might grow and what a given rate of growth would mean to the investors who right now have this big bundle of $290 billion sunk in the two companies. Regardless of what numbers may dazzle you about the deal, that is the one to focus on: the market cap that the company must push up a steep hill to continue rewarding investors (a problem shared by such other highfliers as Cisco).

To start thinking about how AOL Time Warner might meet its challenge, FORTUNE postulated an average annual growth rate for profits of 15% for 15 years, an assumption carrying the thought that growth would be faster than that in the early years and then slow down. This is by no means a growth rate to be sneered at: Most large companies would kill to lock in that kind of performance over a long period. A 15% rate, in any case, would get you, in these after-tax profits we're talking about, to $34 billion (and to more than $50 billion before taxes). Those are huge amounts: For perspective, General Electric's equivalent after-tax profits last year were an estimated $12.5 billion.

In the second part of the exercise, we need to make a guess at what the market might pay for $34 billion coming out of a company that in its 15th year would look like a classy winner yet also have gained a certain maturity. Maybe the market would accord those earnings a multiple of 20. That would be a market valuation of $680 billion, against today's valuation of $290 billion. And what would that mean in terms of an annual return to investors? The stark answer is 5.8%, which an investor might not find acceptable from government bonds, much less AOL Time Warner. In fact, many analysts are saying investors will want an average annual return of 15% from this company, operating as it does in the high-risk world of the Internet. For now, at least, dividends won't be helping: The new company will pay none.

In any case, FORTUNE tried its projections out on Jerry Levin and found, unsurprisingly, that he really didn't like them. He said the growth rate we had postulated was simply too low. He didn't offer a precise alternative, but he did make the point that multiples tend to exceed projected growth rates, often considerably.

So let's cut through the math and come out with a scenario that would allow AOL Time Warner to give investors what they supposedly want: an annual return of 15%. For them to get that over the next 15 years--hold your hats--the market cap of AOL Time Warner would have to reach $2.4 trillion. Yes, $2.4 trillion. That's what $290 billion will grow to in 15 years if it rises at a rate of 15% a year. This amount, eye-popping though it is, also happens to fit nicely with the stated ambitions of Levin and AOL's boss, Steve Case, to make their company the most profitable and valuable in the world.

So now we need a scenario that would transport us to $2.4 trillion. Here's one: a 15-year growth rate in profits of 22% (to $83 billion after tax) and a multiple, in the 15th year, of 29. Can AOL Time Warner pull that off? It just doesn't seem likely. Big companies run into the law of large numbers and slow down, as if mud had clutched their feet. Getting to $2.4 trillion would simply be a prodigious feat, implying superb execution--in a very complicated company--and a trashing of every competitor that counted. It also happens that $83 billion (with goodwill stripped out, to get down to net income) would probably leave AOL Time Warner accounting for more than 10% of that year's FORTUNE 500 profits, which just doesn't seem economically feasible. (In the coming FORTUNE 500 list, no company is likely to account for as much as 4% of the group's earnings.) In short, the prospects for a 15% return to investors over the long term, from the current level of $290 billion, do not look great.

To be even discussing a distant horizon of 15 years is perhaps madcap, given that the Street's analysts are for the moment obsessed with what the company might sell at just one year out, in 2001. In mid-January, with AOL trading at about $63 a share, Ulric Weil, an analyst at the Virginia firm Friedman Billings Ramsey, took FORTUNE through his thinking that AOL Time Warner could be around $90 in 2001 (a forecast not nearly as bullish as some others around). He was going to apply an Internet multiple of 22 to AOL's estimated revenues and a media multiple of 30 to Time Warner's EBITA; take into account $2.5 billion of estimated "synergy" revenues, which he would also multiply by 22; get to a total value for the company of $500 billion; discount that by 15% to get to a present value; divide by 4.7 billion shares; and, lo, you'd have an expected price of about $90 a share.

Wait, said his listener. "Is there a logic to the multiples of 22 for revenues and 30 for EBITA?" "No," Weil hooted. "If you're looking for logic in cybercash, forget it!"

The question of whether there are going to be synergies of convergence--you will please pardon those discredited words--is, needless to say, huge, and very much a part of the murkiness that surrounds the payoff in this merger. The two companies, anticipating they'll be joined before the end of this year, have told analysts to expect about $1 billion of incremental EBITDA in 2001. The "low-hanging fruit" in this corporate orchard, says one insider, is cuts that both companies can make in advertising and direct-mail costs as they begin to exploit one another's marketing channels.

Another kind of fruit that may be harvested right away was suggested by ten partnering arrangements that the two companies announced on merger day. The first arrangement? A plan for AOL to feature Time Warner's In Style magazine. To be sure, a journey to $2.4 trillion must begin with a single step, but as the announcement duly noted, other Time Warner magazines have already had such arrangements with AOL--without a merger, obviously. That raises a point often talked about in big deals: Do you really need to merge to make business arrangements that are beneficial to both sides? No, is one cynic's answer: "To drink milk, you don't need to own a cow."

On the other hand, Jeffrey Sine, a Morgan Stanley Dean Witter investment banker who has worked closely with Time Warner for many years, says he is absolutely convinced that new businesses get "unlocked" when you merge companies and get people to think creatively and cooperatively about what can be done. Amazingly, he pulls an example out of a deal usually thought of as having been a synergistic wasteland: Time Warner's purchase of Turner Broadcasting four years ago. The example is the Cartoon Network, which has 61 million subscribers and, in Sine's opinion, has grown into a $2 billion asset. This business, Sine claims, could never have become a prize had not Turner, with its Hanna-Barbera library and expertise in cable networks, gotten to close quarters with Warner Brothers, which brought Looney Tunes and animation skill to the party.

Sine thinks that the hookup of Time Warner and AOL has endless possibilities for creative thinking and that Jerry Levin, in particular, has the kind of intellect to be fascinated by the possibilities. Says Sine: "In Jerry's mind, a lot of this is, How do I get into a position to tap into the whole new areas of value creation that no one's heard of or even been thinking about?"

That was surely one of the "fuzzies"--Levin's term--motivating him to make the deal. But a dominant reason for him to talk merger at all, he says, was the premium he knew it would bring Time Warner's shareholders. These folks suffered for years after Time Inc. and Warner Communications merged in 1989, until finally the stock price took off. Levin says he was "driven" by a feeling of obligation to the stockholders and by a desire to keep on giving them good returns.

Okay, Levin has engineered a premium for his shareholders. Now, to make the merger work for investors, Case and Levin must move their $290 billion market cap to an extraordinary height. It will be like pushing a boulder up an alp.

REPORTER ASSOCIATE Christine Chen