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September 9, 1998 Event
Internet Stocks: The End of the Rainbow or Fool's Gold? Over the last year, Internet stock valuations have soared beyond expectations. Emerging companies like Amazon.com and America Online have eclipsed the valuations of technology stalwarts such as Advanced Micro Devices and Oracle. More importantly, in the absence of present-day earnings, proxy valuation techniques determine worth in this still maturing marketplace. Money managers and industry insiders alike realize that such valuation schemes are based on future profits, which if not realized, could result in the downfall of Internet powers. Unlike the price to earnings ratios by which most stocks are judged, many Internet stocks are valued on a new set of metrics. Market cap per unique visitor, per page view, and per sales are three of the more popular models in use today. For example, the Internet Stock Index values Yahoo!'s 30.4 million users at $267 per user, resulting in a market cap of $8.1 billion. Excite's 18.9 million users are valued at $94 per user, amounting to a $1.95 billion market cap. Though these models attempt to quantify the worth of Internet companies, traditional earnings-based models still may prove more valid in the future. A more imminent concern warrants close attention. The volatile global economy may herald an approaching Internet slowdown. A severe economic contraction could force companies to slash media budgets leading to a decline in Internet advertising, the major source of revenue for most new media companies. Venture capitalists might shun risky investments, impeding the number of new entrants into the space. The unique atmosphere and culture within Internet companies certainly would change. For most employees, the euphoric ride that has defined the last few years would be over. Companies no longer would be able to lure new employees with generous stock options and would be forced to revert to traditional incentives such as higher base salaries. And their stocks undoubtedly would drop. Perhaps only then we'll find out if the new valuation metrics are legitimate. For sure, Internet firms must remain cautious and be prepared for tougher times ahead.
Internet Investors, Beware
Key Learnings
IRRATIONAL EXUBERANCE
The Internet itself contributes to its stocks' volatility. Online trading has made it easier, less expensive, and more tempting for people to trade stocks more frequently. Most of the people who trade online claim familiarity with Internet companies, and trade these stocks frequently and without discretion. Because of the amount of money flowing into the market and the large number of individual investors, weekly swings of +/-10% may become par for the course.
Internet valuation metrics which exist are used largely to justify and rationalize our stock buying decisions rather than to determine the worth of companies. Investors need a way to feel that their buy and sell decisions are based on some analytical foundation. Yet even people immersed in the Internet industry have little idea where the value lies, other than their own personal opinions and perceptions.
In general, Internet stocks are still way up for the year. So while we hear increasingly that Net stocks are overvalued, we haven't seen too many people put their money where their mouths are.
WHAT GOES UP MUST COME DOWN
Many believe that a correction looms on the horizon. At the very least we may experience a rough ride in the near-term. Another opinion argues that, in a broad sense, the market is likely to rise as long as baby boomers continue to put money away for retirement. When baby boomers begin taking that money out, the market is expected to fall.
Since there is no precedent for a bear Internet market we cannot simply assume that an economic downturn will drag its stocks down. In fact, some sectors of the economy (such as the Net) may even prosper during a recession. One factor that might make the Internet appealing during a bad spell is its relatively low cost of advertising (compared, for instance, to television).
One dire consequence of an Internet market crash is a potential "dimming of hopes," where the entire sector suffers both a psychological and financial setback. A similar dimming of hopes accompanied the 1987 stock market crash, and it took years to restore the psyche of the securities industry.
MEASURES OF WORTH
While the valuation metrics we see today (pageviews, unique users, etc.) are not necessarily based on traditional economic fundamentals, they do attempt to reflect the reality of the current situation. For example, traffic IS revenue (albeit through ads). Furthermore, these methods are used due to the lack of a better approach.
The economic fundamentals of financial markets dictate an inevitable shift to more traditional valuation methods, especially as the industry matures and consolidation occurs. As more is learned about the true size and character of the Internet market, investors will develop a truer sense of worth and potential.
The market remains confused about the definition of an "Internet" company. Dell, for instance, is often billed as a Net company simply because it sells computers online. Many companies boost their stocks simply by cobbling together some weak argument for being an Internet company, and investors buy it.
QUOTE OF THE NIGHT
"Business school test question: How do you value an Internet company? The correct answer is to put nothing down, because you can't!"