Why does the stock of some Internet companies with no earnings sell for such high prices? Why does an industry with so many unprofitable companies continue to attract such huge inflows of new capital? This article examines the difference in valuation methods between Internet related companies and the “old economy.”
Traditional Economic Income Approach
The values of companies in the “old economy” tend to rise and fall with their incomes. This income valuation method balances risk and expected reward in determining the cost of capital (or stock price). Risk is defined as the degree of uncertainty as to the realization of expected future returns. Reward is measured in terms of “economic income.” Economic income is any measure of inflow, such as net revenues, net operating income or net cash flows. These inflows can be converted into a current value through either discounting or capitalizing at appropriate cost of capital.
The cost of capital is the expected rate of return the investment will yield in a competing market where investors have an informed choice.
The most significant factors in calculating the cost of capital are size (market valuecapitalization) economic growth, business and industry risk.
Market Value Approach
The market value approach compares the market price of stocks of corporations engaged in the same or similar lines of business having their stock actively traded in a free and open market either on an exchange or over the counter. This is how all investment bankers, venture capitalists and institutional investors value all entities or corporations. In the case of Internet stocks, the financial markets value the potential future economic income based on a company’s size, growth and industry risk without regard to actual current net income.
In valuing Internet companies, the usefulness of financial audit reports is rather limited. Audited financial statements take into account the current period cost of providing future economic benefits, such as research and development, amortization of good will or strategic investments. Internet companies typically heavily invest in marketing to establish new brands, enter new markets, or gain market share. Accounting standards require companies to reflect the current cost of these expenditures, but do not reflect their expected future benefits in today’s bottom line results. The payoff from these expenditures may not come for years but may have great potential to increase income, revenue or market share.
Business valuations are about estimating future economic income streams discounted back to their present values. The result is then multiplied by capitalizing the cost of capital adjusted for a sustainable long-term economic growth rate. It is necessary to consider economic income as opposed to accounting income for these market valuations.
How do investors justify paying even higher prices for Internet common shares?
The information age will most likely change every aspect of how we do business, both personally and in corporate life. The speed of the growth of Internet companies that deliver these changes will exceed the rate of growth of the industrial revolution. While the anticipated earnings of developmental stage Internet companies are intangible, the value is perceived as real and investors take the risk at much higher multiples. To them, the potential reward or economic payoff is worth the risk. Venture capitalists and companies involved in information technologies have expanded dramatically in funding Internet entities.
If you add back to economic income the investments that accountants are required to write off in the audited financial statements, you can see why the Internet companies may have more value than mature companies whose prospect for economic growth aren’t as great. Even in terms of business risk, experts forsee that everyone will use the Internet in the future just as automobiles were universally adopted in the early 20th century.
Investment Behavior During the
Industrial Revolution
The inflow of huge amounts of capital into new, currently unprofitable industries is not without precedent. In their infancies, railroads and automobiles were both exciting new technologies with unproven economics. Both attracted the attention of visionaries and huge amounts of capital.
The capital costs to build the railroads were enormous. Yet the railroads’ economic potential drew capital to America from all over the world. Many small, undercapitalized trunk lines sprang up. Some of these were built more because of local civic pride than financial reality. Over time, the industry consolidated into a few major carriers. This consolidation allowed service to continue in spite of the original owners’ inability to capitalize operations or growth. These services continued to grow until a new technology, the automobile, began to steal traffic from the railroads.
Early automobile manufacturers were the original “garage startups.” Entrepreneurs and investors were caught up in the romance and potential of a new technology. Again, many small manufacturers fell by the wayside or were acquired in consolidations.
Ironically, these entrepreneurs had a “superhighway” product before there was even a sufficient network of paved roads. Today’s businesses typically all have computers. Making the transition from PC’s to web-based enterprises may not be as daunting as it was to convert from horses and wagons to horseless carriages in the days when most travel was via dirt roads.
Today, individual Internet companies and the e-commerce industry attract investors who hope that the new technology will bring them the same rewards that the railroad barons and captains of industry enjoyed in earlier centuries.
The Internet combines the best features of telecommunications and information technology to make all companies more effective and profitable. Internet or E-Commerce models are potentially better, faster, cheaper, and perhaps in the future more convenient than the way we sell products and services or process information to make informed decisions.
Two years ago, every young company complained: “Where are the venture Capitalists?” In the last year all that has changed as more Internet companies have demonstrated values that venture capitalists, investor angels and other strategic buyers in information technology entities were willing to pay for intangible values as economic investment as opposed to accounting expense.
Gil Ostrick is a principal in Value Added Advisors, LLC which specializes in wealth enhancement solutions for business. More information is available at their web-site, www.CPA-Bizval.Com.
