The valuation of Internet stocks

One of the most perplexing phenomenons in financial markets in recent years was the sudden and domineering emergence of the Internet stocks in the late 1990’s. Many of these Internet stocks were trading at such high prices that are relative to their operating performances that prompted several new and unique valuation measures being suggested to justify the high prices which investors were paying for these Internet shares.

Just as sudden was it emergence was its demise when the prices of the Internet stocks fell to a fraction of their value in the year 2000. This spectacular collapse of the Internet stocks demystified the belief that the surge in value was due to a structural change in the underlying technology of the world economy which might justify the valuations that are separated from conventional benchmarks.

This prompted the discussion on the relevance of financial and non-financial information in the valuation of Internet stocks which was trading at prices that were difficult for analysts to reconcile to the companies’ fundamentals shown in the financial statements. Hence it is relevant to question the contribution of financial statements made to the pricing of Internet stocks. While financial statements were never designed to monopolise all the relevant information used in pricing stocks and securities, they are expected to convey relevant and substantial information to the public. It has however been argued that for fast-changing, technology-based industries, non-financial information is more relevant than accounting or financial information.

The difficulties in valuing internet stocks lie on the fact that the industry and the firms in it are young and that there is very little historical financial information available to which it could be used to forecast future profitability; and the industry is evolving at a very rapid and unpredictable pace that whatever historical data/information which existed would likely be less than useful for valuing these firms. However, it should be noted that the industry offers a substantial amount of non-financial data on Internet usage that could be used as a prediction of future revenues. Further current Internet traffic is highly likely to be positively related to future revenues as it is a reflection of potential future demand for the company’s products and it also has an effect on the rates that the company can charge for advertising.

Value Relevance of Financial Information

In the article produced by Trueman, Wong and Zhang (2000)1, it is found that there is no significant association between bottom-line net income and market value. However there is a positive and significant association between gross profits and market value. It is also found that there is a negative and significant relationship between sales and marketing costs and market value. Further, research and development costs are found to be not significantly associated with stock prices at all. It should be noted that in the article, it is found that the financial variables such as the components of net income explain a significant portion of the variability in the Internet stock prices.

In the articles produced by Hand (2000)2and (2001)3 it is found that net income is significant in a non-linear way to equity prices (in contrast to the above). The profits and losses are priced positively and negatively respectively. It should be noted that the losses are caused by investments in intangibles such as research and development and marketing costs. These intangibles are only priced as assets when income is negative. The pricing of profits and losses changed systematically over time. The pricing of research and development expenditure became more asset-like while the pricing of marketing expenditure became less asset-like.

Value Relevance of Non-Financial Information In Trueman, Wong and Zhang (2000), Internet measures, the non-financial information, such as the website page views and data on unique visitors are being tested for value relevance to Internet stocks prices. “Unique visitors” is the estimated number of different individuals who visit the firm’s website during the month and “Website page views” is the estimated number of pages viewed by the above individuals visiting the firm’s website during the month. This information is readily available from the Internet companies as well as from independent rating firms. It is found that when the Internet measures are included alongside financial information, they are positively and significantly associated with market values of equity.