There's a
technical term in economics - known as the "greater fool theory" -
which applies to situations like pyramid schemes and stock-market
bubbles.
The idea is that while a stock or a moneymaking scheme may be
fundamentally worthless, it may still make sense to invest in it if
a greater fool will come along and take it off your hands at a
higher price.
Unfortunately for flimflam men and "momentum investors" - people
who invest when it looks as though a stock is going up - the supply
of fools eventually runs out and prices tumble to their true levels.
One of the key questions investors are asking themselves today is
this: Have stock prices for dot-coms reached their true levels?
This is where market valuations come in - the measures of what a
company is worth. One easy way to judge the worth of a company is to
multiply the price of each share by the total number of outstanding
shares. This is what is known as the market capitalization of a
company. If the market were perfect, market capitalization would be
the true value of a company.
Other Ways to Value
Another way of valuing a company is to count up its assets,
including its physical facilities and patents.
A company can also be valued by examining its books, by looking
at how many customers it has, how much money it makes and how fast
it is expected to grow in the future.
When the stock market was soaring and the New Economy was
blossoming about two years ago, some Wall Street analysts argued
that dot-coms needed to be valued based on their growth potential,
not on their profitability. As a result, many high-tech companies,
such as Seattle-based Amazon.com Inc., were valued based on
projected revenue or on how quickly they were adding Web site
visitors. "Amazon's revenues grew 170% from 1998 to 1999. This year,
we're forecasting that they'll grow 60% year-over-year, says Tom
Wyman, an analyst at J.P. Morgan & Co. in New York. "You can see
that they're slowing down."
That slowdown in revenue growth - and the resulting drop in
valuations that were based on projected revenue - helps explain why
Amazon's stock price has plummeted from more than $126 in October
1998, hitting a new 52-week low of $19 on Oct. 18.
An Industry Matures
Every company's revenue growth will slow once it reaches a
certain size, says Wyman, but it doesn't necessarily mean that the
first set of valuations was wrong. "If the company does grow 60%, it
will be the fastest growth rate for a retailer this size in the
country," he says. With annual revenue of more than $1 billion and
sales that are growing 60% annually, says Wyman, Amazon's numbers
are "nothing to sneeze at."
But investors today are more concerned with the profitability and
sustainability of New Economy companies, said David Zale, an analyst
at Sands Brothers & Co. in New York. "The only true measurement
of a company's stock price is the ability of a company to generate
cash," he says.
To figure that out, says Zale, investors can look at historic
earnings or future earnings, or examine cash-flow reports to get
hints at how healthy a company is.
What makes it more difficult to determine the value of an
Internet company such as Yahoo Inc. in Santa Clara, Calif., than a
traditional brick-and-mortar firm like Hoffman Estates, Ill.-based
Sears, Roebuck and Co. is that there isn't a lot of history to draw
upon. New Economy companies lack financial track records, and the
sector as a whole is uncharted territory.
"We're just not there yet in terms of knowing who wins and who
loses and what kind of cash flows are associated with being a
winner," says Wyman. "It makes it difficult to pin down whether [a
company] should be worth 20 times revenues, 50 times revenues or two
times revenues."
Meanwhile, Internet companies and their investors have begun to
mature, says Zale.
Substance or Mere Hype?
"You have a change in the shareholders," Zale says. "You have had
shareholders who were in at the beginning who were purely momentum
shareholders. Once there's any hiccup, they're out. The next group
of people comes in [and they] really understand what this business
is about" and concern themselves more with earnings potential and
cash flow, he says.
Once educated investors have taken a close look at dot-coms, they
may find there's not much substance beyond the hype, according to
Jim Horty, president of Horty & Horty PA, an accounting firm in
Wilmington, Del., that specializes in valuing start-ups. That's
because it's typically easier for a traditional firm to launch an
e-business than it is for an Internet firm to acquire a deep
understanding of a particular industry, he says.
Many dot-coms that started with flimsy business models are now
facing competition from traditional businesses - and they often
don't measure up.
"The people who understand the business and the merchandise now
know enough about the dot-com world to have their own outlets,"
Horty says. "And they understand that merchandising business much
better than the dot-coms do."
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