Value lies in the belief of the investor1

Prof. R. Ramaseshan

In less than two decades time, the Internet has changed our lives immeasurably.
Among altering nearly every other aspect of our lives, from shopping, to
communication, to receiving news, the Internet has affected the way business has
evolved. Many established businesses and start-ups have made millions off of the
Internet, and many more hope to do the same.

The first workable prototype of the Internet came in the late 1960s with the
creation of ARPANET, or the Advanced Research Projects Agency Network.
Originally funded by the U.S. Department of Defence, ARPANET used packet
switching to allow multiple computers to communicate on a single network.

On October 29, 1969, ARPAnet delivered its first message - a node-to-node

communication from one computer to another. The technology continued to grow
in the 1970s after scientists Robert Kahn and Vinton Cerf developed the
Transmission Control Protocol and Internet Protocol, or TCP/IP, a communications
model that set standards for how data could be transmitted between multiple
networks.

ARPANET adopted TCP/IP on January 1, 1983, and from there researchers began to
assemble the network of networks that became the modern Internet. The online
world then took on a more recognizable form in 1990, when computer scientist Tim
Berners-Lee developed the World Wide Web, the most common means of accessing
data online in the form of websites and hyperlinks.

The world wide web was opened to the public in January 1991, but at first grew
relatively slowly, as a background in computing was essential to access the
Internet. This divide was bridged by the browser Mosaic launched by Marc
Andreesen in January 1993 and provided an easy way of navigating the web.
Mosaic could be installed on all major operating systems and features such as a
‘back’ and ‘forward’ button made it much easier to use the Internet.

As a result, the network rapidly expanded - the number of people online globally
increased by over 50 times in just six years from 1993 to 1999. Andreesen moved
to Silicon Valley and set up Mosaic Communications Corporation, later renamed as

1
Written by Prof. R. Ramaseshan, on the basis of published news items and articles for the purposes of
classroom discussion.
Netscape Communications Corporation, which attracted a start-up funding of $3
million.

The Netscape Navigator was released in October 1994 and soon became the most
popular browser. Netscape created the JavaScript programming language, the
most widely used language for client-side scripting of web pages. The company also
developed SSL which was used for securing online communications before its
successor TLS took over.

On August 9, 1995, Netscape made an extremely successful IPO, much before

generating profits. The IPO was more a marketing event meant to generate
publicity for the company and was set to be offered at US$14 per share, but a last-
minute decision doubled the initial offering to US$28 per share. The stock's value
soared to US$75 during the first day of trading, nearly a record for first-day gain.
The stock closed at US$58.25, which gave Netscape a market value of US$2.9
billion.

Netscape moment

The success of this IPO subsequently inspired the use of the term Netscape
moment to describe a high-visibility IPO that came to be seen as the dawn of a new
industry. The Netscape IPO also helped kickstart widespread investment in internet
companies that created the dot-com bubble.

Many companies did not have a track record of profits to launch an IPO; yet they
adopted a host of measures to attract investors – backing by venture capitalists,
lock in period for initial investors, offering shares to public for a price much lower
than the expected market valuation, to name a few.

The successful dot-coms of those years had a few things in common: they all
vowed to “change the world”, had crazy-high valuations, and were wildly
unprofitable.

The buzzword New Economy was used to describe new, high-growth industries that
were touted to be on the cutting edge of technology and were believed to be the
driving force of economic growth and productivity. As the Internet and increasingly
powerful computers made their way into consumer and business marketplace, the
new economy was seen as a shift from a manufacturing and commodity-based
economy to one that used technology to create new products and services at a rate
that the traditional manufacturing economy could not match.
Profitability, market share and other traditional approaches to value companies
were derided as representing the old economy and incapable of capturing the
business potential of the newly unleashed force of the internet. During these
maniacal years, profit making was seen as a hurdle to obtain a good valuation for
an IPO; market share was replaced with the number of eyeballs attracted – the
number of visitors to the website of the company that was to indicate the future
business potential of the company. Having a suffix .com came to be associated
with a trendy business plan.

Most dot-com companies incurred net operating losses as they spent heavily on
advertising and promotions to harness network effects to build mind share as fast
as possible, using the mottos "get big fast" and "get large or get lost". These
companies offered their services or products for free or at a discount with the
expectation that they could build enough brand awareness to charge profitable
rates for their services in the future.

The "growth over profits" mentality and the aura of the new economy invincibility
led some companies to engage in lavish spending on elaborate business facilities
and luxury vacations for employees. Upon the launch of a new product or website,
a company would organize an expensive event called a dot com party for branding
and raising awareness.

A sky-high stock market valuation that was divorced from any sort of profitability or
rationality meant a flurry of IPOs, when the venture capitalists could cash out by
selling their share to the average investor. This was a fantasy period when a lot of
VCs actually did not care if a business turned a profit. All that mattered was to get
the IPO mill running.

The IPO boom was accompanied by a boom in the price of existing equities. The
S&P 500 index, covering the largest US-based companies, rose by 115 per cent
between January 1990 and December 1996, prompting concern that the equity
market was over- heating. Alan Greenspan, Chairman of the Federal Reserve
questioned the point at which rising asset prices could be said to result from
‘irrational exuberance’ rather than changes in their intrinsic value. This was
accompanied by a warning that inflated asset prices could eventually result in
problems that Japan had witnessed in the late 1980s.

But the stock market continued its upward journey and the S & P 500 was more
than double compared to when Greenspan made his speech. The cyclically
adjusted PE ratio was at an all-time high at 45, higher than 33, the value reached
during the 1929 crash. And technology stocks had seen a dramatic increase – in a
period of eighteen months, the NASDAQ composite index had increased by more
than three times.

Though the phenomenon occurred in the US, international response was evident –
technology stock indices in Europe, Japan and Asia experienced clear booms and
busts along with the US indices.

Articles and books published then derided value managers who insisted that PE
ratio was still a useful measure in the new economy, predictions that the Dow Jones
index would increase from 10,000 to 36,000, etc. The view that valuations and
share prices had reached an unsustainable level found few takers.

Pricking of the bubble

No single event can be cited as the reason for the bubble to burst – in fact there
were a myriad of factors.

The Fed had finally raised interest rates – three times in 1999 and then twice more
in early 2000, the most sustained round of fiscal tightening over the whole of the
late 1990s. And suddenly, the Fed was seen attempting to rein in equity prices.

Analysts began advising their clients to avoid/divest on internet stocks, saying the
technology sector was no longer undervalued.

But more than anything else, weak dot-coms that had hit the market toward the
tail end of 1999 – companies without a realistic chance to make money over the
long term tipped the scales.

The market reached a bottom in October, 2002 and in thirty months, the NASDAQ
lost 77 per cent of its value and the S & P 500 had fallen by over 48 per cent.
Internet stocks that had witnessed a 1000 per cent return in two years lost all the
gains by the end of 2000.

Points to ponder

Popularity does not mean profit – Rather than focusing on companies that are
popular, it is better to investigate whether a company follows solid business
fundamentals. Popular stocks may be excessively valued in the short-term, but in
the long run, stocks usually need a strong revenue source to perform.

Companies could be speculative – Companies are appraised by measuring their

future profitability, not by speculative investments, as valuations could be overly
optimistic. Never invest in a company based solely on the hopes of what might
happen unless it is backed by real numbers. Instead, make sure you have strong
data to support that analysis.

Basic business fundamentals cannot be ignored – Examine financial variables, such

as sales forecasts, market share, profit margin, dividend payouts, etc.

Peer comparison is critical – correlate with listed companies in the same industry
and form an opinion of the valuation suggested is excessive. No company with a
valuation way off the market norm can generate returns in the near term.

Dot-com déjà vu

Sinking IPOs (Uber, Lyft, and Peloton) or scuttled offerings (WeWork), lavish
advertising, claim to change the world, high valuations, widespread euphoria –
another bubble or this time it is different?