© The Financier • VOL. 13/14, 2006-2007http://www.the-financier.com

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Boom, Bust, Boom: InternetCompany Valuations – From

Netscape to GoogleThomas A. Corr

Henley Management College

The later half of the 1990’s saw a boom in the valuation of publicly traded internet stocks. This periodwas known as the “internet boom”. At the peak of the internet boom in February, 2000, internetpublic company shares in the U.S. represented 20% of the trading volume of all shares on the U.S.stock exchanges, and the market capitalization of these companies equaled 6% of the market capitaliza-tion of all U.S. publicly traded companies. Between March 10, 2000, and April 17, 2000, the technol-ogy heavy NASDAQ would lose 34% of its value.

The purpose of this paper is to address within the framework of behavioural finance theory, theeffect that emotion, uncertainty, and irrational thinking can play in the decisions made by investors.Also addressed are traditional securities valuation, internet company valuations during the internetbubble, and whether the anticipated market capitalization of Google prior to its IPO was a precursor toa second internet bubble.

I. INTRODUCTION – DISCOUNTED CASH FLOWBE DAMNED: THE INTERNET AND

BEHAVIOURAL FINANCE

“A conventional valuation which is established as theoutcome of the mass psychology of a large number of ignorantindividuals is liable to change violently as the result of asudden fluctuation of opinion due to factors which do notreally make much difference to the prospective yield; sincethere will be no strong roots of conviction to hold it steady.”J.M. Keynes

On August 9, 1995, Netscape CommunicationsCorporation (Netscape), an internet browser company,went public and became the first of many internetcompany Initial Public Offerings (IPO’s) in later half ofthe 1990’s. Netscape’s shares were originally priced at

$12, but due to the strong demand the share price at thetime of the IPO was set at $28. The shares traded as highas $75 during their first day of trading and closed at theend of its first day of trading at $58.25, resulting in amarket capitalization for Netscape in excess of $2.2billion. For the trailing 12 month period prior to the IPONetscape was unprofitable and had sales of less than $48million.

The period beginning with boom of the Netscape IPOon August 9, 1995 and ending on March 10, 2000 whenthe technology heavy NASDAQ peaked at 5,048, itshighest level ever, was known as the era of the internetboom. At the peak of the internet boom in February,2000, internet public company shares in the U.S.represented 20% of the trading volume of all shares on theU.S. stock exchanges, and the market capitalization of

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these companies equaled 6% of the market capitalizationof all U.S. publicly traded companies (Ofek andRichardson, 2000). Between March 10, 2000, and April17, 2000, the NASDAQ would lose 34% of its value andwould continue its near-death spiral for almost threeyears, finally losing 75% of its value and wiping $7 trillionfrom investors’ portfolios.

WebVan, a California based on-line grocery retailer,is an example of an internet boom company. WebVanwent public in November of 1999, raising $375 millionand its shares closed on its opening day of trading at$26, giving it a market capitalization of $8.45 billion.WebVan lost $35.1 million during the six monthsended June 30, 1999 on revenue of $395,000. Incalendar 1998 Webvan had no revenues and lost $12million. Eighteen months after going public,WebVan’s shares were trading at 6 cents and soonthereafter the company filed for bankruptcy protectionand discontinued its operations.

The internet boom era was subsequently referred to asthe “internet bubble” and the “dot-com bubble”. Thebursting of the “bubble” was predicted long before theactual burst (Perkins and Perkins, 1999). A description ofthe timeline for the internet bubble, What We Learned InThe New Economy: A Brief History of a Brief Era, isincluded as Exhibit 1.

The basis of financial theory is the belief thatinvestors make their investment decisions based uponall of the information available regarding a particularsecurity, but it appears that this may not always be thecase. What has evolved is an area of study referred to as“Behavioural Finance”. Behavioural Finance attemptsto both understand and explain the effect thatemotion, uncertainty, and irrational thinking can playin the decisions made by investors. Further,Behavioural Finance attempts to address the efficiencyof stock markets and explain such phenomena as theGreater Fool Theory along with other stock marketanomalies. In addition, Behavioural Finance attemptsto address how such flaws in decision making can bepredicted and exploited by others in the stock market(Shiller, 1989).

In a study titled Prospect Theory (Tversky andKahneman, 1979), the authors argued that investorsbased upon the range of probability, put different weightson losses and gains. Their study also discovered thatinvestors are much less satisfied with gains than they aredissatisfied by the equivalent losses. They also discoveredthat investors respond to equivalent situations differentlydependent upon whether it is understood by them interms of losses or gains, and that investors are more likelyto take more risks to avoid losses than they would torealize gains.

After making a decision which results in a loss, investorstend to have a feeling of sorrow and grief (Statman,1988). Therefore the investor’s emotions are effectedsubject to whether or not they are making a gain or loss onthe sale of a security. Statman goes on to argue that thisresults in investors delaying the sale of stocks that wouldresult in a loss to avoid the negative emotions, and havingto potentially deal with disclosing the loss to theiraccountants, family, and financial advisors.

Shiller also puts forth the theory that investors put toomuch weight on their recent investment experiences,whether good or bad, and that the investor makesdecisions based upon this experience that is not consistentwith statistical odds, long run averages, and trends(Shiller, 1989).

Investors also believe that they often have betterinvestment decision making information than otherinvestors, whether in fact they do or not, which results inactivity in the stock market which is hard to rationalize.On each side of a stock market trade is an investor whobelieves that their information is better than the other andclearly they cannot both be correct in their decision(Odean, 1997).

Investors tend to be overconfident in their ownabilities; however increased confidence has no correlationwith greater success (Huberman, 1998). Huberman alsofound that investors favor investing in local companieswith which they have had some experience. In particularhe found that investors are more likely to purchase stockin their local regional Bell company than other regionalBells. The study provides evidence that investors preferlocal or familiar stocks, even though there may be norational reason to prefer the local stock over othercomparable stocks that the investor is unfamiliar with.

Another theory that Behavioural Finance has posturedis that of the herd mentality. The herd mentality theorysuggests that investor’s follow the investment decisions ofothers so that if a bad investment decision is made, theinvestor can take comfort in the fact that others also madethe same incorrect investment decision. Shiller describesin his book “Irrational Exuberance” that rational peopleoften partake in herd behavior. Shiller argues that theindividual’s behavior would be viewed as being rational,but when combined with the behavior of others (theherd), it can produce irrational group behavior (Shiller,2000). Shiller blames “information cascades” for the herdbehavior, which he describes as the reliance of anindividual on some one else’s decisions. The theory ofinformation cascades is a theory of the failure ofinformation about true fundamental value to bedisseminated and evaluated (Shiller, 2000).

A bubble is started and ended based upon an eventwhich may have nothing to do with the inherent value of

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Exhibit 1What We Learned In The New Economy: A Brief History of a Brief Era (the following is excerpted from the Fast Company magazone - Hawn, 2004):

August 9, 1995: The Big Bang

Netscape, just 16 months old, goes public on the Nasdaq. Shares, first priced at $28, open at $71. Founders Marc Andreessen and Jim Clark end up centimillionaires. The New Economy is born.

April 1997: The Biggest Little Startup in History

Storied venture firm Kleiner Perkins Caufield & Byers (also an investor in Netscape) arranges a $48 million private placement for fledgling Internet service provider @Home, giving the company a record-breaking value of more than $1 billion.

September 1997: The Virtues of Narcissism

In a double issue of Fast Company, management guru Tom Peters says your most important job is head marketer of the Brand Called You.

November 13, 1998: Money Really Does Grow on Trees!

TheGlobe.com, a little-known Web portal--whatever that was--shatters IPO records with a 606% first-day rise.

January 1999: Eyeballs by the Truckload

Job sites HotJobs.com and Monster.com pay $2 million and $4 million, respectively, to run five ads during the Super Bowl.

May 28, 1999: Spending Funny Money

With its shares trading near $100, @Home completes a $7.2 billion buyout of Internet portal Excite, another Kleiner Perkins startup, to create "the new media network for the 21st century." It is expected to compete with AOL.

August 1999: Spending More Funny Money

Cisco pays $7.4 billion in stock for Cerent Communications and Monterey Networks, the largest startup purchase of the New Economy.

November 1999: Bonfire of the Inanities

Web retailer Respond.com invites 2,000 Valleyites to its launch party, and 10,000 RSVP. Guests at the $200,000 shindig get individual bottles of Veuve Clicquot champagne.

January 25, 2000: Uh-Oh. Did You Hear Something?

Goldman Sachs files for a $58 million IPO of 18-month-old Noosh Inc., a zero-revenue company that says its key business strategy will be to "exploit our first-mover advantage." The deal is withdrawn May 22.

April 17, 2000: I Definitely Heard Something!

We suddenly run out of greater fools: The stock market crumbles. In just six-and-a-half hours, the Dow plunges 617 points, or 6%; the Nasdaq ends up 34% below its all-time high of a month earlier.

May 2000: Speed...Kills

Fast Company urges being fast in all things. Fast to hire! Fast to partner! Fast to spend. We leave out "Fast to go bust!"

January 2001: So Much for 21st Century New Media Networks

Excite@Home takes a staggering $4.6 billion write-off on its media properties, and files for Chapter 11 bankruptcy in September.

(Continued on next page)

The Financier • Vol. 13/14, 2006-2007 69

the stock (Diba, 1990). Diba goes on to say that the samereason why a bubble may form may also result in the endof the bubble. The rise of the bubble and its variance fromthe fundamentals of valuation can in some situations beviewed as a result of the herd mentality. Typically thebubble grows at a rate in excess of the fundamentals of thevaluation as the herd mentality comes into play, and atsome point the herd will turn and the investors will selltheir shares. This will result in the bubble coming to anend. The diagrams included as Exhibit 2 outline thecyclical nature of the bubble.

It is argued that the pricing of internet stocks duringthe internet bubble was based in part upon herd behaviorand a related phenomenon referred to as the Greater FoolTheory (Cassidy, 2003). The Greater Fool Theorymaintains that it is possible to make money not by buyingsecurities based upon their intrinsic value and a desire toparticipate in the future earnings of the purchasedsecurities, but rather by buying overvalued securitiesbecause there will almost always be someone else (the“Greater Fool”) who is willing to purchase thesesecurities at an even higher price (Williams, 1997). Inpractice the theory works well until the last purchaser ofthe securities is unable to locate a Greater Fool. At thispoint, the pricing of the securities and the market forthem collapses. The Greatest Fool is found, and oncefound the search for the Greater Fool ends. As with therise of the price of the securities, the “bursting” of thebubble also has little to do with the fundamentals of theunderlying company, but rather the end of a period ofoverpricing during which the securities pricing has losttouch with the fundamentals.

The Greater Fool Theory is similar to chain letters. All

participants in a chain letter believe that they will get rich.However, the chain letter is a classic example of yetanother theory called the Zero Sum Game (Harris, 1997),which means that it is little more than money beingexchanged between the participants. At the end of thegame some of the participants may be richer, but the newriches that have been “created” are offset by otherparticipants, who in total are poorer in an amount equalto the riches that were created.

Although the Greater Fool Theory is not a valuationmethodology, it may help explain the high pricing ofinternet securities during the internet bubble period. Therapid rise of asset markets before falling even more rapidly isalso referred to as the Asset Price Bubble Phenomenon(Halcomb, 2002). Other asset price bubbles include thetulip bubble in Holland during the seventeenth century, theSouth Sea bubble, the stock market boom of the 1920’s, thehigh-tech boom of the early 1980’s, and the biotech boomof 1989 – 1990 (Shiller, 1989; Dash 1999).

Within the context of Behavioural Finance andtraditional securities valuation, this paper addresses 1)internet company valuations during the internetbubble, and 2) did the pending IPO of Google portenda Bubble II.

II. TRADITIONAL SECURITIES VALUATION ANDITS APPLICABILITY TO INTERNET COMPANIES –

THE WAY WE WERE

“Value is destroyed, not created, by any business that losesmoney over its lifetime,” – Warren Buffet

Purchasers of securities (investors) buy them in orderto have an opportunity to participate in the future

Exhibit 1. Continued.March 9, 2001: IPO Now Stands for "It's Probably Over"

Netscape founder Marc Andreessen's second startup, Loudcloud, rises just 15 cents on its first day of trading.

October 2001: The Biggest Bankruptcy in History...

Enron, an Old Economy gas-pipeline company turned New Economy market-maker and mystery, goes belly-up.

2002: Until Somebody Does Bernie Ebbers's Books

Between January and August of 2002, ongoing accounting scandals at MCI/WorldCom, Global Crossing, Adelphia, Tyco, and others bring the stock market and many formerly vaunted executives to their knees.

April 23, 2003: And Now the Profile, Mr. Quattrone

Famed tech investment banker Frank Quattrone is arrested in Manhattan by federal prosecutors and charged with obstructing justice. His case ends in a mistrial.

2004: The Big Hope

Investors awaiting the expected IPO of Internet search behemoth Google are still holding their breath. The deal is expected to generate a market cap for Google of as much as $25 billion.

70 Corr

earnings, dividends, or cash-flows of the companies.Subject to the terms of the various classes of securities thata company may issue, investors have the right, on aproportionate basis to the number of shares they own tothe number of shares that the company has issued, toobtain the dividends, cash-flow, and earnings of thecompany. The value of the dividends, cash-flow, andearnings of the company is often referred to as the

intrinsic value of the company (Lee, Myers, Swaminathan,1997).

Internet companies have been viewed as being differentfrom traditional companies for reasons that are addressedin this paper. However, investors purchase internetcompany shares for the same reasons that they purchasetraditional company shares; to participate in the futureearnings of the company. One could therefore argue thatinternet shares should be valued based upon the samefinancial metrics as traditional companies, which is thevalue of future earnings. In many cases however, internetcompanies have no profits and may project negative cashflows for an extended period of time.

Damodaran (2000) argues that the valuation ofinternet companies can be determined using DiscountedCash Flow models. His view is that companies withnegative earnings can be valued using three options. Thefirst is to replace current negative earnings with a positivenumber assuming that the company will revert back topositive earnings in a normal year. The assumption in thisscenario is that the company had previously had positiveearnings in a normal year, and therefore is of no use inscenarios wherein the company has never had positiveearnings. The second option that he puts forth is that thevaluation can be based upon sales in lieu of earnings, sincesales are positive. His view is that sales in conjunction withestimated operating margins could be used to estimateprofits. This scenario may work in a situation where thecompany is loosing money because of a temporaryaberration, but does nothing to assist in valuing aninternet company whose business model may befundamentally flawed, to the extent that the companymay never produce profits based upon its business model.His third option applies when earnings are negative dueto excessive debt of the company. In this scenario heproposes that earnings can be adjusted by reducing theleverage of the company. This rarely would apply in thecase of internet companies, as they tend to have limitedamounts of debt, as they are typically not credit worthyand therefore cannot obtain debt financing and aretypically financed through private or public equityofferings.

This forces the investor to focus on operational issues,in order to determine the possibility of the internetcompany reaching a period of continued profitability, sothat financial metrics may be applied and a valuationdetermined. Briginshaw argues that this forces theinvestor to perform additional analysis when compared totraditional large Fortune 500 and other long establishedpublic companies, that typically have detailed historicaland current financial information available for investors(Briginshaw, 2002). The additional analysis Briginshawidentifies includes:

Exhibit 2

HOW BUBBLES EXPAND:

Rising Asset Prices(stocks currencies, real estate)

Rising Asset Prices(stocks currencies, real estate)

MoreLending

More Investment& Consumption

Spending

MorePaperWealth

Investors buyto Profit fromFalling Prices

Banks haveStronger

Balance Sheets

HOW BUBBLES CONTRACT:

Falling Asset Prices(stocks currencies, real estate)

Falling Asset Prices(stocks currencies, real estate)

LessLending

Less Investment& Consumption

Spending

LessPaperWealth

Investors sellto Avoid

Falling Prices

Banks haveWeaker

Balance Sheets

The following diagram’s are from the Canadian Auto Workers Newsletter of December 1998, and outline the cyclical nature of the bubble.

The Financier • Vol. 13/14, 2006-2007 71

• More careful and painstaking analysis of the internetcompany’s past history and future prospects.• More caveats have to be borne in mind with regard topotential discontinuities and their effect on the future valueof the internet firm.• A lack of accounting data may force reliance on non-accounting or non-financial data, which may be less reli-able or more open to interpretation.• Even with painstaking and careful analysis of past his-tory and future value drivers, valuations are likely to bemore prone to error than valuations of conventional firms.• While old-economy firms tend to have capital struc-tures consisting of debt and equity, new economy firmspossess capital structures in which equity predominates,together with some contingent claims including employeeshare options and convertible debt.

A high growth company is a company that investscapital in new assets, and generates through its operationsa return on capital that on average is higher than for mostcompanies. Many traditional non-internet companies areconsidered high growth companies, and during theinternet bubble virtually all internet companies wereperceived as having the potential to be high growthcompanies. Even though there are many differing viewson how internet companies should be valued (Mills,2000), for the purpose of comparison it is necessary toestablish a common basis for evaluating both traditional“old economy” high growth companies and internet highgrowth companies.

As internet companies were typically perceived as highgrowth companies, then a model that values high growthcompanies would appear to be appropriate to value them.It has been proposed that the investment opportunityapproach is one way to value growth shares (Miller andModigliani, 1961). This approach is normally utilizedwhen the investor believes that he or she can realize a highrate of return and the value is based upon the value of thefuture growth of the company plus the current value ofthe company.

According to Miller and Modigliani (1961), the valueof a growth firm is a function of: (a) normal rate of returnthat an investor can earn by investing in other securities;(b) present value of cash flows from existing operations;and (c) opportunities to make above-average returns onadditional investments in a business. The equation below(1) illustrates the investment opportunities approach:

(1)

• X (0) represents the earnings from company assets,• “p” is the normal rate of return,• “p*” is the rate higher then normal that can be

obtained by investing additional capital “I” at time “(t)”in new real assets.

Critics of this model state that taxes are ignored in thevaluation as are bankruptcy and other potential agencycosts. However, this expression resembles traditionaldiscounted cash flow (DCF) models in that it considersthe financial metrics important in valuing a company.

The “normal” rate of return discounts forecastedcash flows from assets-in-place to the present value. Asthis rate increases (p ), the present value decreases (V ),illustrating in the equation below (2) the negative risk-value relationship fundamental to all DCF models.

(2)

The second expression represents the value of growthopportunities. Expecting returns higher than the normal,the owner invests in new real assets (I(t) ). Increasedinvestments induce high uncertainty regarding thecommercial success of these investments. The uncertaintytranslates into increases in volatility (p* = p), a measure of riskassociated with the opportunity for abnormal returns. Asillustrated in the equation below (3), the increase ininvestments and the underlying uncertainty positively affectthe value (V) of the growth component in the investmentopportunities approach. It is important to point-out that thepositive volatility-value relationship, a feature fundamentalto option pricing models (Black and Scholes, 1973), isopposite to the traditional DCF predictions.

(3)

Traditional DCF models assume that there is noopportunity to consistently produce above normalreturns, (p* = p). This assumption is supported with thesemi-strong version of Efficient Market hypothesis whichsays that it is impossible to produce abnormal returnsbased on all publicly available information, includinghistorical price behavior. Some argue that traditionalDCF models undervalue internet stocks because theyignore the value of growth opportunities in the absence ofsignificant earnings.

The growth component of the investment opportuni-ties approach is similar to the real option pricing methodin several ways. First, it assumes the positive value-volatility relationship. Second, it recognizes theimportance of managerial project selection in investmentsin new assets. Some argue (Jagle 1999) that the realoption-pricing model is applicable to value internet stocksbecause of these assumptions. However, it tends toovervalue internet stock because it ignores the negativeeffect of losses on the value of earnings.

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Like all valuation methodology that includes forecastedcash flows, it is only accurate if the forecasts are accurate.Forecasting the future cash flows of an internet companywhich may at the time have no sales or profits, and as anew industry entrant may have no industry comparables,may be difficult to predict. Furthermore, internetcompanies typically have high R&D and marketing costswhich are difficult to forecast in early stage companies dueto the unknown of competitors positioning, which makesit difficult to project future cash flows and to determinethe appropriate cost of capital.

III. INTERNET COMPANY STOCK PRICING DURINGTHE INTERNET BUBBLE: A CHALLENGE FOR TRADI-

TIONAL VALUATION METHODOLOGIES

intumesce, v. intr.: 1. To swell or expand; enlarge. 2. Tobubble up, especially from the effect of heating

As stated in Section I, on August 9, 1995 Netscapewent public, starting with much fanfare the era of theinternet boom. Traditionally, companies going public are

profitable; however this did not apply in the case ofNetscape which had losses of $14 million in the fiscal yearbefore going public and $6.4 million in the 12 monthtrailing period prior to going public. Therefore,traditional comparable valuation metrics such as price/earnings ratios were not applicable to Netscape. Manymore unprofitable internet companies went publicsubsequent to Netscape during the internet boom period(see Exhibit 3), which forced the companies, investors,and the financial community to look to other metrics tomeasure the value of these companies. In a rare momentof candor, one prominent internet financial analysts,Henry Blodgett of Merrill Lynch, put it this way in 1999:“If most of the internet companies will fail, and we stilldon’t know who the ultimate winners will be, how do wevalue them”.

As discussed in Section I, a common valuationmethodology for companies is the Discounted Cash-Flow (DCF) approach. During the internet bubblehowever, internet company shares continued to increasewell beyond the valuations justified using DCF analysis

Exhibit 3

IPO DateGoogle is:BiggerSales at IPO (in mm)No. of Employees at IPOMore Profitable:Net Income at IPO (in mm)Revenue per EmployeeOlder:Age of Firm at IPOMore ValuableMarket Value at IPO Price (in mm)

Value of Google based upon Industry Comparbles

Fiscal 2003 Sales GrowthSales (annulaized in mm)Number of Employees

Valuation MultiplesMarket Value as of May 24, 2004 (in mm)Price to Sales RatioP/EMV/Employees (in mm)

Netscape8/8/1995

$47.6257

-$6.4$185K

1

$1,027

Yahoo4/11/1997

$1.443

-$0.6$32K

2

$334

E-Bay78%$3,025$8006300

$55,32618.369.1$8.80

Amazon5/14/1997

$30.0256

-$9.1$121K

3

$467

Yahoo71%$3,031$4055500

$41,98313.9103.7$7.60

E-Bay9/23/1998

$19.076

$3.7$250K

3

$730

Ask Jeeves65%$157$54306

$2,25714.441.7$7.40

Average9/23/1998

$24.7158

-$3.1$147K

2.3

$639

Average71%$2,071$4204035

$33,18915.571.5$7.90

GoogleEstimatedSummer2004 $1,173.01907

$144.0$615K

6

$24 billion

Google177%$1,558$2561907

$24,16715.594.4$12.70

Comparisons to Companies that went public in Bubble era:

Google market value based upon Industry Average Price to Sales ration.

The Financier • Vol. 13/14, 2006-2007 73

(Mauboussin, 1998). The DCF methodology simply didnot “fit” the internet company valuations. While intheory it would have been possible to use DCF todetermine the value of internet company shares duringthe bubble, the reality was that the assumptions thatwould have to be made relative to growth, margins, cash-flow, and cost of capital, in order for the DCF model toapproximate the market valuations, would have had to beso aggressive to make the assumptions not credible.

The next attempt to find a valuation methodology thatfit the ever increasing market valuations of internetcompany shares was that of real option theory(Briginshaw, 2002). The rationale for using optiontheory was that the forecasted profits of these companieswere substantial, whilst the potential losses were small ifthe company did not succeed. This theory played nicelyinto the hands of proponents of the view that the internetboom would never end, and who rarely failed to seeenormous profit generation potential in internetcompanies. This resulted in call option techniques such asthe Black-Scholes formula being adopted as rationalvaluation methodology for internet stocks. One of theproblems with this approach however, was that the factorof industry competition was typically not addressed. Evenduring the internet boom it was recognized that internetcompanies in new markets who were successful, wouldattract new market entrants which would potentially havethe effect of limiting the upside of the company beingvalued.

Given the failure of the aforementioned methodologiesto fit the actual market value of the internet companies,there was a movement in the financial community toadopt valuation methodology that would better fit themarket valuations. The methodology that was arrived atwas that of “ratios” which were used to calculate“comparables”. Comparable ratios had been long used tocompare the financial performance of companies withinindustry groups or to compare industry groupsthemselves. These ratios such as P/E (share price/earnings) had components that were actual financialmeasurements. These however could not be utilized ifthe company did not have earnings as in the case of the P/E multiple.

The venture capital and financial community is acreative lot, and not ones to ignore the potentialcommissions and fees to be earned during this boomperiod, as well as the increases in the value of the equitypositions that they held in internet companies.Therefore, in order to justify and support the value ofinternet companies, they developed a number of“multiple” measurements for internet companies rangingfrom the number of users who viewed a web page, to thenumber of subscribers to a web site (whether the

subscription was paid for or not). Whilst these factorswere interesting, and in fact did provide a basis forcomparison between internet companies, they had littleto do with projected cash-flow and value of the company.Moreover, comparing the multiples of one overvaluedinternet company, to another overvalued internetcompany, did nothing to justify the value of thesecompanies based up future earnings. Furthermore, thebusiness models adopted by the internet companies mademany of these comparisons irrelevant and distracted fromthe actual fundamental valuation metrics that should havebeen used; future cash-flows, profits and dividends.

Many internet company specific ratios and comparableswere adopted ensuring that the financial community hada never ending supply of ratios to justify valuations. Theseincluded, but were not limited, to the following.

Market Capitalization divided by:• number of users• views of advertisements on web site• views of pages on web site• points-of-presence• number of websteaders (free home page users)• number of total internet users

Revenue divided by:• number of websteaders• bandwidth (amount of bandwidth used to generatesales)

In addition to the fact that these ratios had little ornothing to do with financial performance, a Forbesmagazine article reported a number of ways in whichthese ratios were being “managed” by the internetcompanies (Wooly, 2000):• Increase unique users by paying another website to gen-erate a hidden (background) pop-up of your site (e.g.About.com until late 2000).• Increase visitors by routing from lotto or gaming siteswhere users have to click through to bet (e.g. Dealtime,Coolsavings).• Increase reach by seeking to attract visitors or users morelikely to be in a panel observed by an internet market sur-vey (e.g. the Mediamatrix panel is thought to contain ahigher proportion of older web surfers than the averageweb user population).

The “management” of these web sites resulted ininflated comparable valuation parameters which furtherdetracted from the usefulness, if any, of these ratios.

Upon the bursting of the internet bubble in 2000,capital became much more difficult to attract and only thestronger of the internet companies survived. “Stronger”in this case meant internet companies that were eithercash flow positive, or had raised sufficient cash during theinternet boom to meet their burn-rate for an extendedperiod of time. Some of these internet companies had

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profits and positive cash-flow, and therefore investorsstarted to value them based upon more traditionalvaluation metrics, as skeptical investors became muchmore cautious in their investment decisions. As a resultthe DCF methodology once again became relevant, as thevalue of the remaining profitable internet companies nowfit much closer the value of traditional companies.

There are a number of factors regarding DCF that needto be considered within the context of valuing internetcompanies. These factors are those that can impact themarket value of internet company shares, but are notnecessarily appropriately considered within the DCFmodel (Core et al, 2001):• DCF discount rates are too high.• DCF is not relevant to the new economy.• DCF cannot capture the value of flexibility.• DCF needs too many assumptions: we cannot accu-rately project growth and margins so there is no point intrying.• DCF does not capture the influences on equity value ofsupport and resistance levels.• DCF does not reflect many stock patterns includingthe Monday effect, January effect, break-out from mov-ing averages, low float effect and lock-up effect.

Notwithstanding the above, the DCF calculation mayresult in a reasonable estimate of value. Moreover, itconsiders the key financial parameters of a business whicheffect shareholder value, which is consistent with thepurpose of the estimating the value. This cannot be saidfor many of the internet industry ratio and comparablemethods that are discussed above.

Exhibit 4 indicates the volatility of the stock market asit relates to the bursting of the internet bubble andcorrelates it to prior stock market crashes in 1929 and1987. According to John Briginshaw, (Briginshaw,2001), there are three possible explanations for the highvaluations that the internet companies commanded andin some cases still command. These are:1. The market had identified new sources of value withininternet firms, sources of value not associated with earningsor cash flows, and therefore missed by traditional valuationparadigms. Because internet firms work within the “neweconomy” where network effects and co-operation are ofvital importance, earnings and future cash-flows do notfully capture the value that thee firms have.2. The market was correctly anticipating “hyergrowth” incompany earnings under “new economy paradigms”. Be-cause internet firms are faster moving and more efficientthan “old economy” firms, they can grow far more quicklyand profitably (after an initial period of losses necessary tobuild up their businesses to a critical mass). In this view,earnings and cash flows are still important, but they areanticipated to grow at unheard of speed.

3. The market was overvaluing these stocks due to a “specula-tive bubble”. Investors systematically overvalued internetstocks. However, this overvaluation persisted because ob-served high returns from holding internet stocks attractedfresh investors into the market. This third explanation seesinternet stock valuation as an example of a Ponzi or pyra-mid scheme (i.e. variances on the Greater Fool Theory).

Briginshaw rejects explanation 1, network effects, in asfar as they exist can be represented as lower ongoingmarketing costs for the firm, and can therefore feed intocash flows. The only way to test between the remainingexplanations is to conduct fundamental valuation analysisof internet firms. Clearly since we now know that the highvalues of 2000 did not persist to the present day, it seemslikely that these values were not supported by fundamentalfinancial metrics.

Carrying out fundamental analysis using data existing atthe peak of the bubble (Higson and Briginshaw, 2000)further confirms that fundamental analysis could notexplain the bubble values. Therefore by process ofelimination, explanation 3 was selected by Briginshaw(Briginshaw, 2001) as the likely cause of the stock marketshigh values in 2000.

In terms of Behavioural Finance, one could arguethat the investor’s decision to invest in internet stock isnot one that can be rationally explained. As manyinternet companies failed, it was obvious to investorsthat the chances of the internet sector companiesbecoming financially self-sustaining was minimal, andfurthermore a rational analysis of their financial metricsshould further distract an investor from purchasinginternet stocks. Nevertheless, investors continued toinvest in the internet sector which could lead anobserver to conclude that investors in internet stockwere not acting rationally.

In Section I, a number of behavioural theories wereidentified that spoke to irrational investment decisions,and these theories may in part explain why investorspurchased internet stocks. These explanations include:

Overconfidence – The rapid increase in the value ofinternet stocks could in part be attributed tooverconfidence which leads to high levels of trading anderrors in judgment.

Desire to Gamble – Some investors may like the rush andthrill of taking a gamble on the internet stocks that theypurchase.

Herd Behaviour - The hype surrounding internet stockscaused investors to become influenced by the action ofothers resulting in an information cascade. Theinformation cascade results in investors purchasing evenmore internet shares, however, once the investorsperception about internet stocks changed, the value of thestocks reduced significantly.

The Financier • Vol. 13/14, 2006-2007 75

In 2004, Google Inc. would pose a challenge to theexperts who attempted to place a value on the companywhen it announced its intention to go public in April ofthat year. Not only would valuation methodologies betested and questioned, but Google would choose amethod of going public that was little used, and almostunheard of in the technology sector.

IV. GOOGLE: THE POTENTIAL BEGINNINGOF BUBBLE II – A BEHAVIOURAL

FINANCE PERSPECTIVE

“We are back in a mini-bubble era in terms of peopleexpecting a lot of these valuations, but I don’t think we’ll seethe same amount of exits the way we did. Companies such asAmazon, eBay, Yahoo and Interactive Corp. are here tostay, but over time the boundaries of what those businesses dowill get fuzzier.” Bill Gates, Chairman MicrosoftCorporation, March 2004

Google Inc. (Google) is an internet search enginecompany whose engine is widely used. The Google webpage (www.google.com) on November 25, 2004 claimedthat a search initiated using its search engine searched8,058,044,651 web pages. “Googol” is the mathematical

term for a 1 followed by 100 zeros. The term was coinedby Milton Sirotta, nephew of American mathematicianEdward Kasner, and was popularized in the book,“Mathematics and the Imagination” by Kasner and JamesNewman (Kasner, 2001). According to Google’s website, Google’s play on the term reflects the company’smission to organize the immense amount of informationavailable on the web.

On April 19, 2004, Google filed its Form S-1Registration Statement (S-1) with the U.S. Securities andExchange Commission (SEC) stating its intent to raiseapproximately $2.7 billion through a share offering. The171 page S-1 document is available at - http://news.findlaw.com/hdocs/docs/google/ipo/. No spe-cific date was set for the Google share offering in the S-1Registration Statement.

As required by the SEC, the S-1 contains significantinformation regarding the planned offering and on thehistorical financial performance of Google. Thisinformation is in part provided so that the investor hasinformation to assist in determining the value of Google forthe purpose of potentially purchasing its common shares.

The following chart (exhibit 5) provides some of thekey information from the Google S-1. The figures for

Exhibit 4. S&P Crash Correlation, 3 Year1927/9 — 1985/7 — 1997/9

“As the Fall begins there is a tenseness on Wall Street. Its presence is undeniable. There is a general feeling that something is going to happen during the present season. Just what it will be, when it will happen or what will cause is anybody's guess." Business Week, September 7, 1929 (four days after the final stock market peak)

1450

1400

1350

1300

1250

1200

1150

1100

1050

1000

950

900

850

800

750Jan-97

Feb-97

Mar-9

7

Apr-97

May-9

7

Jun-97

Jul-97

Aug-97

Sep-9

7

Oct-9

7

Nov-9

7

Dec-9

7

Jan-98

Feb-98

May-9

8

Apr-98

May-9

8

1997/91985/871927/9S&P Crash Correlation - 3 year

Jun-98

Jul-98

Aug-98

Sep-9

8

Oct-9

8

Nov-9

8

Dec-9

8

Jan-99

Feb-99

Mar-9

9

Apr-99

May-9

9

Jun-99

Jul-99

Aug-99

Sep-9

9

Oct-9

9

Nov-9

9

Dec-9

9

Jan-00

Feb-00

Mar-0

0

Apr-00

1997/9

1927/9

1985/7

76 Corr

1999 through 2003 are those reported in the S-1 for thefull fiscal years. The figures for 2004 are created bymultiplying Google’s first fiscal quarter figures by fourand the actual results could therefore be higher or lowerthan those projected depending on numerous factors.

Additional highlights from the S-1 include:• Google had $335 million in cash, cash equivalents andshort-term investments, as of the end of 2003.• Since at least March, 2002, Google has had no quarterwhere net revenues decreased.• Google has earned a profit every quarter since March2002.• Google quarterly profit flattened between the fourthquarter of 2002 and the first quarter of 2003. Of all quar-ters since March 2002, it has dropped only once in thethird quarter of 2003. This was largely due to a significantincrease in stock-based compensation which was expensed.• Google earned less than 3 percent of its net revenues in2003 by serving search results to Yahoo.• Yahoo still retains the right to use Google’s search re-sults on its sites. Google is terminating this right as ofJuly 2004.• No advertiser generated more than 3 percent ofGoogle’s net revenues in 2001, 2002, 2003 and the firstquarter of 2004.• Distribution agreements, the ability to run ads on sitesoutside of Google on the Google Network, accounted for15 percent of Google’s net revenues in 2003 and 21 per-cent as of the first quarter of 2004.

• No Google Network partner generated more than 5percent of Google’s net revenues in 2002, 2003 and thefirst quarter of 2004.• Google had $527 million promised in revenue sharingagreements relating to AdSense placements, at the end of2003. About 39 percent of this is due within the nextyear.• Five Google network partners account for 70 percentof what Google has promised in revenue sharing. Ten part-ners account for 91 percent of the payments.• Based on advertiser billing addresses, Google estimatedthat 74 percent of its net revenues in 2003 came from theUS, dropping to 70 percent for the first quarter of 2004.• Countries outside the US generated 26 percent ofGoogle’s net revenues in 2003, and the figure rose to 30percent for the first quarter of 2004. More than halfGoogle’s traffic, however, came from outside the US.

Approximately 96% of Google’s revenue comes fromadvertising with the remainder coming from othersources, such as enterprise search services, web searchservices and other products as indicated (exhibit 6):

Figures shown are for the full years of 2001, 2002,2003 and for the first three months of 2004 and wereobtained from the S-1 filing.

Google earns it advertisement income from its ownweb sites and it distributes advertisements to partner websites (the S-1 filing calls these partners the GoogleNetwork). This dual distribution has been well-known,but what hasn’t been known was how much revenue the

Exhibit 5

$1,600

$1,400

$1,200

$1,000

$800

$600

$400

$200

$0

-$2001999

99 00 01 02 03 04$0.2$7-$6

RevExpProfit

$19$34-$15

$86$75$7

$348$161$100

$348$161$100

$1,559$937$256

Net Revenue, Expenses & Profit

(in millions of US dollars)

2000 2001 2002 2003 2004

R

E

P

The Financier • Vol. 13/14, 2006-2007 77

Exhibit 6

100%90%80%70%60%50%40%30%20%10%0%

Revenue Sources

2001 2002 2003 2004Ad Revenue Other Revenue

77%

23%

92% 95% 96%

8% 5% 4%

Ad Revenue

Other Revenue

Exhibit 7

100%90%80%70%60%50%40%30%20%10%

0%

Ad Revenue Sources

2001 2002 2003 2004Boogle Network

100%

0%

96%84%

78%

4%

16%22%

Google

Network

partners added to Google. As it turns out, relatively little,though that trend is rapidly reversing (see exhibit 7):

Figures shown are for the full years of 2001, 2002,2003 and for the first three months of 2004 and wereobtained from the S-1 filing. Google gained no majorportal partners or other keyword-driven advertisementdistribution deals that might have accounted for such agrowth in revenue from on the network side. However in2003, it launched its AdSense contextual advertisementprogram and then greatly expanded Adsense (advertise-ments placed by companies and advertising agencies).

Google’s filing is complete with many disclosures thatinvestors are typically warned of including:• Yahoo and Microsoft are specifically named by Googleas its primary competitors.

• Google reveals that it had issues with “employee accessto our advertising system” in 2002, requiring changesmade in 2003 to improve internal controls.• Google worries that proprietary document formatsmight prevent it from indexing information. For in-stance, it says that software providers could perhapsdemand a royalty to search these types of documents.Microsoft Word documents are listed as an example,along with this disclaimer: “If the software provideralso competes with us in the search business, they maygive their search technology a preferential ability tosearch documents in their proprietary format. Any ofthese results could harm our brand and our operatingresults.”• Google discusses that it has regularly paid refunds be-

78 Corr

cause of click fraud and potentially might have to makeretroactive payments.• Google specifically calls out “index spammers” and linkbombing as an “ongoing and increasing effort” that couldharm its results. “If our efforts to combat these and othertypes of index spamming are unsuccessful, our reputationfor delivering relevant information could be diminished.This could result in a decline in user traffic, which woulddamage our business,” the filing says.• Many in senior management and key employees are fullyvested. In short, they could sell their Google shares anddepart Google at any time.• Google notes system failures can be a concern and re-veals in November 2003, it failed to provide web resultsfor 20 percent of its traffic for 30 minutes.

In addition to the aforementioned challenges that arearticulated by Google in their S-1 filing, it is important tofocus on network externalities as Google implies that theywill potentially be the major player in search enginemarket, as their technology will set the standard in themarket (Google Form S-1 Registration Statement, page1). The certainty of Google setting and maintaining thestandard is key to their on going ability to maintain theirdominant position in the market, such as Microsoft hasdone in PC operating systems and eBay has done withinternet auctions. While a standard may be established forsearch engines, Google’s ability to own that standardremains uncertain. Google’s ability to capitalize onnetwork externalities may be the key to their ability toown the standard. Network externalities are thefoundation for Microsoft’s business model in operatingsystems and for eBay’s business model in online auctions.The opportunity to own the standard due to networkexternalities is rare, and companies like eBay andMicrosoft are able to capitalize on such opportunities andearn higher economic returns than those who do not.

The term “network externalities” is used by economiststo describe a condition wherein consumers benefit fromother consumers using the same product or using thesame standard (Gautam et al, 1999). Networkexternalities are considered to be either direct or indirect(Church et al, 2002). Direct are cases like the telephonewherein the more people that utilize the telephone themore valuable owning a telephone becomes to anyindividual telephone user. In the direct effects scenariothere is a positive loop effect that drives continuouslyincreased demand. E-mail is another example of directeffect externalities.

Indirect effects are based on the supply ofcomplementary products. The PC with its plethora ofsoftware from many vendors and hardware peripheralsthat can readily be attached to standard PCs, are anexample of indirect effects based upon complementary

products. On the other hand, the failure of Apple todominate the PC market was in part blamed upon itsdecision to not open its architecture for third partyhardware.

Network externalities do not exist in many industrysectors, however, in rare situations, the nature of networkexternalities in an industry gives individual companies theopportunity to own the standard. This allows them topotentially gain a monopoly position and earn profitsconsistent with their position in the market. In industrieswhere the possibility of strong network externalitiesexists, competitors invariably move to become the majorplayer in the market and to have their product or servicebecome the accepted standard. Once the company has setthe standard and dominates the market, it is difficult forcompetitors to enter the market.

Network externalities exist in the search engine market.The underlying way in which a search engine works interms of its search criteria, and the order in which resultsare displayed, may become a standard. Once this standardhas been accepted by users in the market, users willbecome used to the functionality and the way results areordered and displayed, and likely a standard will emerge.Advertisers will be attracted to the standard once it hasbeen adopted, and developers of web sites will developweb sites in such a manner to take the maximumadvantage of the standard in search engines.

The ability of Google to become the standard and be thebeneficiary of the financial rewards that is often seen bycompanies who gain this position, will likely be key toGoogle’s long term valuation. There is a chance that thecompetitors identified in Google’s S-1, namely Yahoo andMicrosoft, may be able to adopt the same logic as Googleand all companies will in effect share the standard that iscreated. In that event no company will own the standard andbe able to monopolize the market. In addition, if onecompany does become the de-facto standard it will notnecessarily be Google. As stated in the Google S-1 (page 6)“As search technology continues to develop, our competitors maybe able to offer search results that are, or that are perceived to be,substantially similar or even better than those generated by oursearch services. This may force us to compete on bases in additionto quality of search results and to expend significant resourcesin order to remain competitive”. Given this statement, onemay conclude that there is nothing proprietary within theGoogle technology itself that gives them a uniqueopportunity to drive the standard in the market. In addition,the two primary competitors that Google has identified,Microsoft and Yahoo, have significant financial resourcesand market positioning, which may allow them to replicateand make incremental improvements to the logic and searchalgorithms that become the de facto standard for internetsearch engines. Microsoft, which is known as an aggressive

The Financier • Vol. 13/14, 2006-2007 79

company, also has the ability, should it choose, to blockaccess to Word and other proprietary documents fromGoogle’s search engine as stated in Google’s S-1. Thesecompetitive risks and threats may not have been priced intothe valuations of Google that were considered prior to itsIPO.

When considering the aforementioned and theabundance of information that is available in the 171 pageS-1 document, one would assume that prior to the IPOthat the financial community could readily come up withrelatively close and consistent valuations for Google. Thisin fact is not the case. Wall Street’s guessing game prior tothe IPO was appraising the value of Google. On May 7,2004, eight days after the S-1 had been filed, Bloomberg,a major financial reporting organization, provided thefollowing comments from the financial “experts” whohad reviewed the Google S-1:• Martin Pyykkonen, an analyst at Janco Partners, esti-mated the company’s market value at as much as $25 bil-lion. Three days later he revised that to as much as $50billion. Pyykkonen said he changed his estimate after cal-culating that the company’s tax rate may fall this year andits earnings may rise faster than he had earlier forecast. “Iwas initially conservative, but for the rest of the year theyshould continue to kick the ball out of the park,” he said.• Kevin Calabrese at Argus Research said Google prob-ably is worth no more than $17 billion.• Bill Miller, manager of the $14 billion Legg Mason ValueTrust Fund, says he plans to buy Google shares and that itis worth somewhere between $18 and $57 billion.• Troy Mastin at William Blair & Co. said investors mightbid it up to more than $30 billion. He said “Estimatesbased on Google’s fundamentals may fall short of howmuch investors may bid, dazzled by Google’s brand nameand search engine technology”.

Incredibly, given the disclosure provided through theS-1, and given the financial industry’s experience duringthe internet boom/bubble, the valuations of the fourinternet industry financial experts, presumably workingwith the same information, ranges from $17 - $57 billion,and one of the experts increased his expected valuationfrom $25 to $50 billion in 3 days.

At $15 billion, Google’s market value would be lowerthan Yahoo, eBay and Amazon, three major internetcompanies. At $57 billion, it would eclipse all three ofthese companies. In July 2004, prior to the IPO, themarket capitalization of Yahoo was $34.6 billion, EBaywas $52.6 billion and Amazon was $17.4 billion (Exhibit3). According to comments from Bloomberg, analystsnow are now returning to ratios and comparables in orderto estimate the market capitalization of Google, withmost reverting to the method of multiplying the expectedearnings by the price-to-earnings ratio of a competitor.

To determine Google’s value, many analysts are usingYahoo, the second most-used internet search engine, as abasis for measurement (see Exhibit 2 and Exhibit 3 forcomparative figures). Yahoo’s shares trade at about 80times the company’s 2004 estimated earnings per share.Some believe that Google is growing at a rate which maysee it earn $1.50 to $2.00 a share this year. Using thatmethodology results in a calculation which multiplies theearnings per share by 80, Yahoo’s price to earnings ratio,to obtain a forecasted share price for Google in the rangeof $120 - $160. With 246 million shares currentlyoutstanding, this would value Google at $29 - $39billion.

The Google IPO differs from typical IPO’s by givingindividual investors the chance to enter their ownestimates of each share’s value within a range set byGoogle. Only after they have entered their bids, willGoogle and its bankers determine the price. This methodis known as a Dutch auction as opposed to the moreconventional syndicate method of allocating shares toinvestors. There will be two classes of Google stock. The237.6 million Class B shares will have “super-voting”rights of 10 times those of the other Class A shares. Thistwo-part equity capital structure ensures that powerremains firmly in the founders’ hands as the founderscontrol the Class B shares. In addition, Class B shares areconvertible at any time to Class A shares on a one for onebasis.

According to the S-1 (items below quoted directlyfrom the S-1 are in italics), Google expects to use the netproceeds received from the offering for “generalcorporate purposes,” including:• Sales and marketing expenses, R&D expenses, and gen-eral and administrative expenses; Capital expenditures,• Possible acquisitions of businesses, technologies or otherassets (although Google does not have any current agree-ments or commitments with respect to any material acquisi-tions),• Management plans to invest the net offering proceeds(“net” proceeds being the total IPO dollar amount less un-derwriters’ fees and all other transaction costs) until the timethat Google needs to fund the above operating uses. The S-1specifies that the net proceeds will be invested in short-term,investment grade (i.e. low risk) securities.

Given that the Dutch auction method was used for theIPO, it was difficult to determine prior to the IPO whatthe valuation of Google would be, and furthermoreneither the offering price nor the number of Class Ashares to be offered could be determined until the IPOclosed. Only the amount of funding to be raised, $2.7billion, has been provided.

For the purpose of comparison to the “ratio andcomparables” approach that was used by the financial

80 Corr

analysts to value Google, let us look at some DCFscenarios using various assumptions, to see how theresults compare when calculating the value of Google.Exhibit 8 contains four DCF valuations for Googlebased upon various assumptions for growth anddiscount rates, along with financial information thatwas provided in the S-1. The valuations range from $8- $38 billion. As with any valuation methodology, theDCF valuation methodology can produce results thatvary significantly dependent upon the assumptionsmade. For example, the chances of accuratelypredicting Google’s sales growth rate are as one analystput it “about a googol to one”. Revenues grew from$86 million in 2001 to nearly $1 billion in 2003. Giventhe short and dramatic revenue growth history ofGoogle, it would be naïve to think that an investor

could correctly predict the revenue of Google for thenext 5 years, or the next 6 months for that matter.

One source that most financial experts have notconsidered when valuing Google is the company itself.While Google provides no specific information regardingits value in the S-1, the S-1 does include information onstock options granted to employees. In 2003 the averageshare option was granted at $2.65, and Google hasreassessed the value of these options and has recorded thedifference as “compensation expense”. For the firstquarter of 2004 Google added $75.4 million to itsdeferred compensation account which related to theapproximately 1 million options that were granted duringthat period. Therefore approximately $75 was the excessvalue for each share. The options granted during the firstquarter of 2004 were granted at an average price of

Exhibit 8

Base Assumptions:

Growth Years 1 - 10 Growth Years 11+ WACC - High/Low

Year1234567891011+

WACC

PV of Free Cash FlowPV of Residual ValueEnterprise Value

1HighHighLow

80%70%70%40%35%30%20%20%15%15%10%

15%

$5,155,240$33,255,800$38,411,040

2HighHighHigh

80%70%70%40%35%30%20%20%15%15%10%

20%

$3,613,080$10,864,340$14,477,420

SCENARIOS3HighLowHigh

80%70%70%40%35%30%20%20%15%15%5%

20%

$3,613,080$6,913,670$10,526,750

4LowLowHigh

80%45%40%40%35%30%25%20%15%15%5%

20%

$2,928,980$5,388,230$8,317,210

Note: 1) The "High" and "Low" terms are relative terms and not necessarily indicative of what the actual amounts may be. 2) Changes in the Scenarios from the prior one have been highlighted. 3) For the purpose of these calculations the following have been assumed: No - Investments, Debt, Minority Interests and Other Equity 4) Corporate tax rate assumed to be 30%.

The Financier • Vol. 13/14, 2006-2007 81

$16.28. Therefore Google values these shares atapproximately $91. According to the S-1 Google hasapproximately 246 million shares outstanding. Theresulting value of the company based upon the shareestimate of $91 would therefore be $22.4 billion.

Jack Ciesielski the publisher of Analyst’s AccountingObserver used the Black-Scholes method to determinethe price that Google values its shares based upon the“fair value” that Google provided at various times for theoptions in the S-1 (Thurm, 2004). Google says that thefair value of the options issued in the first quarter of 2004based upon Black-Scholes was $67.06. Given the $16.28option price and other financial assumptions, Ciesielskicalculated the value of the shares at $80.44. The resultingvalue of the company based upon the Black-Scholesmethodology would therefore be approximately $19.8billion.

The various valuations (in billions of dollars U.S.) forGoogle that have been discussed can be summarized asfollows:

Google was not alone with its potential high valuation.

Given the great interest in the Google IPO, the herdmentality may have been at play in July, 2004 with othercompanies in the search engine space, even thoughGoogle had yet to go public. During the period ofJanuary – July 2004, shares of search engine companiesAsk Jeeves had increased 143%, Look Smart 66%, andMama.com 368%. The increased valuations were shortlived however, as by mid 2005 the shares of all threecompanies had returned to pricing levels below those oftheir January 2004 price, perhaps as a result of the marketdominance that Google had gained in the search enginespace by mid 2005.

Mama.com, a Montreal-based meta-search engine,announced in June, 2004, that it raised $16.6 million ina stock sale to private equity investors. Mama said it woulduse the money to complement its $11.3 million in cashand equivalents to pursue possible mergers andexpansion. The offer came after the small search player’sstock hit $13, up from $3.25 at the start of 2004. Forcalendar 2003 Mama.com had sales of $8.9 million and aprofit of $211,000. At $13 a share Mama.com would

Exhibit 9

Company

Advertising.comAlibris Blue NileBrightmailClariaECost.comGoogleGreenfieldPlanetOutShopping.com

Business

AdvertisingBooksJewelry Anti-spamPop-up adsRetailerSearchOnline SurveysGay mediaComparison shopping

Amount to be raised

$100$35

$72.9$80

$150$35

$2,700$75 $75 $75

$3,397.9

Profitables

NoNoYesYesYesYesYesYes No Yes

Source: Company SEC filings

Note: - Amount to be raised in millions of dollars U.S. - Profitable: refers to prior fiscal year

Valuation SourceFinancial CommunityDCF SenariosBlack-ScholesGoogle S-1 (compensationadjustment calculation

Low$17$8.3$19.8$22.4

High$57$38.4$19.8$22.4

Exhibit 10

82 Corr

have a market capitalization of approximately $136.5million.

Interchange Corp., a Laguna Hills, CA, company thatoffers local search services, filed for an initial publicoffering in June, 2004. The stock sale net the company$27.75 million. In 2003, the company had profits of$60,000 on $8.8 million in revenue, the company statedin its regulatory filing. Interchange had a marketcapitalization of approximately $128 million based uponits offering.

Gary Stein an analyst with Jupiter Research said “Inthe long run, the gravity of Google is going to attracteverything to it. These other companies are going to risewith it. Everyone wants to invest in search. The nextquestion is what are the markets around it”. Stein went onto say “You have to invest in the company as well as theidea. The company could be taking what they do andcalling it search because it’s the buzzword.”

The valuation of companies such as Mama.com,indicates that we may have the classic informationcascades scenario of the failure of information about truefundamental value to be disseminated and evaluated(Shiller, 2000). In addition, investors may believe that ata potential valuation in the range of $50 billion forGoogle that they should look for other investments in thesearch engine space, which may be undiscovered by otherinvestors, and therefore a better investment. This is aclassic case of the investor thinking that he or she knowsmore than other investors. Furthermore, as theconfidence in the market (search engine) increases,investors will drive the prices away from the fundamentals(Diba, 1990).

V. CONCLUDING REMARKS

“It’s almost a mathematical impossibility to imaginethat, out of the thousands of things for sale on a given day,the most attractively priced is the one being sold by aknowledgeable seller (company insiders) to a less-knowledgeable buyer (investors)”. Warren Buffett

In a July 27, 2004 regulatory filing with the SEC,Google announced that it planned to sell its shares at aprice that was to be determined but would be between$108 and $135. Google indicated its intent to sell 24.6million shares, which at the planned selling price, wouldresult in gross proceeds to Google of between $2.6 and$3.32 billion. An additional 262.5 million sharesremained in the hands of management, employees,investors, vendors, consultants and others which wouldresult in a total of 287.1 million shares being issued at thetime of the IPO. At $135 per share Google would havea market value of approximately $38.75 billion rivalingcorporate giants such as McDonald’s and General

Motors, who on July 27, 2004 had market capitalizationsof approximately $34.2 billion and $23.6 billionrespectively.

Google was unable to close its IPO offering at the $108- $135 share price range. On August 18, 2004 Googleannounced that it was reducing the number of shares thatit was offering to the public from 25.7 million to 19.6million, and reduced the planned target share price rangeto between $85 and $95. The change in the price rangerepresented a 26% decrease in the offering priced basedupon the mid-point of both offerings. On August 19,2004 Google closed its IPO at $85 a share and during itsfirst day of trading closed at $100.34, up 18% from itsoffering price. Google’s share price maintained itsupward trend closing at an all time high on November 3,2004 of $201.60, resulting in a market capitalization ofapproximately $56.4 billion.

On August 19, 2004, the day of that Google begantrading, the Dow Jones industrial average climbed 1.11%and the NASDAQ Composite index rose 2.01% (http://finance.yahoo.com). The same day shares of Googlecompetitors Yahoo Inc. and Microsoft Corp. rose, withYahoo Inc. closing up 0.49% at $28.48 a share, andMicrosoft up 1.52% at $27.46 a share. However, perhapsbased upon the great interest in the Google IPO, the herdmentality may be at play with other companies in thesearch engine market. As aforementioned, the shareprice of search engine companies Ask Jeeves, hadincreased 143%, Look Smart 66%, and Mama.com 368%,during the period of January 1 – August 30, 2004.

The investor enthusiasm for IPO’s that somecompanies had hoped would follow Google’s announcedIPO did not materialize. Google’s S-1 filing of April 29,2004 prompted a number of startups to file their S-1’sindicating their plans to go public. According to anIPOhome.com report (see figure 5 below), during theperiod of January 1 through August 31, 2004, 124 U.S.companies registered for an IPO with the SEC.

The report goes on further to state that 13 of the 124companies have either postponed or canceled theirofferings since July 1, 2004 and that “more than 100others companies wait in limbo as the investor meetingsthat precede IPO’s have ground to a virtual halt”. Theexcitement and press surrounding the Google IPOnotwithstanding, perhaps investors who took financiallosses during the internet bubble of 1998 – 2000, remaincautious regarding purchasing shares of companies thatdo not meet stringent financial criteria.

What is apparent is that historically stock marketshave been subject to various bouts of exuberantincreases in share prices only to be followed by an evenmore severe decline in the value of the shares.However, some of the companies that were initially

The Financier • Vol. 13/14, 2006-2007 83

affected by the bursting bubble in the internet marketare now strong companies. These companies, whichhad solid business models, such as eBay, Yahoo andAmazon, became strong companies and majorcontenders in the markets that they addressed. Theyalso slowly recaptured some of the internet magic ofthe period during the boom and now have relativelyhigh valuations when compared to traditionalcompanies in the same market space. The internetcompanies that have succeeded tend to be pure playcompanies in that their business model is based solelyupon the internet, and the majority of them tend not tocarry inventory (e.g. eBay, Yahoo, and Google), withAmazon being an exception.

Behavioural Finance theory would lead one to theassumption that the high valuations for internetcompanies during the internet bubble were a result ofherd mentality and the Greater Fool Theory.Furthermore, one could assume that the meaninglessratios and comparisons that were created for valuinginternet companies were created as a tool to attempt to

justify the high valuations that arose for internetcompanies, and that they did nothing to measure theintrinsic share value of the internet companies.

Notwithstanding that the DCF methodologies canproduce diverse valuation results based upon theassumptions utilized; at a minimum the results representfinancial assumptions that in the final analysis reflect thevalue of the company, subject to the assumptions of theperson using the DCF methodology.

Google is currently in a strong financial position and iscertainly much stronger than any of the internet companiesthat went public during the internet bubble (see Exhibit 2and Exhibit 3). It appears that the Google IPO had initiateda new internet bubble era in the search space, but not in theinternet space in general. However, the search bubble wasshort lived notwithstanding that Google’s share price madesignificant in the year since it went public. Furthermore, ofthe ten internet companies that had filed with the SEC to gopublic as of May 31, 2004, seven of them were profitable intheir prior fiscal year, which leads one to believe that thecompanies going public are much more mature than thosethat went public in the late 1990’s (see Exhibit 9).According to internet company filings with the SEC, thetotal amount that the ten companies are planning on raisingis approximately $3.4 billion. Of that amount the $2.7billion offering of Google represented approximately 80% ofthe total amount of the funds that all of the companiescombined are planning to raise (given that Google actuallyraised $1.66 billion the ten companies therefore planned onraising $3.36 billion of which Google’s $1.66 billionrepresented approximately 50%). What this indicates is thatthe Google IPO will likely be an anomaly in terms of its sizein 2004, and furthermore there are no other internetcompanies of the size of Google that could gather theattention that Google has, should they go public.

Subsequent to Google’s initial IPO their shares rosesteadily and by September 2005 had reached as high as$320. With trailing annual revenues in excess of $4billion and a market capitalization of approximately $90billion, on September 14, 2005 Google announced itsintention to sell 14,159,265 shares at a price of $295.00.

How other search engine firms will be affected byGoogle in the long term, and the resultant overall effectthat Google will have on the valuation of internetcompanies in general will undoubtedly be subject tomuch study and analysis in the future. However, basedupon the value of Google shares and the shares of othersearch engine companies, it is clear that a temporarybubble did exist in the internet search engine space thatwas short-lived, and that the subsequent shareperformance of Google was unique to Google.Furthermore, the performance of Google’s did not resultin a bubble for internet stocks in general.

Exhibit 11

500

400

300

200

100

0

Number of IPOs as of 8/31/04

Renaissance Capital’s IPOhome.com

Num

ber

of IP

Os

’99 ’00 ’01 ’02 ’03 ’04

406

124

486

8370 68

84 Corr

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TOM CORR is a serial entrepreneur in the technology sector with over30 years of experience in the industry. Since selling his last company in2000, Tom has been involved in venture capital, M&A, interim CEO,and due diligence activities. He is now the Senior Technology Managerat the University of Toronto’s technology transfer group - theInnovations Foundation, and teaches the Entrepreneurship course inthe MBA programme at the University of Toronto. Tom alsocontributed to the best-selling book Art of the Start by Guy Kawasaki.Tom is a Research Associate with Henley Management Collegeworking on his DBA degree and holds a MBA degree from theUniversity of Toronto and an Advanced Postgraduate Diploma inManagement Consultancy from Henley Management College.