Calculating the value of a dot-com

Most of the early dot-com startups, that met a rapid demise during the era of the dot-com bubble, probably started out with great visions, detailed business plans and impressive management teams. Yet, the reality was that they had been brought to market on the basis of speculative ideas, which were given unrealistic prospects for successful profitability. Even respectable brokers had been presenting IPOs (Initial Public Offerings) based upon self-fulfilling speculations.

By concentrating upon ideas, business plans and management skills, the fundamental wisdom that value is based upon assets, earnings and dividends was pushed under the carpet. Traditional concepts of discounting for risk were forgotten as brokers rushed companies with unproven ideas to market. All emphasis was placed upon scaling factors: the reasoning going something like this:

The world wide market for widgets is 100 billion dollars. If half of this can be expected to migrate to the Web, a company with a ten percent share of this market would generate sales of 5 billion dollars. A bricks and mortar company with this order of turnover would be valued at 10 billion dollars. As the efficiencies of trading on-line would be expected to halve sales costs, the profits should be double. This would value the company at 20 billion dollars. Even discounting this value back through a build up time of five years, would still see a present day value of 15 billion dollars, so, the valuation at the time of the IPO will be a bargain at 12 billion dollars.

These calculations assumed that a sound management would be able to capture and retain ten percent of the market, perhaps even more if the company is a first mover. This gets investors falling over themselves to invest in such IPOs, pouring millions of dollars into the hands of "sound management" (but, who had never before been exposed to the unpredictable and chaotic world of e-business).

With the comfort of knowing that the startup is not expected to make profits from day one, most managements looked to the future and set their goals on market share and maximum revenue instead of profits and dividends. Attracting Web traffic and directing customer eyeballs became the sole focus of strategies.

A madness crept into e-business equity markets: an on-line, airline ticket ordering company, saw its equity value rise at one time to a point where it was worth more than the value of United Airlines, American Airlines, British Airways and KLM put together. Investors were pouring money into dot-com companies without any idea of what the basics of the business were, let alone the technology involved.

Companies were being floated on the basis of creating some kind of portal (an entry point on the Web for customers to link to a range of products or services) and these portals were being sold as dot-com businesses on the strength of the future purchases that would be made by the people using these portals. Yet, in essence, these were no more than glorified mailing lists - with each name being valued by as much as a thousand dollars each. In such crazy times, free computers were given away, just to get a name on a list.

At the time, I spoke to a friend of mine who was an analyst for one of the big London brokers who had brought many of these dotcoms to market. He had the job of calculating the launch price of shares when the equity of a company is first offered to the market. He told me that these valuations were based upon the discounted value of the profit that can be earned from customers over a period of several years.

When I raised the point that these customers would have many different alternative ways to spend their money on the Internet and would have the choice of an almost unlimited number of alternative portals and places to buy, he told me that these calculations were made on the basis that most people have a reluctance to change from a familiar source once they have become customers.

Unfortunately, like so many other people involved in these kind of calculations and valuations, he had very little experience of being on the Internet himself. If he'd had, he would have known how easily and quickly people can chop and change around. This tendency to stick with the familiar is a characteristic applying specifically to the world of bricks and mortar and isn't valid in the fast changing world of e-business. It is a world where change is familiar and frequently rewarding.

On the Internet, as soon as people learn from others where they can get a better price or a better service – just by making a few clicks with the mouse – they start to shop around and the concept of customer loyalty becomes redundant. In this situation the only justification for expecting to retain a customer base is by providing exceptionally competitive products or services. This thought didn't seem to enter the calculations of many of investment advisers and analysts.

The discussion got around to a recent dot-com offering, where the IPO equity share price had valued the dot-com higher than the current valuation of the huge multiple retail business of the bricks and mortar company that had initiated it. The dot-com was providing little more than a "free" connection to the Internet, something any other company could do (and subsequently did). How could the equity in this new dot-com business, with virtually no assets, be worth more than that of a long established, successfully trading company which had stores in nearly every town in the country?

My friend pointed out that the company had more than just this list of customers, it also had the vast sum of money that it had gained by selling its equity shares (less the not inconsiderable costs of the launch and the broker's fees). "They will be able to buy out the shares of other dotcoms", he explained.

This conversation then opened my eyes to what the dot-com boom was really about. It was a gigantic zero sum game, winners winning only what the losers were losing. It was all smoke and mirrors. It was almost as if they were all sophisticated scams that were dragging in investment funds to create more scams with the scams feeding off of each other - with the poor investors, who were financing this free for all, getting sucked in deeper and deeper.

It wasn't that most of the people involved were dishonest (although frauds and deceptions abounded), the main fault was that it was a totally new business environment, which nobody understood and where traditional valuations and business practices couldn't be applied.