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Center For Economic ResearchInternet Stock ValuationHow Relational Value Impacts Market Value of Equity Dawn Hukai University of Wisconsin - River Falls School of Business and Economics Helpful comments were provided by Charles Corcoran, Carl Popelka, Mary Tichich, seminar participants at the University of Wisconsin-River Falls, and two anonymous reviewers. Internet Stock Valuation Abstract Many internet industry investors and analysts believe that nonfinancial measures such as pageviews, unique visitors, and number of customers are useful in predicting future market share, earnings, and prices of internet firms. This study focuses on the impact of accounting and nonfinancial information on the valuation of 32 internet-related stocks during the years 1996-1999. Only nonfinancial information was found to be consistently positively related to the market value of equity of internet companies, using both traditional and Ohlson residual income valuation approaches. The unaudited nonfinancial information used in this study was self-identified by the internet firms in their annual reports, and includes number of customers and pageviews. Presumably firms will report the nonfinancial information that is most relevant to their investors, and the value relevance evidence supports this conjecture. Accounting information was not yet consistently positively related to market value of equity in this new industry during the years 1996-1999. The accounting variables of internet firms are highly positively correlated with firm size, and firm size varies greatly within the internet industry. Adding a size variable, deflating by a size variable, and using a log-linear transform are implemented in an attempt to mitigate heteroscedasticity. The log-linear transform was found to be relatively ineffective for dealing with unequal residual variances in the internet industry. Overall, nonfinancial information was found to be more value relevant than accounting information in the early years (1996-1999) of the internet industry. 1. Introduction Recent intense investor interest in internet companies has been driven by the anticipated explosive growth of trade on the internet. Retail sales on the internet are expected to reach $86 billion by 2003. The number of personal computers is also expected to double to 66 million (Clothier, 1999), and business-to-business sales alone are expected to rocket to $1.3 trillion in just three years (Alger, 1999). At the beginning of 2000, the internet industry made up ten percent of the US economy and was the fastest-growing sector (Van Slambrouck, 2000). Wireless access to internet applications is expected to be more popular than wired access by 2004, and recent valuations apparently reflect this anticipation (Bransten, 2000). Nonetheless, the sector also elicits widely divergent opinions about appropriate stock valuation in new industries. The investment hype surrounding internet stocks in general seemed to peak in March 2000, after which internet stock prices fell despite no significant changes in their underlying fundamentals. From March to April 2000 the technology-concentrated NASDAQ Composite Index lost a third of its value (Ip and Browning, 2000). A combination of interest rate fears and a shift in investor psychology have been blamed for the sudden change in mood (Berman, 2000). However, the internet industry continues to grow and change on a daily basis. The uncertainty inherent in the developing internet industry may be illustrated by the history of a more mature industry. For example, automobiles were first sold on the retail market in 1895. The traffic signal did not appear until 19 years later, followed shortly by windshield wipers, and for the first forty years there were no parking meters (Alger, 1999). It is likely that many critical internet accessories and related products have yet to be developed, and as in the automobile industry, not all products will survive market competition in the long-term. While many investors are attracted to the growth opportunities that seem obvious in dot-com companies, older industries (such as electricity, cable television, and biotechnology) experienced valuation bubbles at the outset that eventually deflated. According to most traditional valuation models, the internet firms are still overvalued, considering they exhibit small to negative net earnings and net operating cash flows. Traditional valuation methods including price to earnings and price to cash flow ratios become meaningless when earnings and operating cash flows are negative. Even for those firms that have positive net incomes, the price-to-earnings ratio is extremely high compared to non-internet firms. For example, in January 2000, Yahoo's price-to-earnings ratio was 775, compared to 20 to 25 for non-internet firms. To some extent the P/E ratio reflects high expectations of future earnings and the excitement factor generated by the industry. A price-to-sales ratio has been substituted by some investors and analysts, with the rationale that sales are most important to new firms that generally lose money (Day, 2000). Gross margin has also been suggested as a means of gauging future internet stock performance, given the extreme market share growth strategies of many internet companies that depend on ever increasing marketing expenditures. Despite the dearth of traditional performance measures, investors embraced the internet companies and continued to push prices up from 1996 through March 2000. Internet investors are popularly viewed as short-term speculators, and this limited focus may be one reason for the use of alternative valuation measures, often nonfinancial measures, that are reported in a more timely way than accounting earnings. Analysts describe internet stock valuation methods based upon number of subscribers, page views, hours of use, and customer base rather than more traditional methods based upon present profit potential or even sales growth (Lucchetti, 1998). Supporters argue these nonfinancial measures are the best predictors of future earnings and growth of internet companies and are therefore more relevant valuation measures than present profit or sales growth. In addition, nonfinancial measures may be monitored on a day-to-day basis, while earnings information is often limited to a quarterly or monthly information release. However, there is little consensus as to which nonfinancial measures are the best predictors of future performance. Duration of visits, volume of visits, and even number of customers are not consistently measured from firm to firm (Gurley, 1998). Valuation is also dependent upon the investor's perspective. Is the firm a media (content) firm, an e-business firm, or simply a portal? Splitting the firm into its components necessitates judgments about the appropriate industries and valuation methods for the components. Earnings before taxes, depreciation, amortization, and marketing (analogous to gross margin) is an alternate projection of future earnings that explicitly assumes that marketing costs will fall steeply in the future (Gurley, 1998). Even more a seemingly more traditional valuation method focusing on momentum in revenue growth has been criticized as ignoring good management and industry market share (Tyson, 1999). Each investor appears to have a different idea of how to assess internet stock value, as well as threats to the industry, which were perceived as minimal until early 2000. Threats to internet firms include minimal entry barriers and numerous customers with the ability to search for the lowest price goods. Typical traditional retail firms have 1-4% profit margins, and the overhead saved by operating on the internet may be offset by greater competition, price awareness, shipping costs, and eventually a revised tax structure. Many new industries, such as the computer industry, generated great excitement and valuation at the outset, but the valuations faded despite the underlying usefulness or profitability of the product or service being offered. For example, IBM had 80% of the computer market in the 1960s and 1970s. The P/E for IBM in 1961 was 65, astronomical for the time. However, IBM underperformed the S&P 500 index after 1961, despite growing earnings at 18% per year, for more than 15 years (Siegel, 1999). Threats to the internet industry have been viewed more seriously since the internet stock price drop in early 2000. However, the internet industry remains of great interest to investors and analysts. The second section of the paper reviews relevant prior results of studies focusing on internet stock valuation, the third section discusses the methodological approach used in this paper, and the fourth section describes the empirical results. Section five concludes. 2. Literature Review Several studies have previously examined internet stock valuation. This study is unique in its use of a variety of nonfinancial measures that are reported by the internet firms themselves in their annual reports. These self-selected nonfinancial measures would not be disclosed by the firm if they were not perceived as being useful to the investor or potential investor. As reported in Table 1, the most common self-selected nonfinancial measure that firms choose to disclose is the number of customers/subscribers/registered users (75% of the 32 firms). Some nonfinancial measures, such as pageviews (16% of the 32 firms), are incorporated in prior studies, while others, such as number of registered customers, have not previously been investigated. Gross profits, unique visitors, and pageviews are positively correlated with price in Trueman, Wong, and Zhang (2000). That paper also finds differential effects for different types of internet firms; net income is negatively associated with internet retailer valuation but positively associated with portal and content firms. Pageviews are also found to be relatively more important for internet retail firms than for portal and content firms. Similarly, Rajgopal, Kotha, and Venkatachalam (2000) finds that the proportion of unique visitors to a site is incrementally value relevant beyond book value and earnings. Hand (2000a) finds that basic accounting data, including book value of equity and net income, are highly value relevant to internet firms, but nonfinancial information is not considered in the log-linear regression of market value against beginning of period book value and components of current earnings. Refuting web traffic as the sole indicator of valuation, Hand (2000b) includes several nonfinancial measures and concludes that book value, forecasted earnings, and forecasted earnings growth primarily impact valuation. The results are similar to prior studies in that unique visitors are found to impact valuation incremental to accounting variables. The two Hand papers are innovative in their use of the log-linear regression from Ye and Finn (2000) to mitigate heteroscedasticity and size effects while acknowledging the potential non-linearity between valuation and its underlying drivers. Nonetheless, while the Ohlson (1999) model is invoked in these papers, the nonfinancial web traffic and supply and demand variables are not incorporated via linear information dynamics. In addition, evidence from residual plots derived from log-linear regressions in this paper brings into question the ability of the log-linear regression to control for unequal residual variance. Even after the log-linear adjustment, larger residuals are associated with larger market values of equity. However, the residual income valuation model combined with linear information dynamics is the ideal setting in which to integrate both types of information explicitly. Finally, it is possible that there is no consistent explanation for internet stock price other than a valuation bubble. Evidence of an extended price bubble is provided by Schill and Zhou's (1999) examples of internet carve-out holding values that greatly exceed the market value of the parent companies. The general decrease in internet stock value during March and April 2000 without an underlying change in fundamentals could also be interpreted as evidence of a valuation bubble prior to the correction. However, even within a bubble there are limits on valuation and firms are priced differentially, so there is still much that may be learned about valuation within a price bubble. 3. Methodology The first valuation model studied is a traditional linear model of the form: |
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