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INTERNET STOCKS: ABSTRACTS OF EMPIRICAL RESEARCH PAPERS
This version: January 2001
Contact: info@capitalresearchers.com
PREAMBLE
We provide below a compilation of abstracts of 18 empirical research papers on Internet stocks that have been published over the last year. While a few of the papers have been published or are forthcoming in research journals, most are working papers that are still subject to revision. (Citations and URLs for the papers are provided.) In most cases, the authors' own abstracts are provided; however, in cases where the author's abstract is too brief or is not provided, an excerpt from the paper's summary/conclusions section is included.
There is of course much work in progress that will update, extend, and improve upon the research summarized here. We will update this document periodically as new empirical research becomes available.
The papers summarized below span the following topics:
By bringing together the papers in one document and grouping them according to the categories outlined above, this compilation provides the reader with a quick overview of the major empirical work that has been done so far on Internet stocks.
Please also review our synthesis of the findings of some of the papers summarized below that examine the "value-relevance" of Website traffic in relation to traditional financial variables: "Website Traffic ('Eyeballs'), Financial Performance, and Internet Stock Prices: A Synthesis of the Emerging Empirical Evidence." (www.capitalresearchers.com/WebTraffic_InternetStockPrices.htm).
We welcome, with appreciation, your critiques/comments. Please send them to: info@capitalresearchers.com
RESEARCH PAPERS
THE EYEBALLS HAVE IT: SEARCHING FOR THE VALUE IN INTERNET STOCKS [January 2000]
http://papers.ssrn.com/paper.taf?ABSTRACT_ID=206648
Brett Trueman, M.H. Franco Wong, and Xiao-Jun Zhang
Haas School of Business, University of California, Berkeley
Abstract
In this paper we provide insights into the manner in which (relatively sparse) accounting information, along with measures of Internet usage, are employed by the market in the valuation of Internet firms. Consistent with those who claim that financial statement information is of very limited use in the valuation of internet stocks, we are unable to detect a significant positive association between bottom-line net income and our sample firms’ market prices; in fact, the association is actually negative. However, when we decompose net income into its components, we find gross profits to be positively and significantly associated with prices. In addition, both unique visitors and pageviews, as measures of Internet usage, are found in most instances to provide incremental explanatory power (in some cases considerable) for stock prices. We also separately analyze the e-tailers, and the portal and content/community firms (the p/c firms) in our sample. For the e-tailers we find that bottom-line net income generally has a negative association with stock prices (as for the sample as a whole), while a positive and significant association exists for the p/c firms. In this respect, p/c firms’ shares behave more like those of non-internet companies. Further, we find for the p/c firms that the incremental explanatory power of pageviews and of unique visitors is approximately the same; in contrast, pageviews has much greater incremental explanatory power for the e-tailers than does unique visitors. This suggests that pages viewed per visitor is an especially important metric for the e-tailers, as compared to the p/c firms.
Note
A critique of this paper, Discussion of "The Eyeballs Have It: Searching for the Value in Internet Stocks," by Elizabeth K. Keating of the Kellogg Graduate School of Management, Northwestern University, is available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=248137
The critique highlights the limitations and shortcomings of the paper with respect to research design (model specifications, proxies for variables, etc.), data limitations, statistical methodologies, etc. These limitations and shortcomings also apply to similar papers such as the others on value-drivers summarized below. Here are the abstract and an excerpt from the "Conclusions and Future Research" section of the Keating critique:
Abstract
This commentary describes an Internet valuation paper by Trueman, Wong and Zang (TWZ) presented at the 2000 Journal of Accounting Research conference. TWZ investigate the role of accounting and Internet use data in valuing Internet firms, using a residual income valuation model and two "eyeball" measures of web activity. TWZ reveals that Internet valuations in the 1998-99 period were consistent with investors: (1) differentially weighting permanent and transitory income statement components, (2) relying on non-financial measures of internet use, and (3) using different models for e-tailer vs. portal/content firms. Since the Internet is a nascent industry, the TWZ analysis is constrained by the short trading history, limited financial and non-financial data, and a small sample size. This commentary describes econometric, modeling, and interpretation-related concerns with the TWZ paper and offers suggestions for future research on "New Economy" firms.
Excerpt from the "Conclusions and Future Research" section
…Future researchers can investigate alternative valuation models and specifications, addressing the modeling, econometric, and interpretation-related concerns highlighted during the conference presentation. For example, research could employ Internet use and other non-financial measures that are both grounded in theory (e.g. Ohlson's information dynamics) and more clearly proxy for growth opportunities or assets-in-place. Income statement and cash flow data could be partitioned differently to test more directly whether specific transitory components, such as in-process research and development costs, merger-related costs and restructuring charges are value-irrelevant. Another opportunity is to study the role played by aggressive vs. conservative accounting practices in Internet stock valuation. Return or valuation studies of Internet firms may have also sufficient data to address issues of dependence and associated bias in the standard errors.
The issue of mispricing of high tech stocks is another avenue for accounting research. During the period under study, Internet firms traded at high market/book and price/sales ratios relative to non-internet firms. The business press has suggested that Internet firms were priced based on sales growth and capital expenditures. Internet stock prices fell substantially in mid-2000, following media attention on potential bankruptcies and high "cash burn" rates exhibited by Internet firms. Research could be conducted to understand the original high valuations and reasons for the dramatic decline. Potential explanations could relate to risk, functional fixation, supply and demand factors, life cycle pricing (Anthony and Ramesh [1992]), or under/over-reactions by investors or analysts.
THE RELEVANCE OF WEB TRAFFIC FOR INTERNET STOCK PRICES [January 2000]
http://papers.ssrn.com/paper.taf?ABSTRACT_ID=207989
Shivaram Rajgopal, University of Washington
Suresh Kotha, University of Washington
Mohan Venkatachalam, Graduate School of Business, Stanford University
Abstract
We find that web traffic is relevant for explaining market values and stock returns of pure Internet companies after controlling for accounting information such as book values and earnings. However, we find weak associations between web traffic and sales levels and sales growth. We conjecture that traffic creates future growth potential through network effects and customer relationships that do not necessarily result in current realized sales revenues. We provide preliminary evidence in support of this conjecture by documenting strong associations between acquisition prices and website traffic for a sample of Internet acquisitions.
Excerpt from "Concluding Remarks" section:
…There are several limitations to our analyses. First, although our paper is responsive to recent calls for economic models of firm value that incorporate non-financial measures (Amir and Lev, 1996; Shevlin, 1996; Lambert, 1998), our model positing the factors that explain traffic could be potentially improved. Future work could focus on building better models to explain traffic generation. Second, our REACH measures could be subject to measurement error because PC Data’s survey of web users does not include corporate users. Third, our analysis is limited to traffic measures. Research using a broader set of non-financial measures may provide greater insight into other factors that explain variation in Internet firm values.
PROFITS, LOSSES AND THE NON-LINEAR PRICING OF INTERNET STOCKS [January 2000]
http://papers.ssrn.com/paper.taf?ABSTRACT_ID=204875
John R. M. Hand, Kenan-Flagler Business School, University of North Carolina at Chapel Hill
Abstract
This paper sheds light on the economics of Internet firms by extracting information on major value-drivers from their stock prices. Contrary to conventional Wall Street wisdom that there is little or no method in the pricing of Net stocks, I find that basic accounting data are highly value-relevant in a simple nonlinear manner. Using log-linear regression on quarterly data for 167 Net firms over the period 1997:Q1–1999:Q2, I show that Net firms’ market values are linear and increasing in book equity, but concave and increasing (decreasing) in positive (negative) net income. When Net firms’ earnings are decomposed into revenues and expenses, revenues are found to be weakly positively priced. In contrast, and consistent with the argument that very large marketing costs are intangible assets, not period expenses, Net firms’ market values are reliably positive and concave in selling and marketing expenses when net income is negative, particularly during the first two fiscal quarters after the IPO. R&D expenditures are priced in a similarly concave manner, although more durably beyond the IPO than are marketing costs. The concavity in the pricing of core net income, R&D costs, and selling and marketing expenses runs counter to the notion that Net firms are expected to benefit from extraordinary profitability stemming from large strategic operating options, or increasing returns-to-scale.
Excerpt from "Conclusions" section:
…Finally, it must be stressed that a critical question that cannot be confidently answered by cross-sectional regressions of equity market value on current accounting data is whether the correlations extracted from Net firms’ stock prices are fully rational. Providing a rigorous answer to that question – a burning one in the minds of millions of investors around the world – requires constructing intrinsic value estimates that are independent of observed prices. I pursue such an analysis in another paper (Hand 2000c). What can be said, however, is conventional wisdom that asserts that the pricing of Net stocks is "a chaotic mishmash defying any rules of valuation" (Wall Street Journal, 12/27/99) is false. As with Polonious’ comment on Hamlet’s strange behavior, "Though this be madness, yet there is method in ‘t."
THE ROLE OF ECONOMIC FUNDAMENTALS, WEB TRAFFIC, AND SUPPLY AND DEMAND IN THE PRICING OF U.S. INTERNET STOCKS (April 2000)
http://papers2.ssrn.com/paper.taf?ABSTRACT_ID=221232
John R. M. Hand, Kenan-Flagler Business School, University of North Carolina at Chapel Hill
Abstract
In this paper I measure the importance of three groups of factors in the pricing of U.S. Internet stocks: economic fundamentals, web traffic, and supply and demand forces. Using log-linear regression on a panel of data for Net and non-Net stocks on 2/1/2000, I highlight five findings.
First, contrary to popular perception, neither web traffic or supply and demand forces drive Net stock prices. Rather, economic fundamentals in the form of current book equity, forecasted one-year ahead earnings and forecasted long-run earnings growth dominate in explaining cross-sectional variation in Net stock prices. Second, incremental to economic fundamentals, Net firms’ equity market values are reliably related to only one measure of web traffic—the number of unique visitors to the firm’s web site. Net firms’ equity market values are unrelated to the number of page views, hours spent at the website, the average age and the average income of visitors. Third, over and above economic fundamentals and web traffic, Net firms’ equity market values are reliably correlated with proxies for supply and demand forces in the form of public float, short interest and institutional ownership. Fourth, the value-relevance of supply and demand factors only exists for Net firms with no business-to-consumer web traffic, suggesting that the public familiarity that business-to-consumer e-commerce creates leads to greater capital market efficiency in the pricing of their stock. Finally, the equity values of non-Net stocks are unrelated to supply and demand forces, yet are strongly associated with economic fundamentals.
Overall, I conclude that while the pricing of U.S. Net stocks is dominated by expectations of near- and long-term profitability, they are also uniquely impacted by non-traditional value-drivers in ways that non-Net firms are not.
A RUDE AWAKENING: INTERNET SHAKEOUT IN 2000 (September 2000)
http://www.ssb.rochester.edu/fac/demers/index.htm
Elizabeth Demers, Simon School of Business, University of Rochester
Baruch Lev, Stern School of Business, New York University
Abstract
This study explores the major value-drivers of business-to-consumer ("B2C") Internet companies’ share prices both before and after the "bursting of the Internet bubble" in the spring of 2000. Although many market observers had predicted that the bubble would eventually burst (e.g., Perkins and Perkins 1999), the ultimate and previously unanswered challenge lay identifying which stocks would fall and which ones would survive the shakeout.
We develop an empirical valuation model and provide evidence that the Internet stocks that this model suggests were relatively over-valued prior to the Internet stock market correction experienced relatively larger drops in their price-to-sales ratios when the bubble burst. This result is robust to the inclusion of competing explanatory variables suggested by the economics literature related to industry rationalizations.
We also investigate a number of additional issues related to the rapidly changing Internet world. First, we provide descriptive evidence of the correlation between monthly stock returns and contemporaneous and lagged Nielsen/Netratings web traffic metrics (both levels and changes). We then undertake a factor analysis on the set of Nielsen/Netratings raw web metrics with a view to synthesizing the data into a parsimonious set of orthogonal web performance measures. Our factor analysis results in the extraction of three factors that capture the most relevant dimensions of website performance: (1) reach, (2) "stickiness", and (3) customer loyalty.
Our findings suggest that all three web performance measures are value-relevant to the share prices of Internet companies in each of 1999 and 2000. Our findings of significance for the year 2000 contradict the recent claims of some analysts that web traffic measures are no longer important. We also explore the valuation role of our proxy for B2C companies’ ability to sustain their current rate of "cash burn" and find that this proxy is a significant value-driver in each of 1999 and 2000. Finally, our results suggest that investors adopted a more skeptical attitude towards expenditures on intangible investments as the Internet sector began to mature.
Consistent with the results of prior studies in other knowledge asset based industries, we find that investors appear to implicitly capitalize product development (R&D) and advertising expenses (customer acquisition costs) during the "bubble" period when the market was more optimistic about the prospects of B2C companies. However, neither marketing expenses nor product development costs are implicitly capitalized into value, on average, subsequent to the shakeout in the spring of 2000. Overall, our study provides a preliminary view of the shakeout and maturation of one of the most important New Economy industries to emerge to date – the Internet.
STOCK PRICE PERFORMANCE OF INTERNET FIRMS: IDENTIFICATION OF KEY DRIVERS (1999)
http://www.babson.edu/entrep/fer/papers99/XVII/XVII_B/XVII_B%20Text.htm
Kathleen Seiders and Elizabeth G. Riley
Babson College
Abstract
Valuation of publicly held firms in the electronic commerce industry is volatile: the market recently has witnessed radical stock price increases and declines in newly issued Internet companies. What are the underlying causes of instability and lofty valuations in this market? This research takes initial steps toward identifying and examining the key drivers of Internet firm stock price performance. We propose a model that incorporates traditional and non-traditional variables, test our propositions, and discuss the implications of our results. Findings from this study underscore the need to develop future investigations of Internet sector performance using models that include strategic and marketing-related variables.
Excerpt from "Discussion" section
In this study, we propose and test a mix of non-traditional (e.g., firm visibility) and traditional (e.g., quarterly growth rate) variables posited to influence Internet stock price performance.
The results of our analysis suggest that the measurement and evaluation of these drivers and their individual effects is a contribution to the literature. Our research indicates that shifts in market dynamics, such as growth in individual on-line (and day) trading and earlier public offerings, may have affected the firm valuation process in the electronic commerce sector. Promotion in the popular press may be bringing electronic commerce users who previously were light or non-traders into the market, increasing demand and consequently price.
Results from our first analysis suggest that the proposed set of key drivers of Internet stock price performance provide a strong explanatory model. Five of our seven independent variables make a significant, unique contribution to the model. These findings are particularly interesting because our set of proposed drivers differs from explanatory variables used in traditional models.
The importance of firm visibility and business concept (as operationalized) is notable, as these two factors are highly Internet relevant. Deeds, DeCarolis, and Coombs (1997) argue that uncertainty about future profitability creates an informational barrier for financial markets, generating a need for indicators that are signals of the future performance of firms in emerging industries. The Internet firms we studied are likely to be using aggressive marketing and advertising as a signaling mechanism, sending messages to the marketplace and to potential investors about the capabilities and the future value of the firm.
Market capitalization-to-revenues is both company- and market-driven: a major uptick in the market for one stock may trigger the buying of other Internet stocks to avoid missed opportunity. Dilution’s strong performance may be related, to some degree, to higher quality current market conditions. Companies that need to fund extensive growth to maintain first mover advantage leverage the ability to execute early IPOs.
An interesting result in this model is the lack of significance of management team and investment bank/analyst quality. In general, management quality is high across firms in our sample, suggesting that top tier individuals were recruited for their ability to manage IPO and post-IPO issues and processes. The constraint in variability across firms for this factor likely contributed to our result. This result is consistent with those of Keeley and Roure (1990) and Sandberg and Hofer (1987), who were unable to link firm performance with the background of the founding management team. Roure and Keeley (1990) found no individual effects to be significant, proposing that because most firms were qualified in the measures and above a threshold, additional qualifications added no value.
Our findings relative to investment bank/analyst also may be explicable. Because of Internet market attractiveness, firms are able to choose top-ranked investment bankers and financial analysts. These analysts are broadly quoted in the popular press so their perspectives are shared beyond the institutional investor community—a trend that may dilute their influence. If a higher proportion of retail than institutional shares are traded daily, the relationship we detected could be related to day traders who do not have access to investment research. This phenomenon also may be related to the strong performances of the firm visibility and business concept variables in our model.
…The strength of our primary model supports our fundamental research premise: that the drivers of Internet stock performance differ from traditionally recognized factors. Traditional models are asset or earnings based; Internet firms have low asset intensity and few have earnings. Historically, companies without quarter-to-quarter profitability or financial robustness are unable to go public and gain access to capital. Internet firms are moving to IPO status more rapidly and with fewer constraints….
BACK TO BASICS: FORECASTING THE REVENUES OF INTERNET FIRMS (April 2000)
http://papers2.ssrn.com/paper.taf?ABSTRACT_ID=224597
Brett Trueman, M.H. Franco Wong, and Xiao-Jun Zhang
Haas School of Business, University of California, Berkeley
Abstract
In light of the importance of revenues in the valuation of Internet stocks, this paper examines the roles played by analysts, past revenues, and web usage data (unique visitors, pageviews, and minutes spent at a firm’s web sites) in the forecasting of future revenues. In contrast to evidence from other industries, we find that analysts’ revenue forecasts almost always underestimate the revenues of Internet firms. Historical revenue growth is shown to have incremental predictive power over analysts’ forecasts, more so for our sample of portal and content/community firms than for our e-tailer sample. Estimates of web usage growth, on the other hand, generally have significant incremental value for predicting the revenues of the e-tailers, but little predictive power for the revenues of the p/c firms. Finally, we examine whether measures of web traffic have incremental value in the prediction of revenues above time-series forecasts. This issue is especially important when valuing firms with little or no analyst coverage, where there is, of necessity, an increased reliance on historical revenues for forecasting purposes. We find that all three web usage metrics do have significant incremental predictive power.
Excerpt from "Summary and Conclusions" section
…Our results yield several additional implications. First, they strongly suggest that either analysts are not fully taking into account the information in past revenues and current web usage numbers (both of which are publicly available) in determining their revenue forecasts, or that they are intentionally biasing these forecasts. Second, they make clear the value for forecasting purposes of both improving upon the estimates of quarterly web traffic growth and obtaining more timely web usage numbers. Finally, given the differences between our results for the p/c firms and the e-tailers, they emphasize the importance, for analytical purposes, of not treating all the firms in the Internet industry as if they were homogeneous. This point was also made by Trueman, Wong, and Zhang (2000) who found significant differences between p/c firms and e-tailers in the association between their stock prices and both financial and non-financial data.
RATIONAL PRICING OF INTERNET COMPANIES
Financial Analysts Journal, May-June 2000
Eduardo S. Schwartz, Anderson School of Management, UCLA
Mark Moon, Fuller & Thaler Asset Management
Abstract
We apply real-options theory and capital-budgeting techniques to the problem of valuing an Internet company. We formulate the model in continuous time, form a discrete time approximation, estimate the model parameters, solve the model by simulation, and then perform sensitivity analysis. We report that, depending on the parameters chosen, the value of an Internet stock may be rational if growth rates in revenues are high enough. Even with a real chance that a company may go bankrupt, if the initial growth rates are sufficiently high and if this growth rate contains enough volatility over time, then valuations can reach a level that would otherwise appear dramatically high. In addition, the valuation is highly sensitive to initial conditions and exact specification of the parameters, which is consistent with observations that the returns of Internet stocks have been strikingly volatile.
RATIONAL PRICING OF INTERNET COMPANIES REVISITED [September 2000]
www.anderson.ucla.edu/acad_unit/finance/26-00.pdf
Eduardo S. Schwartz, Anderson School of Management, UCLA
Mark Moon, Fuller & Thaler Asset Management
Excerpt from "Introduction"
In Schwartz and Moon (2000) we developed a model for pricing Internet companies using real options theory and modern capital budgeting techniques. The novelty of the approach is that uncertainty about the key variables which determine the value of an Internet company play a central role in the valuation. In particular, we considered uncertainty in both the revenues and the rates of growth in revenues.
In this article we expand and improve the model in several directions. First, we introduce a third stochastic variable to the model, variable costs. These are allowed to follow a mean reverting process with volatility that also mean reverts deterministically. This feature is important since many Internet companies have not yet been profitable but, presumably, are expected to be profitable in the future.
Second, we use the fact that the theoretical framework allows us to compute the "beta" of the stock as means of inferring the risk premium in the model. The estimation of the market price of risk in the model, an unobservable parameter, was one of the most challenging aspects of the approach. We can now use the beta of the Internet stock to infer this parameter.
Third, we explicitly take into account capital expenditures and depreciation when calculating the net after tax cash flows. This is done by introducing a third deterministic path-dependant state variable - Property, Plant and Equipment – which increases with capital expenditures and decreases with depreciation. This feature of the model is important for Internet companies that require large investment in fixed assets.
Fourth, we attempt to improve the bankruptcy condition in the model by allowing the cash balances to become negative. This allows for future equity and debt financing. The optimal financing is that which maximizes the value of the firm.
Fifth, we suggest a number of simplifying assumptions that considerably facilitate the practical implementation of the model. One of these is to set all the speeds of adjustment in the model equal to one another and derive them from the "half-life" of the company to becoming a "normal" firm. Another is to have only one market price of risk in the model by assuming that the growth rates in revenues and variable costs are orthogonal to the "market" returns.
Sixth, we relate the half-life of the deviations to analysts’ (or the evaluator’s) expectations about future revenues. This comes from the fact that the speed of adjustment of the growth rate in revenues is the most critical one for valuation purposes. The expanded model, then, has six state variables, three of which are stochastic and three of which are deterministic (although path dependant). The three stochastic variables are revenues, the growth rate in revenues and variable costs. The three deterministic variables are the amount of cash available, the loss-carry-forward and the accumulated Property, Plant and Equipment. We solve the problem by Monte Carlo simulation which can easily deal with this number of state variables and the complex path-dependencies of the problem.
In Section 2 we present the model with all the new features described above in its continuous-time version. Since the model is solved by simulation using an interval of time that can be quite long, such as one quarter or one year, Section 3 discusses in detail a discrete time approximation. Section 4 provides an illustrative example of the approach by pricing Exodus Communications stock and Section 5 presents comparative statics with respect to some of the key parameters. Section 6 concludes.
Excerpt from "Conclusion" section
...Like any other valuation method, our real options approach to value Internet companies depends critically on the parameters used in the estimation. The next step in the implementation of the model would be to use cross-sectional data of many Internet companies to estimate some of the parameters. Finally, since the growth rate in revenues is not observable, "learning models" could be used to update this critical factor in the model when new information on revenues is revealed.
PRICING AN EMERGING INDUSTRY: EVIDENCE FROM INTERNET SUBSIDIARY CARVE-OUTS (November 2000)
http://papers2.ssrn.com/paper.taf?ABSTRACT_ID=192133
[Presented at the 2001 American Finance Association Meeting (www.afajof.org/prog2001.shtml)]
Michael J. Schill and Chunsheng Zhou
Anderson Graduate School of Management, University of California, Riverside
Abstract
We examine price behavior in the emerging Internet industry by comparing investor valuation of Internet subsidiary carve-outs with that of the parent. We provide examples of parent firms whose Internet carve-out holdings exceed the market value of the entire parent by a large magnitude and over an extended period of time. We reject alternative tax, liquidity, and agency cost hypotheses previously proposed as explanations of a related phenomenon, the closed-end fund discount. We conclude that investors, or at least an important clientele of investors, value direct Internet asset holdings more richly than indirect holdings via the parent and that arbitrage costs accommodate prolonged mispricing. Our findings appear to be common among other emerging industries rather than unique to the Internet sector.
Summary and Conclusions
For our small sample of Internet related carve-outs, we observe that direct shares trade at a large premium to indirect shares held by the parent. For some carve-outs, the value of the parent's holdings in the subsidiary exceed the total market value of the parent firm. We apply our sample to received explanations for a related phenomenon, the closed-end fund discount. We find that agency-cost-based models do not appear to fully explain the valuation premiums associated with parent's holdings in carve-outs. Subsidiary businesses are relatively small and unprofitable. Management ownership tends to be greater for the parent than for the carve-out subsidiary. Wide management overlap across parents and subsidiaries is common. Such observations are inconsistent with the large extraction of wealth from the subsidiary to the parent required for an agency-based explanation.
Moreover, we also conclude that only a small fraction of the value difference is explained by such explanations as taxes, marketability constraints, or off-balance sheet claims. Overall, the evidence may be best explained with models where clienteles of investors with optimistically biased expectations drive the prices of subsidiaries above the values consistent with parent valuations and arbitrage costs prohibit market forces from eliminating the disparity between parent-subsidiary valuations (Miller, 1995; Pontiff and Schill, 2000). We find that Internet carve-out investors can be characterized as non-institutional, aggressive traders. Moreover, pricing discrepancies are eliminated upon the announcement of a spin-off of parent holdings consistent with the elimination of binding arbitrage constraints. Our evidence gives further credence to similar findings by Lee, Shleifer, and Thaler for closed-end funds. The evidence also lends support to Nanda's notion of opportunistic carve-out transactions--conglomerate firms increase their financing flexibility by raising equity in the division most in favor with investors. Parent companies use the carve-out transaction as a way to opportunistically access the excessive investor demand for Internet assets.
This paper provides an important quantification of the importance of investor behavior price impact. The persistence and magnitude of valuation inconsistency suggests that overpricing in emerging industries, such as the Internet industry may be much larger than previously documented (Schwartz and Moon, 2000). If industry overpricing allows managers to opportunistically carve-out industry-related subsidiaries, managers may also opportunistically undertake other transaction, such as mergers, employing overvalued equity. The case of Internet carve-outs provides a striking example of how large artificial wealth can be.
CAN THE MARKET ADD AND SUBTRACT? MISPRICING IN TECH STOCK CARVE-OUTS (November 2000)
http://gsbwww.uchicago.edu/fac/owen.lamont
[Presented at the 2001 Meeting of the American Finance Association (www.afajof.org/prog2001.shtml)]
Owen A. Lamont, Graduate School of Business, University of Chicago and NBER
Richard H. Thaler, Graduate School of Business, University of Chicago and NBER
Abstract
Recent equity carve-outs in US technology stocks appear to violate a basic premise of financial theory: identical assets have identical prices. In our sample, holders of a share of company A are expected to receive x shares of company B, but the price of A is less than x times the price of B. A prominent example involves 3Com and Palm. Arbitrage does not eliminate these blatant mispricings due to short sale constraints, so that B is overpriced but difficult or impossible to sell short. Evidence from options prices shows that shorting costs are extremely high, eliminating exploitable arbitrage opportunities.
Conclusion
There are two important implications of the efficient market hypothesis. The first is that price changes are unpredictable, implying that it is not easy to make money. The second is that prices are "correct" in the sense that prices reflect fundamental value. This latter implication is, in many ways, more important than the first. Do asset markets offer rational signals to the economy about where to invest real resources? If there are some stocks that are selling for prices that are much higher or lower than their intrinsic value, then those companies are attracting too much or too little capital. While important, this aspect of the efficient market hypothesis is the most difficult to test because intrinsic values are unobservable. That is why tests of relative valuation are important. The literature on closed-end funds is one example. The fact that closed-end funds often trade at substantial discounts or premia makes one wonder whether other assets may also be mispriced.
These negative stubs are in a similar category, though the mispricing appears to be even more blatant. Unlike closed-end funds where arguments about agency costs by the fund managers, tax liabilities, and bad estimates of net asset value can cloud the picture, in this case any investor who can multiply by 1.5 should be able to tell that Palm is overpriced relative to 3Com.
There are two key findings of this paper that need to be understood as a package. First, we observe gross violations of the law of price. Second, these do not present exploitable arbitrage opportunities because of the costs of shorting the subsidiary. In other words, the no free lunch aspect of the efficient market hypothesis is intact, but the price equals intrinsic value component takes another beating. Still, it possible to argue that we have only six cases here that collectively represent a tiny portion of the US equity market. Maybe everything else is just fine. Why should we be concerned? Put another way, are these cases of blatant mispricing the tip of a much bigger iceberg, or the entire iceberg?
We think that we should be concerned because these cases should be ones that are relatively easy for the market to get right. Suppose we consider the possibility that Internet stocks were priced much too high around 1998-2000. The standard efficient markets reaction to such claims is to say that this cannot happen. If irrational investors bid up prices too high, arbitrageurs will step in to sell the shares short, and in so doing will drive the prices back down to rational valuations. The lesson to be learned from this paper is that arbitrage may be difficult or costly. In the case of Palm, arbitrageurs faced little risk, but could not find the shares of Palm in order to go short. We have identified cases in which arbitrageurs are unable to arbitrage relative mispricing. More generally, there might be cases of mispricing in which arbitrageurs are unwilling to arbitrage mispricing because of fundamental risk or noise trader risk.
The conclusion we draw from all of this is that there is one law of economics that does still hold: the law of supply and demand. Prices are set where the number of shares demanded equals the number of shares supplied. In the case of Palm, some investors were willing to pay apparently ridiculous amounts in order to get the shares, and the supply of shares to sell could not rise to meet that demand because of short sale constraints. Similarly, if some investors are willing to bid up the shares of Internet stocks, and not enough courageous investors are willing to meet that demand by selling short, then optimists will set the price.
A ROSE.COM BY ANY OTHER NAME (November 2000)
[Forthcoming, Journal of Finance]
http://www.mgmt.purdue.edu/faculty/rau/
http://papers2.ssrn.com/paper.taf?ABSTRACT_ID=254052
P. Raghavendra Rau, Orlin Dimitrov, and Michael Cooper
Krannert School of Management, Purdue University
Abstract
We document a striking positive stock price reaction to the announcement of corporate name changes to Internet related dotcom names. This "dotcom" effect produces cumulative abnormal returns on the order of 74% for the ten days surrounding the announcement day. The effect does not appear to be transitory; there is no evidence of a post announcement negative drift. The announcement day effect is also similar across all firms, regardless of the firm’s level of involvement with the Internet. A mere association with the Internet seems enough to provide a firm with a large and permanent value increase.
Excerpt from "Conclusions"
We find that companies that change their name to a dotcom name earn significant abnormal returns on the order of 53% for the five days around the announcement date. The effect is not transitory; there is no post-event negative drift. These results contrast with evidence in previous literature on corporate name changes, such as Bosch and Hirschey (1989) or Karpoff and Rankine (1994) who find an insignificant excess return around the announcement date, with a positive pre-announcement drift followed by a negative post-announcement drift.
We argue that our results are driven by a degree of investor mania - investors seem to be eager to be associated with the Internet at all costs. This is supported by the fact that our announcement returns are similar across all firms, regardless of the company’s actual involvement with the Internet. Evidence of investor mania seems especially true when we consider the finding that firms with little or no sales generated from the Internet experience the greatest long horizon returns. The returns to firms announcing dotcom name changes are much greater returns during the months in which more name changes occur suggesting some degree of a "hot" name change period effect. A mere association with the Internet seems enough to provide a firm with a large and permanent value increase.
Whether what we document is a form of investor mania or whether investors are rational in pricing large expectations of future earnings from the Internet into the stock price, will only become obvious over time. However, our evidence in this paper lends more support to the investor mania hypothesis than to the rational pricing hypothesis. In this sense, this paper adds to a growing body of evidence documenting irrational investor behavior, both at the aggregate and at the individual level.
VALUING INTERNET BUSINESS
Business Strategy Review, March 2000
Chris Higson, London Business School
John Briginshaw, University of California, Berkeley
Abstract
Is there a bubble in Internet stock prices, has the new economy changed the rules of stock valuation? In this article, the authors argue that the old rules still apply. The only way to test the reasonableness of new economy stock prices is to model the company's ability to generate cash in the future. This analysis also allows the development of a view about the performance that would be needed to justify current valuations. The analysis suggests that many Internet valuations are stretched. Investors are focused on growth prospects for the firms, but realistic analysis about future profitability has been neglected in what will be an increasingly competitive world. Further, investors' assumptions that the new economy businesses will not require assets are unrealistic in many cases. Finally, because some new economy stocks are overvalued, there is a risk of misdirection of productive resources.
EMPIRICAL EVIDENCE ON THE IPO VALUATION OF INTERNET-BASED COMPANIES (1999)
http://www.hkkk.fi/sijoittajapalvelin/arkisto/ipotutkimus.html
Tuukka Seppä, Lauri Palmu and Hanna Kallio
Helsinki School of Economics and Business Administration
Abstract
This paper provides currently lacking empirical evidence on the IPO valuation of Internet-based companies. We compare the IPO performance of Internet-based companies to the experience from the overall market. We find that the IPOs of Internet-based companies have been significantly underpriced. We note that the underpricing has been significantly larger than the long-term average. Our results are in line with the hypothesis that mostly negative consensus EPS forecasts do not contain information on the post-IPO development of the firm’s equity value. However, we note a significant co-movement of reported sales and share prices.
We find that the IPOs of Internet-based companies have been significantly underpriced. We note that the underpricing has been significantly larger than the long-term average. Our results support the hypothesis that the investors require compensation for the greater riskiness of the Internet-based companies and that the ‘hot issue’ market exists.
We find that the results do not support the existence of a long-run underpricing phenomenon in the case of Internet-based companies. However, the short observation period and the bullish market conditions reduce the reliability of this result.
We note a significant co-movement of reported sales and share prices. However, we note that consensus EPS forecasts may not have explanatory power over the post-IPO development of the firm’s equity value. Our results are in line with the hypothesis that the information content of negative accounting earnings is limited. We conclude that market participants are likely to rely on the expectation a positive development in sales results in future abnormal earnings.
Thus, the market practitioners’ view seems not to be quite consistent with the generally accepted valuation theory.
Further research should be directed to observing the long-term underpricing phenomenon in more detail. In addition, as time goes on and the earnings or earnings estimates of the majority of Internet-based companies become positive, it would be interesting to empirically test the applicability of the theoretical valuation models to Internet-based companies. Current knowledge suggests that there should be no reason why they would not apply.
WHY DO (OR DID?) INTERNET-STOCK IPOs LEAVE SO MUCH 'MONEY ON THE TABLE'? (November 2000)
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=244049
Presented at the Australasian Finance and Banking Conference, December 2000, Sydney, Australia.
Roberto Arosio, Politecnico Di Milano
Giancarlo Giudici, University Of Bergamo
Stefano Paleari, Politecnico Di Milano
Abstract
The "new economy" advent and the Euro's arrival have given energy to EU stock markets. Even though late with respect to the US and the UK, the number of firms going public on these markets has considerably increased, even as a consequence of the birth of new pan-European second markets. Most IPOs resulted in huge short-run returns, compared to the offer price. The initial underpricing has been particularly manifest for firms whose products and service pertain to high-tech sectors, and distinctively to the Internet world. Yet, a substantial correction in stock prices has occurred in 2000 driven by investors' concerns about Internet companies' cash flow deficits. Many firms have been induced to delay their offerings, and the offer prices were revised downward either by the issuers or by the market with mortifying initial returns. In this paper we analyze a survey of Internet stock IPOs, listed on the Euro's secondary Stock Exchanges. The sample is made up by 86 IPOs, listed on the EASDAQ and EURO-NM markets from 1 January 1999 to 1 May 2000.
We find an initial average return equal to 76.43%, i.e. the first-day offer price is much higher than the offer price. More than 4.6 billion euro were "left on the table" by the IPOs issuers (54.3 million euro on the average). We aim at investigating why Internet-stock IPOs leave (or just left?) so much "money on the table". We find that the initial underpricing is strongly related to the information gathered during book building activity in the pre-selling period, which drives the revision of the prospectus price range and signals the IPO quality to uninformed investors. In fact, when the offer price is equal to the maximum price in the ex-ante file range the mean underpricing is equal to 93.71% while it is negative when the offer price is equal to the minimum price. By focusing on Italian Internet companies IPOs we also verify that "hot" IPOs underpricing does not annoy the issuers, since they discover to be much wealthier than expected, coherently with the "prospect theory" by Loughran and Ritter (2000).
Finally we find that the initial return is driven by a number of determinants: it is positively related to the market momentum but negatively related to the density of IPOs in the same national market during the 30 days before the offering, consistently with the "hot issue markets" theory. Interestingly, accounting data from the prospectus about sales and profits seem to force the initial underpricing, too. The dilution of insiders' ownership is not recognized as a significant determinant.
We argue that the remarkably high initial return of Internet stock IPOs in Euro-land is related to Internet euphoria, but also to the limits of traditional evaluation methods adopted by intermediates in determining the offer price.
DO THE INDIVIDUALS CLOSEST TO INTERNET FIRMS BELIEVE THEY ARE OVERVALUED? (June 2000)
http://papers.ssrn.com/paper.taf?abstract_id=235535
Paul Schultz, University of Notre Dame
Mir Zaman, University of Northern Iowa
Abstract
Two explanations are commonly offered for the large number of recent IPOs by Internet firms: that they are rushing to go public when Internet stock prices are irrationally high, and that they are trying to grab market share in an industry with large economies of scale. We examine the actions of Internet firm managers, underwriters and venture capitalists to determine their motives for going public. Mergers and acquisitions provide strong evidence of a rush to grab market share. Evidence that they are trying to sell overpriced stock is much weaker.
Summary and Conclusions
Two facts about Internet companies are well-known to even casual observers of the stock market. First, market capitalizations of Internet firms are very high when measured against their current revenues or earnings. Second, there has been a flood of IPOs of Internet firms. These offerings have raised tremendous amounts of money for entrepreneurs with little more than an idea for making money on the Internet. In this paper we examine two explanations for these observations. The first is that Internet firms are rushing to go public to take advantage of irrationally high prices for Internet stocks.
The second is that Internet businesses have tremendous potential and firms are rushing to go public to establish market share and take advantage of economies of scale. These explanations are not mutually exclusive.
To explore Internet firms’ motives for going public, we examine the behavior of the individuals closest to them; their managers, underwriters and venture capitalists. The evidence that they are going public to take advantage of irrationally high prices is weak. Internet firms sell a smaller proportion of their total equity to the public in IPOs than do firms in other industries. Managers of Internet firms sell fewer shares from their personal holdings in IPOs than do managers of other firms. Seasoned equity offerings are only slightly more common for Internet IPOs than others after holding the firms’ aftermarket returns constant. Venture capitalists are more likely to back Internet IPOs than others. The investment bankers with the most valuable reputations are more likely to underwrite Internet firm IPOs than IPOs of other firms.
This evidence does not refute the hypothesis that Internet stocks were overpriced when so many were going public in 1996-2000. Entrepreneurs have been shown to be overly optimistic and this may explain their failure to cash out at IPOs. However, our results do weigh against a particularly troubling version of the overpriced IPO hypothesis - that insiders are taking advantage of irrational prices by issuing equity to a gullible public.
Our findings provide much stronger support for the hypothesis that Internet stocks are hurrying to go public to grab market share. Internet firms are buying other Internet firms at a furious pace. In addition, there are far more strategic alliances involving Internet firms than other recent IPOs. The adage that Internet firms must get bigger fast or they will get smaller fast is supported by the data.
DOES RISK MATTER? CORPORATE INSIDER TRANSACTIONS IN INTERNET-BASED FIRMS (March 2000)
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=220128
Lisa K. Meulbroek, Harvard Business School
Abstract
This paper investigates an unintended consequence of equity-based compensation plans: in highly volatile firms, managers appear to undermine the compensation system's intended effect of aligning managers' interests with those of shareholders. Specifically, many managers are selling at least a portion of their equity stakes, or exercising their stock options and selling the acquired shares. These sales may reduce the desired incentive-alignment; they also have the potential to directly decrease equity value if market participants interpret the sales as a signal that managers believe their firms to be overvalued. But overvaluation is not the only reason that these corporate insiders sell. Many managers in Internet-firms have undiversified portfolios, holding mainly the equity of their firms. This lack of diversification, combined with the high volatility of Internet-based firms, and the limited control managers have over that volatility, gives managers an incentive to diversify by selling their stock holdings, irrespective of their beliefs about the accuracy of the current stock price. Indeed, based upon the average Internet firm's volatility of 113% annually (relative to the 22% of the S&P 500 Index), a non-diversified insider would be better off selling shares to diversify even if he/she believed the firm to be undervalued by the market by almost 50%. This paper investigates whether the market response to insider selling in Internet-based companies reflects these multi-faceted incentives. I find that, in contrast to insider selling in the general population of firms, sales in Internet-based companies do not produce negative excess returns (the mean return on an insider selling day is +0.82%, net-of-market movements, for an Internet-based firm). This result suggests that market participants do not, on average, interpret managerial sales in Internet-based as a signal of overvaluation. The relatively high incidence of managerial sales in Internet-based firms may instead reflect the high value managers' place on holding a diversified portfolio, an observation that raises questions about the optimal compensation-mix in such firms.
WINNER TAKES ALL: COMPETITION, STRATEGY, AND THE STRUCTURE OF RETURNS IN THE INTERNET ECONOMY (November 2000)
http://papers2.ssrn.com/paper.taf?abstract_id=250371
Thomas H. Noe and Geoffrey Parker
Tulane University
Abstract
In this paper, we develop an economic rationale for the following stylized facts: Web-based firms command high (and highly volatile) valuations relative to earnings, spend profligately on advertising and marketing, and usually lose money. Our rationale is based on the winner-take-all structure of high-fixed-cost, low-marginal-cost, markets for information goods. This market structure ensures that market participation and the investment strategy are highly stochastic. Moreover, if a firm chooses to participate in a web market, it is optimal to act very aggressively through saturation advertising. While increases in advertising costs reduce the probability of entry, once the decision to enter is made, firm strategies are insensitive to advertising price. These competitive strategies generate returns that are highly positively skewed, following a Pareto-like distribution. Thus, firms have a small chance of huge gains combined with a large probability of ruin. In dynamic competition, firms weakened by early rounds are less likely to challenge in subsequent rounds. However, when a challenge is attempted, it is always aggressive. In addition, since large expenditures in the first period produce valuable strategic real options in later periods, which are treated as expenses using traditional accounting methodology, the financial valuation of internet firms may actually be negatively related to performance using standard accounting measures of profitability that fail to capitalize these strategic real options.