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

com

Boom, Bust, Boom: Internet Company Valuations From Netscape to Google

Thomas A. Corr

Henley Management College

The later half of the 1990s saw a boom in the valuation of publicly traded internet stocks. This period was known as the internet boom. 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 the U.S. stock exchanges, and the market capitalization of these companies equaled 6% of the market capitalization of all U.S. publicly traded companies. Between March 10, 2000, and April 17, 2000, the technology heavy NASDAQ would lose 34% of its value. The purpose of this paper is to address within the framework of behavioural finance theory, the effect 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 internet bubble, and whether the anticipated market capitalization of Google prior to its IPO was a precursor to a second internet bubble.

I. INTRODUCTION DISCOUNTED CASH FLOW BE DAMNED: THE INTERNET AND BEHAVIOURAL FINANCE A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective yield; since there will be no strong roots of conviction to hold it steady. J.M. Keynes On August 9, 1995, Netscape Communications Corporation (Netscape), an internet browser company, went public and became the first of many internet company Initial Public Offerings (IPOs) in later half of the 1990s. Netscapes shares were originally priced at

$12, but due to the strong demand the share price at the time of the IPO was set at $28. The shares traded as high as $75 during their first day of trading and closed at the end of its first day of trading at $58.25, resulting in a market capitalization for Netscape in excess of $2.2 billion. For the trailing 12 month period prior to the IPO Netscape was unprofitable and had sales of less than $48 million. The period beginning with boom of the Netscape IPO on August 9, 1995 and ending on March 10, 2000 when the technology heavy NASDAQ peaked at 5,048, its highest level ever, was known as the era of the internet boom. 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 the U.S. stock exchanges, and the market capitalization of

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these companies equaled 6% of the market capitalization of all U.S. publicly traded companies (Ofek and Richardson, 2000). Between March 10, 2000, and April 17, 2000, the NASDAQ would lose 34% of its value and would continue its near-death spiral for almost three years, finally losing 75% of its value and wiping $7 trillion from investors portfolios. WebVan, a California based on-line grocery retailer, is an example of an internet boom company. WebVan went public in November of 1999, raising $375 million and 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 months ended June 30, 1999 on revenue of $395,000. In calendar 1998 Webvan had no revenues and lost $12 million. Eighteen months after going public, WebVans shares were trading at 6 cents and soon thereafter the company filed for bankruptcy protection and discontinued its operations. The internet boom era was subsequently referred to as the internet bubble and the dot-com bubble. The bursting of the bubble was predicted long before the actual burst (Perkins and Perkins, 1999). A description of the timeline for the internet bubble, What We Learned In The New Economy: A Brief History of a Brief Era, is included as Exhibit 1. The basis of financial theory is the belief that investors make their investment decisions based upon all of the information available regarding a particular security, but it appears that this may not always be the case. What has evolved is an area of study referred to as Behavioural Finance. Behavioural Finance attempts to both understand and explain the effect that emotion, uncertainty, and irrational thinking can play in the decisions made by investors. Further, Behavioural Finance attempts to address the efficiency of stock markets and explain such phenomena as the Greater Fool Theory along with other stock market anomalies. In addition, Behavioural Finance attempts to address how such flaws in decision making can be predicted and exploited by others in the stock market (Shiller, 1989). In a study titled Prospect Theory (Tversky and Kahneman, 1979), the authors argued that investors based upon the range of probability, put different weights on losses and gains. Their study also discovered that investors are much less satisfied with gains than they are dissatisfied by the equivalent losses. They also discovered that investors respond to equivalent situations differently dependent upon whether it is understood by them in terms of losses or gains, and that investors are more likely to take more risks to avoid losses than they would to realize gains.

After making a decision which results in a loss, investors tend to have a feeling of sorrow and grief (Statman, 1988). Therefore the investors emotions are effected subject to whether or not they are making a gain or loss on the sale of a security. Statman goes on to argue that this results in investors delaying the sale of stocks that would result in a loss to avoid the negative emotions, and having to potentially deal with disclosing the loss to their accountants, family, and financial advisors. Shiller also puts forth the theory that investors put too much weight on their recent investment experiences, whether good or bad, and that the investor makes decisions based upon this experience that is not consistent with statistical odds, long run averages, and trends (Shiller, 1989). Investors also believe that they often have better investment decision making information than other investors, whether in fact they do or not, which results in activity in the stock market which is hard to rationalize. On each side of a stock market trade is an investor who believes that their information is better than the other and clearly they cannot both be correct in their decision (Odean, 1997). Investors tend to be overconfident in their own abilities; however increased confidence has no correlation with greater success (Huberman, 1998). Huberman also found that investors favor investing in local companies with which they have had some experience. In particular he found that investors are more likely to purchase stock in their local regional Bell company than other regional Bells. The study provides evidence that investors prefer local or familiar stocks, even though there may be no rational reason to prefer the local stock over other comparable stocks that the investor is unfamiliar with. Another theory that Behavioural Finance has postured is that of the herd mentality. The herd mentality theory suggests that investors follow the investment decisions of others so that if a bad investment decision is made, the investor can take comfort in the fact that others also made the same incorrect investment decision. Shiller describes in his book Irrational Exuberance that rational people often partake in herd behavior. Shiller argues that the individuals behavior would be viewed as being rational, but when combined with the behavior of others (the herd), it can produce irrational group behavior (Shiller, 2000). Shiller blames information cascades for the herd behavior, which he describes as the reliance of an individual on some one elses decisions. The theory of information cascades is a theory of the failure of information about true fundamental value to be disseminated and evaluated (Shiller, 2000). A bubble is started and ended based upon an event which may have nothing to do with the inherent value of

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Exhibit 1 What 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.

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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.

the stock (Diba, 1990). Diba goes on to say that the same reason why a bubble may form may also result in the end of the bubble. The rise of the bubble and its variance from the fundamentals of valuation can in some situations be viewed as a result of the herd mentality. Typically the bubble grows at a rate in excess of the fundamentals of the valuation as the herd mentality comes into play, and at some point the herd will turn and the investors will sell their shares. This will result in the bubble coming to an end. The diagrams included as Exhibit 2 outline the cyclical nature of the bubble. It is argued that the pricing of internet stocks during the internet bubble was based in part upon herd behavior and a related phenomenon referred to as the Greater Fool Theory (Cassidy, 2003). The Greater Fool Theory maintains that it is possible to make money not by buying securities based upon their intrinsic value and a desire to participate in the future earnings of the purchased securities, but rather by buying overvalued securities because there will almost always be someone else (the Greater Fool) who is willing to purchase these securities at an even higher price (Williams, 1997). In practice the theory works well until the last purchaser of the securities is unable to locate a Greater Fool. At this point, the pricing of the securities and the market for them collapses. The Greatest Fool is found, and once found the search for the Greater Fool ends. As with the rise of the price of the securities, the bursting of the bubble also has little to do with the fundamentals of the underlying company, but rather the end of a period of overpricing during which the securities pricing has lost touch 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 yet another theory called the Zero Sum Game (Harris, 1997), which means that it is little more than money being exchanged between the participants. At the end of the game some of the participants may be richer, but the new riches that have been created are offset by other participants, who in total are poorer in an amount equal to the riches that were created. Although the Greater Fool Theory is not a valuation methodology, it may help explain the high pricing of internet securities during the internet bubble period. The rapid rise of asset markets before falling even more rapidly is also referred to as the Asset Price Bubble Phenomenon (Halcomb, 2002). Other asset price bubbles include the tulip bubble in Holland during the seventeenth century, the South Sea bubble, the stock market boom of the 1920s, the high-tech boom of the early 1980s, and the biotech boom of 1989 1990 (Shiller, 1989; Dash 1999). Within the context of Behavioural Finance and traditional securities valuation, this paper addresses 1) internet company valuations during the internet bubble, and 2) did the pending IPO of Google portend a Bubble II. II. TRADITIONAL SECURITIES VALUATION AND ITS APPLICABILITY TO INTERNET COMPANIES THE WAY WE WERE Value is destroyed, not created, by any business that loses money over its lifetime, Warren Buffet Purchasers of securities (investors) buy them in order to have an opportunity to participate in the future

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Exhibit 2 The following diagrams are from the Canadian Auto Workers Newsletter of December 1998, and outline the cyclical nature of the bubble.
HOW BUBBLES EXPAND: Rising Asset Prices (stocks currencies, real estate)

More Paper Wealth

Banks have Stronger Balance Sheets More Lending

Investors buy to Profit from Falling Prices

More Investment & Consumption Spending

Rising Asset Prices (stocks currencies, real estate) HOW BUBBLES CONTRACT: Falling Asset Prices (stocks currencies, real estate)

Less Paper Wealth

Banks have Weaker Balance Sheets Less Lending

Investors sell to Avoid Falling Prices

Less Investment & Consumption Spending

Falling Asset Prices (stocks currencies, real estate)

earnings, dividends, or cash-flows of the companies. Subject to the terms of the various classes of securities that a company may issue, investors have the right, on a proportionate basis to the number of shares they own to the number of shares that the company has issued, to obtain the dividends, cash-flow, and earnings of the company. The value of the dividends, cash-flow, and earnings 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 different from traditional companies for reasons that are addressed in this paper. However, investors purchase internet company shares for the same reasons that they purchase traditional company shares; to participate in the future earnings of the company. One could therefore argue that internet shares should be valued based upon the same financial metrics as traditional companies, which is the value of future earnings. In many cases however, internet companies have no profits and may project negative cash flows for an extended period of time. Damodaran (2000) argues that the valuation of internet companies can be determined using Discounted Cash Flow models. His view is that companies with negative earnings can be valued using three options. The first is to replace current negative earnings with a positive number assuming that the company will revert back to positive earnings in a normal year. The assumption in this scenario is that the company had previously had positive earnings in a normal year, and therefore is of no use in scenarios wherein the company has never had positive earnings. The second option that he puts forth is that the valuation can be based upon sales in lieu of earnings, since sales are positive. His view is that sales in conjunction with estimated operating margins could be used to estimate profits. This scenario may work in a situation where the company is loosing money because of a temporary aberration, but does nothing to assist in valuing an internet company whose business model may be fundamentally flawed, to the extent that the company may never produce profits based upon its business model. His third option applies when earnings are negative due to excessive debt of the company. In this scenario he proposes that earnings can be adjusted by reducing the leverage of the company. This rarely would apply in the case of internet companies, as they tend to have limited amounts of debt, as they are typically not credit worthy and therefore cannot obtain debt financing and are typically financed through private or public equity offerings. This forces the investor to focus on operational issues, in order to determine the possibility of the internet company reaching a period of continued profitability, so that financial metrics may be applied and a valuation determined. Briginshaw argues that this forces the investor to perform additional analysis when compared to traditional large Fortune 500 and other long established public companies, that typically have detailed historical and current financial information available for investors (Briginshaw, 2002). The additional analysis Briginshaw identifies includes:

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 More careful and painstaking analysis of the internet companys past history and future prospects. More caveats have to be borne in mind with regard to potential discontinuities and their effect on the future value of the internet firm. A lack of accounting data may force reliance on nonaccounting or non-financial data, which may be less reliable or more open to interpretation. Even with painstaking and careful analysis of past history and future value drivers, valuations are likely to be more prone to error than valuations of conventional firms. While old-economy firms tend to have capital structures consisting of debt and equity, new economy firms possess capital structures in which equity predominates, together with some contingent claims including employee share options and convertible debt. A high growth company is a company that invests capital in new assets, and generates through its operations a return on capital that on average is higher than for most companies. Many traditional non-internet companies are considered high growth companies, and during the internet bubble virtually all internet companies were perceived as having the potential to be high growth companies. Even though there are many differing views on how internet companies should be valued (Mills, 2000), for the purpose of comparison it is necessary to establish a common basis for evaluating both traditional old economy high growth companies and internet high growth companies. As internet companies were typically perceived as high growth companies, then a model that values high growth companies would appear to be appropriate to value them. It has been proposed that the investment opportunity approach is one way to value growth shares (Miller and Modigliani, 1961). This approach is normally utilized when the investor believes that he or she can realize a high rate of return and the value is based upon the value of the future growth of the company plus the current value of the company. According to Miller and Modigliani (1961), the value of a growth firm is a function of: (a) normal rate of return that 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 on additional 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 the valuation as are bankruptcy and other potential agency costs. However, this expression resembles traditional discounted cash flow (DCF) models in that it considers the financial metrics important in valuing a company. The normal rate of return discounts forecasted cash flows from assets-in-place to the present value. As this rate increases (p ), the present value decreases (V ), illustrating in the equation below (2) the negative riskvalue relationship fundamental to all DCF models. (2) The second expression represents the value of growth opportunities. Expecting returns higher than the normal, the owner invests in new real assets (I(t) ). Increased investments induce high uncertainty regarding the commercial success of these investments. The uncertainty translates into increases in volatility (p* = p), a measure of risk associated with the opportunity for abnormal returns. As illustrated in the equation below (3), the increase in investments and the underlying uncertainty positively affect the value (V) of the growth component in the investment opportunities approach. It is important to point-out that the positive volatility-value relationship, a feature fundamental to option pricing models (Black and Scholes, 1973), is opposite to the traditional DCF predictions. (3)

Traditional DCF models assume that there is no opportunity to consistently produce above normal returns, (p* = p). This assumption is supported with the semi-strong version of Efficient Market hypothesis which says that it is impossible to produce abnormal returns based on all publicly available information, including historical price behavior. Some argue that traditional DCF models undervalue internet stocks because they ignore the value of growth opportunities in the absence of significant earnings. The growth component of the investment opportunities approach is similar to the real option pricing method in several ways. First, it assumes the positive valuevolatility relationship. Second, it recognizes the importance of managerial project selection in investments in new assets. Some argue (Jagle 1999) that the real option-pricing model is applicable to value internet stocks because of these assumptions. However, it tends to overvalue internet stock because it ignores the negative effect of losses on the value of earnings.

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Exhibit 3
Comparisons to Companies that went public in Bubble era: Netscape Yahoo 8/8/1995 4/11/1997 IPO Date Google is: Bigger $47.6 $1.4 Sales at IPO (in mm) 257 43 No. of Employees at IPO More Profitable: -$6.4 -$0.6 Net Income at IPO (in mm) $185K $32K Revenue per Employee Older: 1 2 Age of Firm at IPO More Valuable $334 Market Value at IPO Price (in mm) $1,027 Value of Google based upon Industry Comparbles Fiscal 2003 Sales Growth Sales (annulaized in mm) Number of Employees E-Bay 78% $3,025 $800 6300 Yahoo 71% $3,031 $405 5500 Ask Jeeves 65% $157 $54 306 Average 71% $2,071 $420 4035 Google 177% $1,558 $256 1907 Amazon 5/14/1997 E-Bay 9/23/1998 Average 9/23/1998 Google Estimated Summer 2004 $1,173.0 1907 $144.0 $615K 6 $24 billion

$30.0 256 -$9.1 $121K 3 $467

$19.0 76 $3.7 $250K 3 $730

$24.7 158 -$3.1 $147K 2.3 $639

Valuation Multiples Market Value as of $55,326 $41,983 May 24, 2004 (in mm) 13.9 Price to Sales Ratio 18.3 103.7 P/E 69.1 $7.60 MV/Employees (in mm) $8.80 Google market value based upon Industry Average Price to Sales ration.

$2,257 14.4 41.7 $7.40

$33,189 15.5 71.5 $7.90

$24,167 15.5 94.4 $12.70

Like all valuation methodology that includes forecasted cash flows, it is only accurate if the forecasts are accurate. Forecasting the future cash flows of an internet company which may at the time have no sales or profits, and as a new industry entrant may have no industry comparables, may be difficult to predict. Furthermore, internet companies typically have high R&D and marketing costs which are difficult to forecast in early stage companies due to the unknown of competitors positioning, which makes it difficult to project future cash flows and to determine the appropriate cost of capital. III. INTERNET COMPANY STOCK PRICING DURING THE INTERNET BUBBLE: A CHALLENGE FOR TRADITIONAL VALUATION METHODOLOGIES intumesce, v. intr.: 1. To swell or expand; enlarge. 2. To bubble up, especially from the effect of heating As stated in Section I, on August 9, 1995 Netscape went public, starting with much fanfare the era of the internet boom. Traditionally, companies going public are

profitable; however this did not apply in the case of Netscape which had losses of $14 million in the fiscal year before going public and $6.4 million in the 12 month trailing period prior to going public. Therefore, traditional comparable valuation metrics such as price/ earnings ratios were not applicable to Netscape. Many more unprofitable internet companies went public subsequent to Netscape during the internet boom period (see Exhibit 3), which forced the companies, investors, and the financial community to look to other metrics to measure the value of these companies. In a rare moment of 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 still dont know who the ultimate winners will be, how do we value them. As discussed in Section I, a common valuation methodology for companies is the Discounted CashFlow (DCF) approach. During the internet bubble however, internet company shares continued to increase well beyond the valuations justified using DCF analysis

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(Mauboussin, 1998). The DCF methodology simply did not fit the internet company valuations. While in theory it would have been possible to use DCF to determine the value of internet company shares during the bubble, the reality was that the assumptions that would have to be made relative to growth, margins, cashflow, and cost of capital, in order for the DCF model to approximate the market valuations, would have had to be so aggressive to make the assumptions not credible. The next attempt to find a valuation methodology that fit the ever increasing market valuations of internet company shares was that of real option theory (Briginshaw, 2002). The rationale for using option theory was that the forecasted profits of these companies were substantial, whilst the potential losses were small if the company did not succeed. This theory played nicely into the hands of proponents of the view that the internet boom would never end, and who rarely failed to see enormous profit generation potential in internet companies. This resulted in call option techniques such as the Black-Scholes formula being adopted as rational valuation methodology for internet stocks. One of the problems with this approach however, was that the factor of industry competition was typically not addressed. Even during the internet boom it was recognized that internet companies in new markets who were successful, would attract new market entrants which would potentially have the effect of limiting the upside of the company being valued. Given the failure of the aforementioned methodologies to fit the actual market value of the internet companies, there was a movement in the financial community to adopt valuation methodology that would better fit the market valuations. The methodology that was arrived at was that of ratios which were used to calculate comparables. Comparable ratios had been long used to compare the financial performance of companies within industry groups or to compare industry groups themselves. These ratios such as P/E (share price/ earnings) had components that were actual financial measurements. These however could not be utilized if the company did not have earnings as in the case of the P/ E multiple. The venture capital and financial community is a creative lot, and not ones to ignore the potential commissions and fees to be earned during this boom period, as well as the increases in the value of the equity positions that they held in internet companies. Therefore, in order to justify and support the value of internet companies, they developed a number of multiple measurements for internet companies ranging from the number of users who viewed a web page, to the number of subscribers to a web site (whether the

subscription was paid for or not). Whilst these factors were interesting, and in fact did provide a basis for comparison between internet companies, they had little to do with projected cash-flow and value of the company. Moreover, comparing the multiples of one overvalued internet company, to another overvalued internet company, did nothing to justify the value of these companies based up future earnings. Furthermore, the business models adopted by the internet companies made many of these comparisons irrelevant and distracted from the actual fundamental valuation metrics that should have been used; future cash-flows, profits and dividends. Many internet company specific ratios and comparables were adopted ensuring that the financial community had a never ending supply of ratios to justify valuations. These included, 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 generate sales) In addition to the fact that these ratios had little or nothing to do with financial performance, a Forbes magazine article reported a number of ways in which these ratios were being managed by the internet companies (Wooly, 2000): Increase unique users by paying another website to generate a hidden (background) pop-up of your site (e.g. About.com until late 2000). Increase visitors by routing from lotto or gaming sites where users have to click through to bet (e.g. Dealtime, Coolsavings). Increase reach by seeking to attract visitors or users more likely to be in a panel observed by an internet market survey (e.g. the Mediamatrix panel is thought to contain a higher proportion of older web surfers than the average web user population). The management of these web sites resulted in inflated comparable valuation parameters which further detracted 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 the stronger of the internet companies survived. Stronger in this case meant internet companies that were either cash flow positive, or had raised sufficient cash during the internet boom to meet their burn-rate for an extended period of time. Some of these internet companies had

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profits and positive cash-flow, and therefore investors started to value them based upon more traditional valuation metrics, as skeptical investors became much more cautious in their investment decisions. As a result the DCF methodology once again became relevant, as the value of the remaining profitable internet companies now fit much closer the value of traditional companies. There are a number of factors regarding DCF that need to be considered within the context of valuing internet companies. These factors are those that can impact the market value of internet company shares, but are not necessarily appropriately considered within the DCF model (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 accurately project growth and margins so there is no point in trying. DCF does not capture the influences on equity value of support and resistance levels. DCF does not reflect many stock patterns including the Monday effect, January effect, break-out from moving averages, low float effect and lock-up effect. Notwithstanding the above, the DCF calculation may result in a reasonable estimate of value. Moreover, it considers the key financial parameters of a business which effect shareholder value, which is consistent with the purpose of the estimating the value. This cannot be said for many of the internet industry ratio and comparable methods that are discussed above. Exhibit 4 indicates the volatility of the stock market as it relates to the bursting of the internet bubble and correlates it to prior stock market crashes in 1929 and 1987. According to John Briginshaw, (Briginshaw, 2001), there are three possible explanations for the high valuations that the internet companies commanded and in some cases still command. These are: 1. The market had identified new sources of value within internet firms, sources of value not associated with earnings or cash flows, and therefore missed by traditional valuation paradigms. Because internet firms work within the new economy where network effects and co-operation are of vital importance, earnings and future cash-flows do not fully capture the value that thee firms have. 2. The market was correctly anticipating hyergrowth in company earnings under new economy paradigms. Because internet firms are faster moving and more efficient than old economy firms, they can grow far more quickly and profitably (after an initial period of losses necessary to build up their businesses to a critical mass). In this view, earnings and cash flows are still important, but they are anticipated to grow at unheard of speed.

3. The market was overvaluing these stocks due to a speculative bubble. Investors systematically overvalued internet stocks. However, this overvaluation persisted because observed high returns from holding internet stocks attracted fresh investors into the market. This third explanation sees internet stock valuation as an example of a Ponzi or pyramid scheme (i.e. variances on the Greater Fool Theory). Briginshaw rejects explanation 1, network effects, in as far as they exist can be represented as lower ongoing marketing costs for the firm, and can therefore feed into cash flows. The only way to test between the remaining explanations is to conduct fundamental valuation analysis of internet firms. Clearly since we now know that the high values of 2000 did not persist to the present day, it seems likely that these values were not supported by fundamental financial metrics. Carrying out fundamental analysis using data existing at the peak of the bubble (Higson and Briginshaw, 2000) further confirms that fundamental analysis could not explain the bubble values. Therefore by process of elimination, explanation 3 was selected by Briginshaw (Briginshaw, 2001) as the likely cause of the stock markets high values in 2000. In terms of Behavioural Finance, one could argue that the investors decision to invest in internet stock is not one that can be rationally explained. As many internet companies failed, it was obvious to investors that the chances of the internet sector companies becoming financially self-sustaining was minimal, and furthermore a rational analysis of their financial metrics should further distract an investor from purchasing internet stocks. Nevertheless, investors continued to invest in the internet sector which could lead an observer to conclude that investors in internet stock were not acting rationally. In Section I, a number of behavioural theories were identified that spoke to irrational investment decisions, and these theories may in part explain why investors purchased internet stocks. These explanations include: Overconfidence The rapid increase in the value of internet stocks could in part be attributed to overconfidence which leads to high levels of trading and errors in judgment. Desire to Gamble Some investors may like the rush and thrill of taking a gamble on the internet stocks that they purchase. Herd Behaviour - The hype surrounding internet stocks caused investors to become influenced by the action of others resulting in an information cascade. The information cascade results in investors purchasing even more internet shares, however, once the investors perception about internet stocks changed, the value of the stocks reduced significantly.

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Exhibit 4. S&P Crash Correlation, 3 Year 1927/9 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)
S&P Crash Correlation - 3 year 1927/9 1985/87 1997/9
1450 1400 1350 1300 1250 1200 1150 1100

1997/9

1050 1000

1985/7 1927/9

950 900 850 800 750

Jan-97

In 2004, Google Inc. would pose a challenge to the experts who attempted to place a value on the company when it announced its intention to go public in April of that year. Not only would valuation methodologies be tested and questioned, but Google would choose a method of going public that was little used, and almost unheard of in the technology sector. IV. GOOGLE: THE POTENTIAL BEGINNING OF BUBBLE II A BEHAVIOURAL FINANCE PERSPECTIVE We are back in a mini-bubble era in terms of people expecting a lot of these valuations, but I dont think well see the same amount of exits the way we did. Companies such as Amazon, eBay, Yahoo and Interactive Corp. are here to stay, but over time the boundaries of what those businesses do will get fuzzier. Bill Gates, Chairman Microsoft Corporation, March 2004 Google Inc. (Google) is an internet search engine company whose engine is widely used. The Google web page (www.google.com) on November 25, 2004 claimed that a search initiated using its search engine searched 8,058,044,651 web pages. Googol is the mathematical

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term for a 1 followed by 100 zeros. The term was coined by Milton Sirotta, nephew of American mathematician Edward Kasner, and was popularized in the book, Mathematics and the Imagination by Kasner and James Newman (Kasner, 2001). According to Googles web site, Googles play on the term reflects the companys mission to organize the immense amount of information available on the web. On April 19, 2004, Google filed its Form S-1 Registration Statement (S-1) with the U.S. Securities and Exchange Commission (SEC) stating its intent to raise approximately $2.7 billion through a share offering. The 171 page S-1 document is available at - http:// news.findlaw.com/hdocs/docs/google/ipo/. No specific date was set for the Google share offering in the S-1 Registration Statement. As required by the SEC, the S-1 contains significant information regarding the planned offering and on the historical financial performance of Google. This information is in part provided so that the investor has information to assist in determining the value of Google for the purpose of potentially purchasing its common shares. The following chart (exhibit 5) provides some of the key information from the Google S-1. The figures for

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Exhibit 5 Net Revenue, Expenses & Profit

(in millions of US dollars) $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 -$200 1999 Rev Exp Profit 99 $0.2 $7 -$6 2000 00 $19 $34 -$15 2001 01 $86 $75 $7 2002 02 $348 $161 $100 2003 03 $348 $161 $100 2004 04 $1,559 $937 $256 P E R

1999 through 2003 are those reported in the S-1 for the full fiscal years. The figures for 2004 are created by multiplying Googles first fiscal quarter figures by four and the actual results could therefore be higher or lower than those projected depending on numerous factors. Additional highlights from the S-1 include: Google had $335 million in cash, cash equivalents and short-term investments, as of the end of 2003. Since at least March, 2002, Google has had no quarter where net revenues decreased. Google has earned a profit every quarter since March 2002. Google quarterly profit flattened between the fourth quarter of 2002 and the first quarter of 2003. Of all quarters since March 2002, it has dropped only once in the third quarter of 2003. This was largely due to a significant increase in stock-based compensation which was expensed. Google earned less than 3 percent of its net revenues in 2003 by serving search results to Yahoo. Yahoo still retains the right to use Googles search results on its sites. Google is terminating this right as of July 2004. No advertiser generated more than 3 percent of Googles net revenues in 2001, 2002, 2003 and the first quarter of 2004. Distribution agreements, the ability to run ads on sites outside of Google on the Google Network, accounted for 15 percent of Googles net revenues in 2003 and 21 percent as of the first quarter of 2004.

No Google Network partner generated more than 5 percent of Googles net revenues in 2002, 2003 and the first quarter of 2004. Google had $527 million promised in revenue sharing agreements relating to AdSense placements, at the end of 2003. About 39 percent of this is due within the next year. Five Google network partners account for 70 percent of what Google has promised in revenue sharing. Ten partners account for 91 percent of the payments. Based on advertiser billing addresses, Google estimated that 74 percent of its net revenues in 2003 came from the US, dropping to 70 percent for the first quarter of 2004. Countries outside the US generated 26 percent of Googles net revenues in 2003, and the figure rose to 30 percent for the first quarter of 2004. More than half Googles traffic, however, came from outside the US. Approximately 96% of Googles revenue comes from advertising with the remainder coming from other sources, such as enterprise search services, web search services 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 were obtained from the S-1 filing. Google earns it advertisement income from its own web sites and it distributes advertisements to partner web sites (the S-1 filing calls these partners the Google Network). This dual distribution has been well-known, but what hasnt been known was how much revenue the

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Exhibit 6 Revenue Sources

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 92% 77% 95% 96% Ad Revenue

23% 8% 2001 2002 Ad Revenue 5% Other Revenue 4%

2003 2004 Other Revenue

Exhibit 7 Ad Revenue Sources

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 100% 96% 84% 78% Google

22% 16% 4% 0% 2001 2002 Boogle 2003 2004 Network 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 were obtained from the S-1 filing. Google gained no major portal partners or other keyword-driven advertisement distribution deals that might have accounted for such a growth in revenue from on the network side. However in 2003, it launched its AdSense contextual advertisement program and then greatly expanded Adsense (advertisements placed by companies and advertising agencies). Googles filing is complete with many disclosures that investors are typically warned of including: Yahoo and Microsoft are specifically named by Google as its primary competitors.

Google reveals that it had issues with employee access to our advertising system in 2002, requiring changes made in 2003 to improve internal controls. Google worries that proprietary document formats might prevent it from indexing information. For instance, it says that software providers could perhaps demand a royalty to search these types of documents. Microsoft Word documents are listed as an example, along with this disclaimer: If the software provider also competes with us in the search business, they may give their search technology a preferential ability to search documents in their proprietary format. Any of these results could harm our brand and our operating results. Google discusses that it has regularly paid refunds be-

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cause of click fraud and potentially might have to make retroactive payments. Google specifically calls out index spammers and link bombing as an ongoing and increasing effort that could harm its results. If our efforts to combat these and other types of index spamming are unsuccessful, our reputation for delivering relevant information could be diminished. This could result in a decline in user traffic, which would damage our business, the filing says. Many in senior management and key employees are fully vested. In short, they could sell their Google shares and depart Google at any time. Google notes system failures can be a concern and reveals in November 2003, it failed to provide web results for 20 percent of its traffic for 30 minutes. In addition to the aforementioned challenges that are articulated by Google in their S-1 filing, it is important to focus on network externalities as Google implies that they will potentially be the major player in search engine market, as their technology will set the standard in the market (Google Form S-1 Registration Statement, page 1). The certainty of Google setting and maintaining the standard is key to their on going ability to maintain their dominant position in the market, such as Microsoft has done in PC operating systems and eBay has done with internet auctions. While a standard may be established for search engines, Googles ability to own that standard remains uncertain. Googles ability to capitalize on network externalities may be the key to their ability to own the standard. Network externalities are the foundation for Microsofts business model in operating systems and for eBays business model in online auctions. The opportunity to own the standard due to network externalities is rare, and companies like eBay and Microsoft are able to capitalize on such opportunities and earn higher economic returns than those who do not. The term network externalities is used by economists to describe a condition wherein consumers benefit from other consumers using the same product or using the same standard (Gautam et al, 1999). Network externalities are considered to be either direct or indirect (Church et al, 2002). Direct are cases like the telephone wherein the more people that utilize the telephone the more valuable owning a telephone becomes to any individual telephone user. In the direct effects scenario there is a positive loop effect that drives continuously increased demand. E-mail is another example of direct effect externalities. Indirect effects are based on the supply of complementary products. The PC with its plethora of software from many vendors and hardware peripherals that can readily be attached to standard PCs, are an example of indirect effects based upon complementary

products. On the other hand, the failure of Apple to dominate the PC market was in part blamed upon its decision to not open its architecture for third party hardware. Network externalities do not exist in many industry sectors, however, in rare situations, the nature of network externalities in an industry gives individual companies the opportunity to own the standard. This allows them to potentially gain a monopoly position and earn profits consistent with their position in the market. In industries where the possibility of strong network externalities exists, competitors invariably move to become the major player in the market and to have their product or service become the accepted standard. Once the company has set the standard and dominates the market, it is difficult for competitors to enter the market. Network externalities exist in the search engine market. The underlying way in which a search engine works in terms of its search criteria, and the order in which results are displayed, may become a standard. Once this standard has been accepted by users in the market, users will become used to the functionality and the way results are ordered and displayed, and likely a standard will emerge. Advertisers will be attracted to the standard once it has been adopted, and developers of web sites will develop web sites in such a manner to take the maximum advantage of the standard in search engines. The ability of Google to become the standard and be the beneficiary of the financial rewards that is often seen by companies who gain this position, will likely be key to Googles long term valuation. There is a chance that the competitors identified in Googles S-1, namely Yahoo and Microsoft, may be able to adopt the same logic as Google and all companies will in effect share the standard that is created. In that event no company will own the standard and be able to monopolize the market. In addition, if one company does become the de-facto standard it will not necessarily be Google. As stated in the Google S-1 (page 6) As search technology continues to develop, our competitors may be able to offer search results that are, or that are perceived to be, substantially similar or even better than those generated by our search services. This may force us to compete on bases in addition to quality of search results and to expend significant resources in order to remain competitive. Given this statement, one may conclude that there is nothing proprietary within the Google technology itself that gives them a unique opportunity to drive the standard in the market. In addition, the two primary competitors that Google has identified, Microsoft and Yahoo, have significant financial resources and market positioning, which may allow them to replicate and make incremental improvements to the logic and search algorithms that become the de facto standard for internet search engines. Microsoft, which is known as an aggressive

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company, also has the ability, should it choose, to block access to Word and other proprietary documents from Googles search engine as stated in Googles S-1. These competitive risks and threats may not have been priced into the valuations of Google that were considered prior to its IPO. When considering the aforementioned and the abundance of information that is available in the 171 page S-1 document, one would assume that prior to the IPO that the financial community could readily come up with relatively close and consistent valuations for Google. This in fact is not the case. Wall Streets guessing game prior to the 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 the following comments from the financial experts who had reviewed the Google S-1: Martin Pyykkonen, an analyst at Janco Partners, estimated the companys market value at as much as $25 billion. Three days later he revised that to as much as $50 billion. Pyykkonen said he changed his estimate after calculating that the companys tax rate may fall this year and its earnings may rise faster than he had earlier forecast. I was initially conservative, but for the rest of the year they should continue to kick the ball out of the park, he said. Kevin Calabrese at Argus Research said Google probably is worth no more than $17 billion. Bill Miller, manager of the $14 billion Legg Mason Value Trust Fund, says he plans to buy Google shares and that it is worth somewhere between $18 and $57 billion. Troy Mastin at William Blair & Co. said investors might bid it up to more than $30 billion. He said Estimates based on Googles fundamentals may fall short of how much investors may bid, dazzled by Googles brand name and search engine technology. Incredibly, given the disclosure provided through the S-1, and given the financial industrys experience during the internet boom/bubble, the valuations of the four internet industry financial experts, presumably working with the same information, ranges from $17 - $57 billion, and one of the experts increased his expected valuation from $25 to $50 billion in 3 days. At $15 billion, Googles market value would be lower than Yahoo, eBay and Amazon, three major internet companies. At $57 billion, it would eclipse all three of these companies. In July 2004, prior to the IPO, the market capitalization of Yahoo was $34.6 billion, EBay was $52.6 billion and Amazon was $17.4 billion (Exhibit 3). According to comments from Bloomberg, analysts now are now returning to ratios and comparables in order to estimate the market capitalization of Google, with most reverting to the method of multiplying the expected earnings by the price-to-earnings ratio of a competitor.

To determine Googles value, many analysts are using Yahoo, the second most-used internet search engine, as a basis for measurement (see Exhibit 2 and Exhibit 3 for comparative figures). Yahoos shares trade at about 80 times the companys 2004 estimated earnings per share. Some believe that Google is growing at a rate which may see it earn $1.50 to $2.00 a share this year. Using that methodology results in a calculation which multiplies the earnings per share by 80, Yahoos price to earnings ratio, to obtain a forecasted share price for Google in the range of $120 - $160. With 246 million shares currently outstanding, this would value Google at $29 - $39 billion. The Google IPO differs from typical IPOs by giving individual investors the chance to enter their own estimates of each shares value within a range set by Google. Only after they have entered their bids, will Google and its bankers determine the price. This method is known as a Dutch auction as opposed to the more conventional syndicate method of allocating shares to investors. There will be two classes of Google stock. The 237.6 million Class B shares will have super-voting rights of 10 times those of the other Class A shares. This two-part equity capital structure ensures that power remains firmly in the founders hands as the founders control the Class B shares. In addition, Class B shares are convertible at any time to Class A shares on a one for one basis. According to the S-1 (items below quoted directly from the S-1 are in italics), Google expects to use the net proceeds received from the offering for general corporate purposes, including: Sales and marketing expenses, R&D expenses, and general and administrative expenses; Capital expenditures, Possible acquisitions of businesses, technologies or other assets (although Google does not have any current agreements or commitments with respect to any material acquisitions), Management plans to invest the net offering proceeds (net proceeds being the total IPO dollar amount less underwriters fees and all other transaction costs) until the time that Google needs to fund the above operating uses. The S-1 specifies 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 the IPO, it was difficult to determine prior to the IPO what the valuation of Google would be, and furthermore neither the offering price nor the number of Class A shares to be offered could be determined until the IPO closed. Only the amount of funding to be raised, $2.7 billion, has been provided. For the purpose of comparison to the ratio and comparables approach that was used by the financial

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Exhibit 8

Base Assumptions: SCENARIOS 2 High High High

Growth Years 1 - 10 Growth Years 11+ WACC - High/Low Year 1 2 3 4 5 6 7 8 9 10 11+ WACC PV of Free Cash Flow PV of Residual Value Enterprise Value

1 High High Low

3 High Low High

4 Low Low High

80% 70% 70% 40% 35% 30% 20% 20% 15% 15% 10% 15% $5,155,240 $33,255,800 $38,411,040

80% 70% 70% 40% 35% 30% 20% 20% 15% 15% 10% 20% $3,613,080 $10,864,340 $14,477,420

80% 70% 70% 40% 35% 30% 20% 20% 15% 15% 5% 20% $3,613,080 $6,913,670 $10,526,750

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%.

analysts to value Google, let us look at some DCF scenarios using various assumptions, to see how the results compare when calculating the value of Google. Exhibit 8 contains four DCF valuations for Google based upon various assumptions for growth and discount rates, along with financial information that was provided in the S-1. The valuations range from $8 - $38 billion. As with any valuation methodology, the DCF valuation methodology can produce results that vary significantly dependent upon the assumptions made. For example, the chances of accurately predicting Googles sales growth rate are as one analyst put it about a googol to one. Revenues grew from $86 million in 2001 to nearly $1 billion in 2003. Given the short and dramatic revenue growth history of Google, it would be nave to think that an investor

could correctly predict the revenue of Google for the next 5 years, or the next 6 months for that matter. One source that most financial experts have not considered when valuing Google is the company itself. While Google provides no specific information regarding its value in the S-1, the S-1 does include information on stock options granted to employees. In 2003 the average share option was granted at $2.65, and Google has reassessed the value of these options and has recorded the difference as compensation expense. For the first quarter of 2004 Google added $75.4 million to its deferred compensation account which related to the approximately 1 million options that were granted during that period. Therefore approximately $75 was the excess value for each share. The options granted during the first quarter of 2004 were granted at an average price of

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Exhibit 9

Company Advertising.com Alibris Blue Nile Brightmail Claria ECost.com Google Greenfield PlanetOut Shopping.com

Business Advertising Books Jewelry Anti-spam Pop-up ads Retailer Search Online Surveys Gay media Comparison shopping

Amount to be raised $100 $35 $72.9 $80 $150 $35 $2,700 $75 $75 $75 $3,397.9

Profitables No No Yes Yes Yes Yes Yes Yes No Yes

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

Exhibit 10

Valuation Source Financial Community DCF Senarios Black-Scholes Google S-1 (compensation adjustment calculation

Low $17 $8.3 $19.8 $22.4

High $57 $38.4 $19.8 $22.4

$16.28. Therefore Google values these shares at approximately $91. According to the S-1 Google has approximately 246 million shares outstanding. The resulting value of the company based upon the share estimate of $91 would therefore be $22.4 billion. Jack Ciesielski the publisher of Analysts Accounting Observer used the Black-Scholes method to determine the price that Google values its shares based upon the fair value that Google provided at various times for the options in the S-1 (Thurm, 2004). Google says that the fair value of the options issued in the first quarter of 2004 based upon Black-Scholes was $67.06. Given the $16.28 option price and other financial assumptions, Ciesielski calculated the value of the shares at $80.44. The resulting value of the company based upon the Black-Scholes methodology would therefore be approximately $19.8 billion. The various valuations (in billions of dollars U.S.) for Google that have been discussed can be summarized as follows: Google was not alone with its potential high valuation.

Given the great interest in the Google IPO, the herd mentality may have been at play in July, 2004 with other companies in the search engine space, even though Google had yet to go public. During the period of January July 2004, shares of search engine companies Ask Jeeves had increased 143%, Look Smart 66%, and Mama.com 368%. The increased valuations were short lived however, as by mid 2005 the shares of all three companies had returned to pricing levels below those of their January 2004 price, perhaps as a result of the market dominance that Google had gained in the search engine space by mid 2005. Mama.com, a Montreal-based meta-search engine, announced in June, 2004, that it raised $16.6 million in a stock sale to private equity investors. Mama said it would use the money to complement its $11.3 million in cash and equivalents to pursue possible mergers and expansion. The offer came after the small search players stock hit $13, up from $3.25 at the start of 2004. For calendar 2003 Mama.com had sales of $8.9 million and a profit of $211,000. At $13 a share Mama.com would

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have a market capitalization of approximately $136.5 million. Interchange Corp., a Laguna Hills, CA, company that offers local search services, filed for an initial public offering 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 stated in its regulatory filing. Interchange had a market capitalization of approximately $128 million based upon its offering. Gary Stein an analyst with Jupiter Research said In the long run, the gravity of Google is going to attract everything to it. These other companies are going to rise with it. Everyone wants to invest in search. The next question is what are the markets around it. Stein went on to say You have to invest in the company as well as the idea. The company could be taking what they do and calling it search because its the buzzword. The valuation of companies such as Mama.com, indicates that we may have the classic information cascades scenario of the failure of information about true fundamental value to be disseminated and evaluated (Shiller, 2000). In addition, investors may believe that at a potential valuation in the range of $50 billion for Google that they should look for other investments in the search engine space, which may be undiscovered by other investors, and therefore a better investment. This is a classic case of the investor thinking that he or she knows more than other investors. Furthermore, as the confidence in the market (search engine) increases, investors will drive the prices away from the fundamentals (Diba, 1990). V. CONCLUDING REMARKS Its almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a lessknowledgeable buyer (investors). Warren Buffett In a July 27, 2004 regulatory filing with the SEC, Google announced that it planned to sell its shares at a price that was to be determined but would be between $108 and $135. Google indicated its intent to sell 24.6 million shares, which at the planned selling price, would result in gross proceeds to Google of between $2.6 and $3.32 billion. An additional 262.5 million shares remained in the hands of management, employees, investors, vendors, consultants and others which would result in a total of 287.1 million shares being issued at the time of the IPO. At $135 per share Google would have a market value of approximately $38.75 billion rivaling corporate giants such as McDonalds and General

Motors, who on July 27, 2004 had market capitalizations of approximately $34.2 billion and $23.6 billion respectively. Google was unable to close its IPO offering at the $108 - $135 share price range. On August 18, 2004 Google announced that it was reducing the number of shares that it was offering to the public from 25.7 million to 19.6 million, and reduced the planned target share price range to between $85 and $95. The change in the price range represented a 26% decrease in the offering priced based upon the mid-point of both offerings. On August 19, 2004 Google closed its IPO at $85 a share and during its first day of trading closed at $100.34, up 18% from its offering price. Googles share price maintained its upward trend closing at an all time high on November 3, 2004 of $201.60, resulting in a market capitalization of approximately $56.4 billion. On August 19, 2004, the day of that Google began trading, 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 Google competitors Yahoo Inc. and Microsoft Corp. rose, with Yahoo Inc. closing up 0.49% at $28.48 a share, and Microsoft up 1.52% at $27.46 a share. However, perhaps based upon the great interest in the Google IPO, the herd mentality may be at play with other companies in the search engine market. As aforementioned, the share price of search engine companies Ask Jeeves, had increased 143%, Look Smart 66%, and Mama.com 368%, during the period of January 1 August 30, 2004. The investor enthusiasm for IPOs that some companies had hoped would follow Googles announced IPO did not materialize. Googles S-1 filing of April 29, 2004 prompted a number of startups to file their S-1s indicating their plans to go public. According to an IPOhome.com report (see figure 5 below), during the period 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 124 companies have either postponed or canceled their offerings since July 1, 2004 and that more than 100 others companies wait in limbo as the investor meetings that precede IPOs have ground to a virtual halt. The excitement and press surrounding the Google IPO notwithstanding, perhaps investors who took financial losses during the internet bubble of 1998 2000, remain cautious regarding purchasing shares of companies that do not meet stringent financial criteria. What is apparent is that historically stock markets have been subject to various bouts of exuberant increases in share prices only to be followed by an even more severe decline in the value of the shares. However, some of the companies that were initially

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Exhibit 11

Number of IPOs as of 8/31/04 500 486

406 400

300

200 124 100 83 70 68

0 99 00 01 02 03 04

Renaissance Capitals IPOhome.com

affected by the bursting bubble in the internet market are now strong companies. These companies, which had solid business models, such as eBay, Yahoo and Amazon, became strong companies and major contenders in the markets that they addressed. They also slowly recaptured some of the internet magic of the period during the boom and now have relatively high valuations when compared to traditional companies in the same market space. The internet companies that have succeeded tend to be pure play companies in that their business model is based solely upon the internet, and the majority of them tend not to carry inventory (e.g. eBay, Yahoo, and Google), with Amazon being an exception. Behavioural Finance theory would lead one to the assumption that the high valuations for internet companies during the internet bubble were a result of herd mentality and the Greater Fool Theory. Furthermore, one could assume that the meaningless ratios and comparisons that were created for valuing internet companies were created as a tool to attempt to

justify the high valuations that arose for internet companies, and that they did nothing to measure the intrinsic share value of the internet companies. Notwithstanding that the DCF methodologies can produce diverse valuation results based upon the assumptions utilized; at a minimum the results represent financial assumptions that in the final analysis reflect the value of the company, subject to the assumptions of the person using the DCF methodology. Google is currently in a strong financial position and is certainly much stronger than any of the internet companies that went public during the internet bubble (see Exhibit 2 and Exhibit 3). It appears that the Google IPO had initiated a new internet bubble era in the search space, but not in the internet space in general. However, the search bubble was short lived notwithstanding that Googles share price made significant in the year since it went public. Furthermore, of the ten internet companies that had filed with the SEC to go public as of May 31, 2004, seven of them were profitable in their prior fiscal year, which leads one to believe that the companies going public are much more mature than those that went public in the late 1990s (see Exhibit 9). According to internet company filings with the SEC, the total amount that the ten companies are planning on raising is approximately $3.4 billion. Of that amount the $2.7 billion offering of Google represented approximately 80% of the total amount of the funds that all of the companies combined are planning to raise (given that Google actually raised $1.66 billion the ten companies therefore planned on raising $3.36 billion of which Googles $1.66 billion represented approximately 50%). What this indicates is that the Google IPO will likely be an anomaly in terms of its size in 2004, and furthermore there are no other internet companies of the size of Google that could gather the attention that Google has, should they go public. Subsequent to Googles initial IPO their shares rose steadily and by September 2005 had reached as high as $320. With trailing annual revenues in excess of $4 billion and a market capitalization of approximately $90 billion, on September 14, 2005 Google announced its intention to sell 14,159,265 shares at a price of $295.00. How other search engine firms will be affected by Google in the long term, and the resultant overall effect that Google will have on the valuation of internet companies in general will undoubtedly be subject to much study and analysis in the future. However, based upon the value of Google shares and the shares of other search engine companies, it is clear that a temporary bubble did exist in the internet search engine space that was short-lived, and that the subsequent share performance of Google was unique to Google. Furthermore, the performance of Googles did not result in a bubble for internet stocks in general.

Number of IPOs

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TOM CORR is a serial entrepreneur in the technology sector with over 30 years of experience in the industry. Since selling his last company in 2000, Tom has been involved in venture capital, M&A, interim CEO, and due diligence activities. He is now the Senior Technology Manager at the University of Torontos technology transfer group - the Innovations Foundation, and teaches the Entrepreneurship course in the MBA programme at the University of Toronto. Tom also contributed to the best-selling book Art of the Start by Guy Kawasaki. Tom is a Research Associate with Henley Management College working on his DBA degree and holds a MBA degree from the University of Toronto and an Advanced Postgraduate Diploma in Management Consultancy from Henley Management College.

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