April 1999 Internet Stock Prices and Modeling By ManMohan S. Sodhi "Casino capitalists trading Internet shares appear to be stark, staring mad." Thus spoke The Economist[1], arguing why Internet stock prices must fall. Many rich and famous people, including Microsoft Chairman Bill Gates, have commented on these prices as being excessive. But, finance textbooks say, "In an efficient market, you can trust market prices." [2] Possible conclusions: The Economist is stark, staring mad; rich and famous people are not always right; the market is not efficient; or the market is efficient and the stocks are correctly valued. Quoting Nobel Prize winner Bill Sharpe, who says that "we are all pretty much flying blind," The Economist argues that even the experts do not know how to value Internet shares. Given your modeling expertise, the challenge to you is to devise a satisfactory model to explain the stock price of such companies as Amazon.com, eTrade, or Yahoo. You can come up with satisfactory parameters for existing models and/or invent new models altogether. Here are some possible starting points: Traditional financial analysis. This usually means Discounted Cash Flow in which the stock price is discounted sum of earnings per share in every period using the expected rate of return for an equivalent risk class as the discount factor. You will also need a model for earnings per share over time as many of these companies have negative profits. For instance, Amazon.com has had negative earnings every quarter since March 1996, although with large quarterly revenue increases. You can use risk-return models such as the capital asset pricing model with beta. But how do you measure beta for Internet stocks? And, how do you explain stocks like theglobe.com that had a 600 percent single-day gain for its IPO? Technical analysis. This goes against finance theory, but there are many popular methods for predicting stock price behavior in this category using such analysis as the relative movement of the 20-day moving average against the 50-day moving average. Note these models do not attempt to "explain" the stock price. Greater fool theory. My understanding of this theory is that while an investor may know he is a fool in buying the stock at the current price, he believes there exists a greater fool who will later buy it at a higher price from him. There was some simulation modeling work done at Caltech to develop this theory to explain stock price crashes. Chaos theory. Models using chaos theory are in the category of technical analysis, developed with a view to look for market inefficiencies by studying patterns in stock price. But, from what I remember from an Economist survey from a while ago, firms using such models have not consistently beaten the market in returns. Complexity theory and increasing returns. Developed by Brian Arthur from the University of California at Berkeley, the "increasing returns" theory has been touted by Hagel and Armstrong [3] to explain the power and economic value of virtual communities giving Microsoft as an example of "increasing returns." But, unlike Microsoft's lock on users, does Amazon.com really have a lock on users to prevent them from moving to BarnesAndNoble.com? Basics of supply and demand. Only a small percentage of the total stocks of Internet companies is actually available in the market. For instance, eBay went public with only 9 percent of its equity. Hedge funds shorted these stocks believing them overvalued; but when the stocks went higher, the funds had to buy scarce stock, increasing prices even further. So maybe there are some supply-demand issues with Internet stocks that are different from other stocks. Tips from the Web itself. There are many sites on the Web with advice on valuing stock prices. A popular one, The Motley Fool Online [4], provides the Fool Ratio for "small- and mid-cap growth stocks" as the ratio of the price-earnings ratio (PE ratio) and the percent growth rate of earnings per share. According to them, Fools Ratio for undervalued stocks is less than one, and that for overvalued stocks exceeds one, with caveats. Based on this, Yahoo is highly overvalued with its PE ratio of 1,446 (March 1, 1999) and an estimated growth rate of only 70 percent (assuming costs grow proportional to revenues). Why this analysis? The above analysis may seem facetious but there are some fundamental questions. Maybe Amazon.com is more than a cheap and convenient way to buy books, and maybe sites like eTrade cause more of us to make more transactions at $8 each than we would with brokers to whom we pay $145 per transaction. So by turning things on their heads in commerce, cyberspace has given us reason to make changes in the way we model stocks and revenues, and has provided other modeling opportunities. Having said all that, am I going to rush out and buy some Internet stocks? Well, I may be crazy about modeling, but I ain't stark, staring mad. References The Economist, "Why Internet shares will fall, " Jan. 30, 1999. Richard A. Brealy and Stewart C. Myers, "Principles of Corporate Finance," Third Edition, 1988, McGraw-Hill Book Company, New York. John Hagel III and Arthur G. Armstrong, "net.gain: Expanding markets through virtual communities," 1997, Harvard Business School Press, Cambridge. The Motley Fool, www.fool.com. Dr. ManMohan S. Sodhi is president of the Logistics Section of INFORMS and Experienced Consultant in supply chain planning with Andersen Consulting in Chicago. He is the founder of the OR news group, sci.op-research, and helped design and create INFORMS Online. He welcomes your comments at MohanSodhi@AOL.com. Table of Contents OR/MS Today Home Page OR/MS Today copyright © 1999 by the Institute for Operations Research and the Management Sciences. All rights reserved. Lionheart Publishing, Inc. 506 Roswell Street, Suite 220, Marietta, GA 30060, USA Phone: 770-431-0867 | Fax: 770-432-6969 E-mail: lpi@lionhrtpub.com URL: http://www.lionhrtpub.com Web Site © Copyright 1999 by Lionheart Publishing, Inc. All rights reserved.