Freeserve float will test the net

Is it safe to buy shares in the web? asks Sarah Barnett

Freeserve, Dixons' free internet service, has gone off like a rocket since its launch last September and has attracted 1.25 million users. The next stage of its expansion is the 20 per cent flotation planned for next month, when investors will have the chance to buy into the firm.

Freeserve has become this country's largest internet service provider (ISP), chosen by one in five net users. The company is estimated to be worth between pounds 1bn and pounds 2bn. While the valuations are attractive, the flotation is taking place amid worsening forecasts for internet shares. So will the Dixons shares be a good buy? And are internet shares currently a good investment?

The biggest American names in the internet world have been dealt heavy blows in recent weeks. Amazon.com, the first star of internet shopping, has seen its share price decline fast. Its market value has halved from its late-April peak of nearly $36bn (pounds 22.5bn). America Online, the biggest provider of both internet access and online information, has experienced a 40 per cent fall from its peak, leaving it valued at $120bn rather than $190bn.

Despite the net's huge potential, no single stock is a sure-fire bet. Jeremy Batstone, head of research at NatWest Stockbrokers, says that there are a number of unique risks: "The barriers to entry are extraordinarily low and profits for many are a distant dream. The conventional measures for valuing a business don't apply and the analysis of the sector is in its infancy," he says.

Given that these companies don't make a profit, rendering traditional valuation yardsticks such as price-to-earnings ratios useless, how do you go about valuing an internet share?

"Don't get carried away with the hyperbole that half the world is going to be using the internet next year. Strip off the sequins and get back to the basic cloth," advises Justin Urquhart Stewart, a director at Barclays Stockbrokers.

He suggests that the best way to look at internet stocks is to study the dynamics of the business and compare them to non-electronic operations offering similar services.

"Internet companies are really electronic hoardings - like a large poster site - with mail-order capabilities. Amazon is simply an operation that has built up a database in order to sell to that database whatever product it wishes. The nearest parallel is a mail-order company like Great Universal Stores," he says.

So one of the key things to look at when analysing an online retailer is how effectively you feel it is marketing its wares through both its "advertising hoarding" - in other words, its home page - as well as the advertising links it has established with other sites.

For internet service providers such as Freeserve (there are more than 100 of these in the UK alone) profit potential depends on the advertising income they generate as well as revenue from e-commerce.

In the case of ISPs, the home page is a portal or gateway to the internet. This will offer links to other sites on the web as well as its own range of services such as news, share price quotes and games.

By building a large audience on these portal websites, service providers can charge advertisers high rates and make money from online shopping.

While the basic business proposition of ISPs and online retailers sounds all right in theory, those who watch the stock market closely are worried that in practice many will become victims of their own success.

Retailers are currently engaged in a vicious price war aimed at pushing the competition out of the market. But the severity of the battle has led some to question whether there will ultimately be any winners. For example, Amazon.com offers 50 per cent discounts on the biggest-selling books, which begs the question exactly how it will ever make money and how it has achieved far higher valuations than traditional, profit-making retailers.

Similarly, questions have been posed about the ability of internet service providers to generate a profit. In the UK, unlike the rest of Europe and the US, most providers now allow you to get on the net for free. Revenue is generated by charging users for support - help lines usually cost between 50p and pounds 1 a minute to use - as well as advertising and e-commerce transactions on their portal site.

As the service is free (except for the cost for support), the providers face a problem in ensuring customer loyalty. What will stop their users deserting to the competition?

Also, users can easily bypass their service provider's home page in favour of other portals such as the popular Yahoo! or Excite. It is even possible for users to create their own portals consisting of their favourite internet links. The more users use alternative portals, the more potential advertising revenues are reduced.

To avoid getting your fingers burnt, rather than investing in a single share, it might be worth exploring a broadly based technology unit trust that includes internet stocks among its investment options.

Last month, Framlington launched the UK's first internet-dedicated fund, called NetNet.

Craig Walton, the group's marketing director, says the fund is a good way to spread risk through diversification and also "enables you to play the internet game in several different ways".

The fund invests in pure internet stocks such as Amazon and eBay, companies that support the infrastructure behind the internet such as Microsoft and Intel, and more familiar names such as clothing retailer Gap, which uses the net as a distribution channel.

Although share prices might be falling in the internet sector, this does not mean that it is no longer worth investing in. Analysts believe that the recent downturn is simply a much needed cooling-off after frenetic market activity.

If you are keen to invest in the internet phenomenon, caution is the watchword. Don't throw large sums of money at it and consider reducing your risk by investing in a broadly-based portfolio of technology shares.

n Framlington, 0345 775511.