s Freeserve heads for flotation, internet companies are booming again. Freeserve, the free internet service provider (ISP) launched by Dixons just nine months ago, is expected to be valued at up to pounds 1.5bn at the issue price, so how should Foolish investors value these companies?
The short answer is we cannot. Internet commerce is such a new business, and the companies that trade in it are working to such innovative business models, that company valuation is perhaps the hardest game in town. Internet companies must eventually stand scrutiny of their profits, and their shares will be valued accordingly. But precious few of these companies are actually trying to make a profit; instead, they are concentrating on fast growth to capture market share as quickly as possible.
Remember the Netscape flotation? Four years ago Netscape was the first of these companies to go public. Its shares more than doubled in their first two days of trading, and since then prices for other internet companies have headed skywards.
No one knows whether this is a genuine opportunity for Foolish investors, or a hype-led bubble. But two things are certain - the internet is here to stay, and it will revolutionise the way we do business.
About a year ago, when there were very few internet companies around, almost any new flotation was guaranteed to reap handsome rewards for investors. But quite a few of those early stars have fallen back from their peak prices recently. So, as the number of companies to choose from increases, are investors becoming more discerning in their stock picking?
To get an idea of how poor the usual valuation benchmarks are at assessing internet companies, let's look at how the big players are faring in terms of valuation.
In terms of market capitalisation, the world's largest internet company by far, at around $130bn (pounds 83bn), is AOL. Its share price rose from its 52-week low of $17.25 to a peak, in early April, of $175.50.
Since then, it has fallen back to around $120. While still close to 600 per cent up since its low point, that represents a fall of more than 31 per cent since April.
AOL has some earnings too, albeit only half a dollar per share, giving it a price-to-earnings ratio (p/e) of around 240.
The share price of Yahoo!, at $31bn (only a quarter of the size of AOL), shows a similar story. From a low of $29.50, it rose to a majestic $244 before falling back to hover around the $150 mark. That is a 38 per cent fall since its peak, but still a nice little earner for those who bought in a year ago.
Yahoo! also has some real earnings, but at only 41c per share, the company's p/e stands at 366.46.
What about online auction house eBay, with a market capitalisation of $15.4bn? From a low of around $8.50 it peaked at $234 before falling back to the $120 mark - more than a 47 per cent slide. And earnings? Seven cents a share, for a p/e of 1,756.70.
Finally, everybody's favourite, Amazon.com. Market cap is $22.24bn; it had a 52-week low of $21; its high point was $221 until it fell to less than $140. That's a 38 per cent fall from its peak, but still more than 500 per cent up on its low point. And no profits yet.
Foolish investors should be able to see through all this talk of astronomical p/es, entertaining though it may be. When an expanding company first starts moving into profit, its earnings will start off very small and unrepresentative of future years, so its p/e will be pretty meaningless. A company cannot really be valued using its p/e until it has a few years of solid profits under its belt, and that is the hard one to call.
Internet commerce is far from mature, but it is still important to distinguish the winners from the losers. The business will become very competitive, and only good companies will succeed. In the not-too distant future, it will be necessary to identify the ones that have the right approach to long-term profitability in order to make good returns, rather than just loading up with any internet company that happens to come along - just like the Foolish approach to any other sector, really.
And it will be interesting to look back in 10 or 15 years and see how things have gone, and how this year's little ups and downs have faded into insignificance.
Motley Fool, www.fool.co.uk
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