[WSJ] Order in Internet Stock Valuations.

Adam Rifkin -4K (adam@XeNT.ics.uci.edu)
Tue, 28 Dec 1999 01:48:57 -0800 (PST)

Well, this Wall Street Journal article is the darnedest thing:

Bonus points go to Greg Ip for making use of
Jim's-Word-of-the-Millennium, "network effect"...

By the way, at some point in November or December the entire Internet
sector became worth more than Microsoft, and no one noticed. With a
Y2K-induced meltup, the sector could reach a paper value over $1 trillion.

I do find it interesting that AOL and Yahoo together are 33% of the
current $900 billion. The big get bigger.

> Analyst Discovers the Order
> In Internet Stocks Valuations
> Internet stocks, the conventional wisdom goes, are a chaotic mishmash
> defying any rules of valuation.
> But one unconventional analyst thinks he has found proof of precisely
> the opposite: that Internet stocks adhere to a mathematical valuation
> system so rigid, it resembles patterns found in nature. That pattern
> suggests there may be fewer ultimate winners in the Internet arena than
> some investors expect.
> The analyst, Michael Mauboussin, the chief investment strategist at
> Credit Suisse First Boston, found this pattern, not by comparing
> Internet stocks to more ordinary benchmarks such as earnings, but by
> looking at the valuation of Internet stocks relative to one another.
> Among Internet stocks, he says, "there is literally a mathematical
> relationship between the ranking of the stock and its capitalization."
> Most conventional analysis finds the sector's enormous valuation
> irrational. Mr. Mauboussin doesn't try to justify the high prices
> investors are willing to pay for Internet stocks as a group. Instead, he
> is intrigued by how so much of the stock-market value of Internet
> concerns is clustered into just a handful of companies. Indeed, just 1%
> of 400 companies in the sector account for 40% of its $900 billion value
> in the stock market.
> Mr. Mauboussin uses some mathematical wizardry to find the pattern.
> Simply scattering the companies' value and ranking (relative to one
> another) on an ordinary chart results in a hockey-stick-like pattern: a
> couple of companies in the multiple billions of dollars, and everything
> else clustered close to zero.
> Using some slightly different but relatively simple math, he found that
> each company's value bears a predictable relationship to the others'. He
> couldn't find a pattern like this in any other sector.
> "I don't know why it works for this sector, but it suggests a couple of
> things," Mr. Mauboussin says. "One, there is a little method to the
> madness of how the market values these things. More important, these are
> winner-take-all or winner-take-most markets."
> The pattern emerges when the companies' values are plotted along with
> their market-capitalization rank on a logarithmic chart. On such a
> chart, each inch equals a similar percentage change. For example, the
> distance between 100 and 1,000 is the same as that between 1,000 to
> 10,000, because both moves represent a 900% increase. Mr. Mauboussin
> says this is characteristic of a "power law," normally found only in
> measuring natural or social phenomena, such as the frequency of
> earthquakes of a certain size and the number of cities of a certain
> population.
> ("Power" comes from the mathematical term for a number rising
> exponentially; 10 to the power of two is 100, to the power of three is
> 1,000, etc.)
> Once you know the ranking of the Internet stocks, the analysis does a
> pretty good job of predicting their market capitalizations. The market
> cap of first-ranked America Online was 92% of what the CSFB predicted
> when the analysis was done; second-ranked Yahoo's was 91%, fourth-ranked
> Amazon.com's was 64%, ninth ranked Excite At Home was 83%, 18th-ranked
> Priceline.com's was 101%, and 141st-ranked iVillage's was 77%.
> Mr. Mauboussin and colleagues Alexander Schay and Stephen Kawaja looked
> for something similar in eight other sectors, including financial
> companies and utilities. They found the pattern in spots but nowhere as
> consistently as with Internet stocks.
> The implication, they argue, is that Internet companies have unique
> economics. Consumers who are overwhelmed with choice gravitate to a few
> well-known sites. As some sites get bigger, they attract more users, and
> the more users they attract, the richer and more useful they become,
> attracting more users. This produces a "winner-take-all" outcome: a
> handful of Web sites with almost all the business, and the rest with
> next to nothing.
> Indeed, CSFB's research was spurred in part by work at the Xerox Palo
> Alto Research Center that found a "power law" relationship between
> Web-site usage and ranking. It found the top 0.1% of sites got 32% of
> usage, the top 1% got 56%, the top 10% got 82%. The value of the
> companies themselves follows the same pattern.
> "The value of network grows exponentially as users join," Mr. Mauboussin
> says. "A handful of sites get most of the traffic and thus a chance to
> monetize the traffic in a way others can't. Yahoo!, Lycos, GO.com ...
> have the exact same capabilities but radically different market caps.
> The market seems to be valuing this network effect."
> Not everyone is convinced that the pattern is significant.
> "You have to ask if this could just be coincidence, because people have
> looked at these things hundreds of ways and once in a while, you'll hit
> on something," says Andrew Sterge, a mathematician and chief executive
> of BNP/Cooper Neff Group in King of Prussia, Pa. BNP/Cooper Neff, a unit
> of France's Banque Nationale de Paris, specializes in derivative
> securities and quantitative-style hedge funds.
> Mr. Sterge notes, for example, that the value of CSFB's third-ranked
> stock, Charles Schwab (which some might dispute is an Internet stock),
> is far less than its analysis predicts.
> But he adds it makes sense that the stocks of Internet companies, few of
> which make money, adhere to a more mathematical valuation pattern than
> traditional stocks.
> "These companies are not weighed down by the rules of thumb that are
> used in valuing companies that make earnings, are part of industries and
> have histories. They're out there floating in the purest form of
> capitalism. People compare finance to physics a lot, and this is the
> best universe in which to do that, where none of the conventional
> financial analysts' wisdom has any relevance. Chaos theory and fractals
> would be very appropriate in valuing Internet stocks because they're
> priced on psychology and the feedback information you get from other
> people trading them."
> Indeed, Mr. Sterge thinks Internet stocks are less like common stocks
> than stock options. An option gives you the right to buy an underlying
> stock at a later date at a fixed "strike" price. The option is worthless
> if, at its expiration, the stock is below the strike price. But the
> option's value rises faster and faster as the underlying stock tops the
> strike price.
> Likewise, an Internet company will "expire" worthless if lenders and
> investors tire of financing its losses. But if it starts to make money,
> its value could rise rapidly as network effects take hold.
> Other investors are intrigued but still unconvinced.
> "This would be some of the first real quantitative evidence of a
> rational relative pricing scheme" among Internet stocks, says Ted
> Aronson, head of Aronson Partners, a Philadelphia quantitative-fund
> manager. But "I'm so prejudiced against [Internet stocks] ... it's hard
> to imagine the vast crowd pricing these will be any smarter than in any
> other sectors."
> Indeed, Mr. Mauboussin readily acknowledges his analysis only finds
> Internet stocks are correctly valued relative to each other, not that
> the overall sector is appropriately valued. But it does suggest that it
> isn't as overvalued as most analysts think, he says. For example, while
> the average value of a company with "dot-com" in its name is about $500
> million, that is distorted by the enormous values of a handful. The
> median value -- half the companies are above the median, half below --
> is just $53 million, proving the market thinks the vast majority of
> Internet companies are worth little.
> Whether Internet stock investors are ignorant or farsighted, the market
> seems to be valuing them correctly, he says. "Power laws are not managed
> by anybody. It's just a mathematical relationship that happens to be
> ubiquitous in nature."


I ain't gettin' no love from Nike.
-- Jerry Maguire