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Why have Shares in Internet & Technology companies been so volatile in the last few years?
Introduction
In 1/000, there was a belief that ‘dotcoms’ were going to change business methods and replace the ‘old economy’. People thought that Internet based companies could eliminate the cost of real estate and sales staff, reducing average total costs therefore being able to undercut the costs of traditional competitors and make higher profit margins. It was relatively easy for small companies to get funding from venture capitalists and by placing shares on OFEX or AIM. Investors believed the hype and shares boomed.
In March 000 technology shares slumped . Since then dotcoms and technology stocks have been in the doldrums, Venture capitalists have become more conservative and the Initial Public Offering (IPO) market has snapped shut since internet companies would not be able to raise much capital in the new market. Advertising revenues have collapsed, confidence has dropped out of the market and investors have lost confidence in the stocks, resulting in an oversupply of shares leading to plunging market capitalisations and share prices.
This chain of events caused the share price of Internet and Technology companies to rise to dizzy heights, then fall as quickly as they rose. In this report the volatility shown by this sector shall be analysed.
Methodology
The Information used has been both from primary and secondary sources.
Secondary data has been collected using various websites such as Moneyextra, Imiweb, Ft.com, Bigcharts and The Economist. These websites have been used to collect essential financial statistics on the companies used, as well as information about the sector. To gain more specific information I have used company reports for Lastminute.com, Bookham Technology and Vodafone. I have used these companies as barometers to indicate the relative rise and fall of the Techmark and NASDAQ (high tech) share indices, to the ‘Old Economy’ FTSE 100.
For a primary source I have conducted an interview with a local stockbroker, representing Charles Stanley & Company Ltd.
For further information on methodology, consult appendices 1 - 8
Analysis
The Boom Period
It is inaccurate to blame a single variable on the initial boom of the sector; the sudden rise can be attributed to 5 factors
• Media & Public Hype. This is not novel, the Australian Mining Boom and the UK Property Boom are earlier examples. People bought into the stock when companies possessed no fundamental attributes to back up the share price and high P/E’s, representing an increase in expectations on earnings per share (EPS).
This shows how the market ‘bid up’ share prices way above their real value. This lead to extremely high PE ratios. For example at the height of the boom, March 000, Vodafone’s share price was 400p with an EPS of 4.64p, giving a PE ratio of 86.
In June 00, Vodafone’s share price was 80p with an EPS of 5.p, giving a PE ratio of 15. . This is a more realistic ratio.
This also lead to massive overvaluation classic in the case of small companies like Sopheon & Superscape, where the stock rose to £5 per share, but is now valued at approximately £0.15 .
This was a trend set by many Internet based companies flooding the market. The business sector they were in had very low or no barriers to entry and whilst the ‘dotcoms’ had good ideas the funding they were able to obtain was not sufficient to cover the ‘burn rate’. The capital was used so quickly (i.e. burnt) before estimated profitability could be realised. These companies had good ideas as well as niche markets, but were not sufficiently funded to represent themselves and didn’t posses robust enough business plans, with overestimated profitability.
The growth of these firms was unprecedented and their market capitalisation was overvalued compared to their net assets. An example is eBay, which offered itself on the stock market on the 4th September 18 for $18 per share. months on the company traded at around $0, a staggering rise of 1,600%, while profitability declined. Another months on the company was still to make a profit and had a market capitalisation of $7,56,85,50.00 (i.e. $7.5bn)
• High Expectations. People paid extremely high prices in ‘hope value’ for the stock. For the sector as a whole, especially the dotcom’s, people paid inflated prices for the stock due to the expectation of future profits that realistically couldn’t materialise. This ‘hope value’ was generated by the analysts who talked the stock up, as well as the herding instinct of the city, creating huge levels of demand, as they too wanted to gain the sort of returns made by other investors, greed overcame sense. This can be expressed best when we compare the share price to the asset based share value. For example Bookham Technology & Lastminute.com (September 001)
Bookham Technology Lastminute.com
Total Assets Less Current Liabilities £68,410,000 £8,455,000
Total Ordinary Shares In Issue 18,861,000 170,17,0
Asset Value Per Share £.08 £0.5
At the height of the year Bookham was trading at 5,00p, a massively inflated price over book value. It was trading at 00p at the end of 001, and is now trading at approx 74 ½ p; undervalued. It would be the opinion of the shareholders to liquidate the assets of the business because they would receive more per share.
Rising market capitalisations allowed the shares to reach the FTSE 100 & 50 indices, forcing tracker funds to buy stock. These tracker funds buy into the market as a proportion of the shares within them. For example Vodafone is the nd largest company within the FTSE 100, with a market share of 10% , this means a tracker fund who invests £100,000 in the FTSE 100 will invest £10,000 with Vodafone. Companies such as ARM Holdings and Bookham Technology reached this level of trading. This created further artificial demand for the product so the price rose further.
Further ‘hope value’ was added by the brokers whose estimates for the shares were inflated. However when we examine the EPS values for the companies rising share prices couldn’t be justified with no fundamentals
Vodafone Group
18 1 000 001 00 00E 004E
Norm EPS (p) .68 .75 4.64 .55 5. 5.7 6.6
Bookham Technology
18 1 000 001 00 00E 004E
Norm EPS (p) -4.7 -10.0 -1. -5.0 -7.8 -.8 -0.
Lastminute.com
18 1 000 001 00 00E 004E
Norm EPS (p) -0.40 -.0 -6.4 -. -8.56 5.1 15.0
• Low Asset Bases & Demonstration of Goodwill. The publicly quoted company usually acquired a private company owned and started by the management and promoters of the company. The PLC acquired the private company at an inflated price thus creating goodwill.
For example
X Ltd
Shareholders funds = £15m Property = £10m
Current Assets = £5m
Total Net Assets = £15m
X Ltd is Acquired by X.com PLC
Shareholder funds = £0m Net Assets = £15m
Goodwill = £15m
Total = £0m
This happened in many cases, notably with Vodafone with their acquisition of many smaller telecoms companies. Also large companies such as Marconi were buying up-and-coming firms and many mergers were taking place during the boom, for example supply contracts with Bookham Technology . This caused the share prices to increase as these companies could now reap larger economies of scale, which would lower their costs. An example of an inflated acquisition is AOL who paid $4. billion for Netscape.
Goodwill inflated massively as companies overpaid in order to secure the supposed massive profit growth of the future. This also precipitated the fall, when auditors forced goodwill to be depreciated leading to massive losses. For example, AOL Time Warner Inc has just announced losses of $100 bn with a large proportion being attributed to the amortisation of goodwill.
• Liquidity of Shares. Small companies’ shares are relatively limited and were only given to the financial institutions of the city via ‘placing’ . Thus there was limited liquidity in the market, shown by wide bid offer spreads. These quotes are two-way prices, the lower of which is known as the bid price (the price at which the holder can sell shares) and the higher is the offer price (the price at which the holder can buy shares).
Limited liquidity meant few shares were released by current holders when the price increased so demand for shares increased along a price inelastic supply curve. Later in the boom many companies issued more capital to increase liquidity of the market for shares, making supply more elastic and slowing share price growth.
Scarcity value causing increased demand and insufficient supply, can be seen on a demand and supply diagram
• The Profit-Signalling Mechanism. This attracted more new investors to the stock market. For example Vodafone’s share price increased from 0p in January 1 to 50p in January 000, an increase of15% , for a supposed ‘blue chip’. New entrants, such as Bookham Technology rose from ,000p to 5,00p in months a 65% increase .
Consequently supply increased and due to the factors mentioned increased demand. Demand is a ‘self-fulfilling’ prophecy, as demand increases so does the price (See Fig 1.).
As the demand increases excess demand is created at the equilibrium price and quantity of P1, Q1. This causes prices to be ‘bid-up’ to clear the excess-demand. As prices increases there is a contraction of demand and extension of supply, until equilibrium is re-established at the increased price of P, and the increased quantity of Q. As demand increases the shares become more price inelastic, as investors are willing to pay more.
The Bust Period
Here the focus is on three companies, which will act as barometers for representing the state of the technology sector as a whole
Vodafone PLC - caused the initial decline.
Bookham Technology PLC - entered the market at its peak, but consequently fell with the competition.
Lastminute.com PLC - appears to have survived the volatile nature of the market and is becoming profitable.
The bust may be attributed to the following
• Lack of Fundamentals. The market upwards trend was mainly a function of momentum; investors kept on buying in the hope that the stock would go up and up. Many investors failed to analyse the stock on a fundamental basis, i.e. ratio of market price to asset value. Thus investors were subject to a weak form of market efficiency, and did not rely on fundamental analysis. It was speculation based on market trends and naïve investing.
Vodafone caused a bust period due to this. This company is large and even this ‘blue chip’ firm was paying what appeared to be huge amounts of money in ‘hope value’, to develop the rd Generation (G) mobile telecommunications market. Vodafone overpaid world governments in order to obtain the licences to develop the technology.
This investment was necessary, otherwise the company would be deemed as ex-growth, but it was difficult to see how the firm would generate the cash needed to pay off the initial expenditure over the next 5 years. The strategy and figures were questioned. This lack of confidence in such a major company led to a downturn in the sector and forced people to examine the financial viability of their portfolios, which led to a snowball effect throughout the sector as share sales, produced falling prices.
This may be seen on a demand and supply curve
The figure shows how as demand fell, prices fell along a price elastic supply curve, produced due to a saturation of companies back into the market, thus scarcity value disappeared.
The companies lacked fundamentals to support their share price
• Poor or non existent asset backing
• Low turnover by company/low EPS in stock
• No dividends
• Shrinking Market/slowing growth
• Poor Liquidity
There was a sudden realisation after Vodafone that the market couldn’t deliver the expected profits because of oversupply in the market place.
Investors failed to realize that many of the dotcom’s and other technology companies had and still have very weak financials. Prior to the peak of technology stocks in March of 000, external financing was very easy to get for technology companies. Private investors were more than willing to invest in start-up tech companies. Those companies that were riding the tech wave could simply issue additional shares at an inflated price. Thus, cash flow problems were nonexistent for these companies. The well soon ran dry and many start-ups were unable to finance operating activities internally. The external environment was beginning to realize that many of these start-ups were not producing the results as expected. Many dotcoms and other technology-laden companies were forced into bankruptcy within the first six months since IPO.
Share price decreased so market capitalisations fell, forcing tracker funds to fall. An example of this is Bookham Technology which reached the FTSE 100 in 000, but now operates in the FTSE small cap . People started to look at shares with very high P/E Ratios to see if that premium was too optimistic.
This was the case for all companies; in March 000 their ratios were as follows
Vodafone
Price EPS PE
400p 4.64p 86.
Bookham Technology
Price EPS PE
4,000p -5.0p -160
Lastminute.com
Price EPS PE
40p -6.4p -1.5
• Weak Revenue & Earnings Base. Many tech and dot.com companies also suffered and still suffer from a weak revenue and earnings base. Early in 000, many companies with less than $1 million in sales had market caps in the billions (Vodafone & Bookham Technology). For example in June 000 Bookham Technology had a market capitalisation of (18,861,0005,00) £68, 6, 00, 0000 but a turnover of just £6.m . Companies such as TheGlobe.com made a net loss of more than $16m on sales of $5.5m .
This should have been an immediate signal to investors that a company is overvalued. Even if sales are growing exponentially, sales will have to grow for years before a billion dollar market cap can be justified. Investors had prematurely priced in years of great results and excellent earnings. When these results were not delivered in the short-term, investors reassessed their outlook on various stocks and adjusted their portfolios accordingly. This reassessment caused many investors to return to fundamental valuations. The NASDAQ market as a whole saw a 67% decline from 000-00 . This caused many billion-dollar dotcoms to be reduced to a small fraction of their year high, for example the ‘% club’ companies who lost % of their market value, e.g. the Norwegian search engine company Fast Search .
• Conservative Use of the Web to Reduce Costs. Many dotcoms did not capitalize on using the Web as a tool to reduce costs. Many investors believed that the Internet would create a distinct advantage for Web companies, while bricks and mortar companies would be at a disadvantage. It soon became apparent that margins were about the same for Internet and non-Internet companies. For example, Internet retail companies had to establish a distribution centre and invest in a large quantity of inventory, while still having to rely on a distinctly low tech postal system. This does not differ much from a bricks and mortar company as a large capital investment must be made followed by a high volume of sales to maintain operations. Most dotcoms in this space have yet to determine a way to become profitable. Many dotcoms even have losses that exceed sales (Lastminute.com is yet to announce profitable earnings). There is also the problem of certain retailing online e.g. Boo.com offered women’s clothing, but there is no system to try clothes on or compare (However the technology is being developed).
• Periphery Companies. The bust also appeared bigger because the boom had sucked in many periphery companies who were bracketed as being dotcom’s, e.g. telephone exchanges. The boom made many of these companies profitable once again, and the banks handed out indiscriminate loans, which materialised into bad debts.
• Saturation of Small Companies. The Profit-Signalling Mechanism attracted many smaller companies to join the market. A classic example of this was Bookham Technology. In the first quarter after flotation, its price had risen to £5 per share, it is now 74 ½ p . One problem with such companies was that they didn’t have enough working capital to produce a financially viable product. They had very high PE Ratios and after spending huge amounts on R & D, when the product was finally marketed, there was little demand and no sales.
Lastminute.com is the best publicised of all the companies affected by this volatile period. The company floated on the London Stock Exchange and the NASDAQ National Market on 14 March 000 and its initial share price was £4.80 per share, but in the first quarter the price fell to £1.0 . It then steadily declined. It is a true dotcom company survivor and is soon expected to become a profitable business. This is because of two factors; firstly the company is extremely well managed by two very astute entrepreneurs, secondly it has a novel idea, for which there is a genuine consumer demand.
To summarise we may attribute the bust period to
• The overvaluing of companies in the sector
• The problems faced due to oversupply within the market
• The lack of economic fundamentals possessed by the companies in question and resulting reduced confidence
• The lack of demand for the services and goods offered by the companies, as well as lack of competitiveness
• Reduced economic activity and long term global economic uncertainty e.g. Iraq
Conclusion
What is the result of the stock market gyrations over the last 5 years?
The world of e-commerce has too many companies vying for business. Market analysts have compared the crash in the internet and technology market to a forest fire that has cleared out the jungle and created space for fewer but stronger web companies. Venture capitalists will now be more careful examining business proposals and will only invest in businesses with sound commercial plans.
The wall of money that hits web entrepreneurs should shrink in size. Investors will now be more careful before speculating on hot new IPO’s, as ‘old economy’ values are now back in vogue with investors, Revenue, Earnings and Profits are benchmarks again.
Most Internet start ups failed because they were based on the premise that the internet represented a revolutionary business model. The Internet still has the potential as a tool for firms to expand their business, if they can combine it with a distinctive product and avoid ruinous price wars. For example, supermarkets will benefit from the internet because the internet is just one more outlet for the chain.
The volatility has also lead to a massive drop in confidence. There has been a flight of cash by investors to real assets, thus property prices have risen greatly. In the last year (001/00) commercial property in the south has risen by 10/1 ½% .
Finally, it may be said that now is the time to invest in Internet companies, as many are grossly undervalued. There is opportunity in the sector; however we will not see the mega profits and one must be content with a slow growth. The FTSE is now trading on 11x trend earnings, and yielding almost 4%. Dividends grow by real GDP and inflation implying that equities will return 4% plus inflation plus real GDP, consequently the equity market should return 8% .
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