The End of an Era (c) Felipe Rodriquez - 13 February 2000 SUMMARY
When public perception about the Internet becomes pessimistic, an era of supposedly unlimited growth and extremely high valuations on the stock markets comes to an abrupt end. Introduction - The valuation of a company Equity valuation is a process that requires an objective and a subjective assesment of a company. The objective part in the calculations are based on current earnings and cashflow of a company and on the 30 year bond rate. The subjective part of the calculation is based on an estimation of future growth, the length of future growth, and a risk discount factor. If equity analysis would be an entirely objective process, then stock markets would be efficient and predictable. In such a case everything about a company would always be known, and would be processed in the valuation. Therefore there would never be any over- or undervaluation in the market. This is also what the (in)famous efficient market theorie predicts. Unfortunately the precise value of a company at any time of its history cannot be accurately predicted, there's always the subjective influence of the hopes and fears of people. Any mathematical valuation of a company uses subjective elements of future expectations. Subjectively the investor tries to establish a growth rate of a company, or tries to make an educated guess on the amount of years that growth will continue. The investor also estimates the risk of an equity, and discount such risk accordingly in the future. The optimistic subjective estimations of millions of people have caused technology stocks to be extremely expensive. By paying such a large price investors are expecting high growth and an almost unlimited timeframe of future growth. The new paradigm is shaking - negative perceptions.. The optimistic investor believes that the Information Era is the start of a development that is as important as the industrial revolution. _And_ that this development will create more productivity, and unlimited progress and growth. The illusion of unlimited growth is a vulnerable and dangerous one. Certain events can change this perception of unlimited growth. For example the realization that the technology and infrastructure of the Internet are still immature and unreliable. The Internet is sensitive to sabotage, information warfare, and terrorism. Teenage hackers are capable of hacking into websites of large companies and the pentagon. Trojan horses are spread every day through Email, to exploit the the host system. And recently a number of important Internet commerce sites, Internet icons like amazon.com and yahoo.com, where shut down for hours by electronic sabotage. Another fear factor that will sometime change perception is that modern military strategy is based in part on information warfare. Doctrines have been written about this topic by various countries like the USA and China. Complete attack/defence schemes have been developed. And at some point in the future these information warfare doctrines will be used in warfare between nations. The USA, and any other country that depends on information technology, are extremely vulnerable to attack in the information infrastructure. An enemy of the US, such as a group of skilled information terrorists or a foreign nation, would seem to have no problem shutting down the critical business operations of internet companies like Amazon, Yahoo, E-trade and others for an unlimited time. Information warfare can be used effectively as economic warfare. Companies like Amazon.com have negative profit margins, despite the fact that they are by far the largest merchant on the Internet. Future profit margins are expected by most investors, but how can we be certain there will ever be a positive profit margin ? Amazon.com, and other companies, gamble on a branding strategy that focuses on becoming the most important merchant on the Internet. By increasing market share, and sales volume, merchants hope to earn some money in the future. But in the future we may not need to know _who_ sells the book. Assuming we'll have intelligent agents that automatically find the cheapest books for us, at the best rated merchant, and with the lowest shipping cost. Our entirely rational shopping agents of the future will not be impressed by a strong brandname like amazon.com. Conclusion: no future profits are guaranteed. Performance = Perception = Performance Positive performance in the market is caused in part by perception of the very positive performance. And vice versa. Perception and performance influence eachother. Strong positive performance creates an optimistic perception of the future. Many investors buy shares because they have only been going up. They believe they will go up some more. The perception becomes the performance. If either performance or perception change negatively, they affect the eachother negatively. If the perception of the future of opportunities on Internet changes negatively, the price of Internet stocks performance drops, because people start selling their shares. That reinforces the negative perception, and people become more pessimistic. The current optimistic cycle is easily reversed into a negative perception cycle. What the wise do first, the fools do last. Many of the last movers in the optimistic market are heavily margined. Highly margined investors are often forced to sell shares when the market dips, pushing prices even lower, thereby forcing more margined investors out of the game. Interest rates and inflation The always changing subjective perception of events is accompanied by interest rates that are in an upward trend. Central banks are preempting future inflation by raising interest rates and tightening liquidity. Long term interest rates are an objective number in equity valuation. A high interest rate affects the intrinsic value of a company. Discounted cashflow valuations discount the value of future cashflow with the long term interest rate, and an additional risk premium. As interest rates go up, the intrinsic value of a company goes down. Intrinsic value works like a magnet on share prices. When the intrinsic value of a company drops the share price drops too, eventually. Conclusion ? The current bull cycle of the market is driven by technology companies. The shares of these companies often have insanely high valuations. These valuations reflect interest rate and the optimistic future expectations of the investors that buy these shares. Optimistic perceptions have changed in past eras because presidents changed, or because of war, or because of inflation, or because of higher interest rates. Or because of a combination of such events. Perceptions will change, they always do. We cannot be certain that the Internet can and will grow indefinitely, or that the Internet is an optimal business environment where profits will always be high. It is only now becoming clear to investors that the Internet as a business infrastructure is far from mature. Computers and businesses on the Internet are vulnerable to attack, or other hostile activities. It cannot be expected anymore that the Internet provides a safe and sound environment for electronic commerce. If investors collectively change their perception into a negative one, a selloff would occur, naturally driving down share prices. That in turn reinforces the negative perception, and drives down prices even further. With margin levels at an historic high, a dip in the market could cause a massive amount of margin calls, squeezing more investors into selling off. A longterm harmful side-effect is that call options would have substantially lower valuations. Many employees, especially in tech companies, are compensated with stock call options. The price of these options directly relate to the share price of a company. Higher share price means higher call options prices. Lower price means lower call option prices, until at some point the options become worthless. As options become less valuable, less people will be inclined to work in the tech sector. That would push wages up because these companies have to start paying employees hard currency, decreasing the earnings of the company. Lower earnings usually means lower stock price, reinforcing the downward cycle. When our collective perception about the Internet becomes a little bit more pessimistic, an era of supposedly unlimited growth and extremely high valuations could come to an abrupt end.
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