"--Companies in new fields of activity-- provide no sound basis for the determination of intrinsic value-- Analysts identify such companies as highly speculative and not attempting to value them-- The buyer of such securities is not making an investment, but a bet on a new technology, a new market and a new service-- Winning bets can produce very rich rewards, but they are in an odds-setting rather than a valuation process " -- excerpts from Security Analysis by Benjamin Graham.

Every few years there is a lot of hype and hoopla over a new industry: radio in the 50s, cable TV in the early 90s, aquaculture and financial services in the mid-90s and, in-between there were some small timers like granites and mushrooms. Now, there are the businesses of software and Internet that have caught investor fancy. New technologies and novel market opportunities were catalysts in each of these phases. The trends are same except for the unprecedented pace and scale of opportunities now.

A 5-year old company with just Rs 25 lakh profits was bought for over Rs 500 crore. This refers to the takeover of IndiaWorld by Satyam Infotech (Sify). Nobody would have dreamt of anything like this a few years back. On the other hand, the traditional investor is puzzled to arrive at a valuation model to justify this price.

Traditional analysts, lovers of tangible assets, blame the market for high valuation of the Internet stocks disregarding thin or even negative bottomlines. But the reality is quite different. It is actually the shortage of Internet stocks that has created all the hype. That is, the valuations are based more on the demand-supply position than on the operating fundamentals.

The demand-supply analysis defines the value of a company's equity as to what the market is willing to pay at a given moment in time. In other words, it is the meeting point of the marginal buyer and the marginal seller.

But at the same time, the gap between what the marginal buyer is willing to pay and what the buyer actually knows, is greater today. And the buyer wants to call it opportunity while the traditional analyst calls it foolishness.

Foolish because, any .com company worth its name is approaching the public, confident of getting their issue oversubscribed many times. Such thinking is vindicated by the fact that most of these companies see a jump of more than 100 per cent on the very first day of listing. Take the recent case of SKumars.com, whose par issue was oversubscribed 12 times and got listed at Rs 70. Interestingly, the company is yet to finalise its business plans.

But, do all companies in the business of Internet deserve similar valuations?

The bottomlines of Cisco Systems and Intel are dominated by incomes from Internet-related business. But they cannot be compared with AmericaOnline.com or Amazon.com. The reason being that their revenue model is dependent on a large physical infrastructure than on the Internet.

In fact, some features enumerated below are necessary for a company to be equated as an Internet concern.

The revenue model of a company should be dependent on the continued growth of the Internet.

If a company can succeed without the continued rapid growth of the Internet, it is probably not an Internet company and does not deserve the valuations given to an Internet company. For instance, the business model of Intel is not solely dependent on the Internet. But of course, growth of the Internet will certainly help the company to improve its bottomline. In that sense, it cannot be termed as an Internet company.

Take the case of Cisco Systems, a major supplier of Internet-related hardware. It handles 80 per cent of its orders on-line. Amazon.com, an on-line bookstore, providing a business of $32 million a day through the Internet at the same time the largest e-commerce company, has a business of just $6 million. But yet, Amazon gets the valuation of an Internet company, while Cisco gets valuation of a hardware company albeit a better valuation than many other hardware manufacturers. Because it can survive even without the Internet while better valuation than other hardware companies because growth of the company is accelerated due to the Internet.

The company's revenue growth should be at least equal to the growth of Internet

The growth rate of an individual company and the total Internet market should move in tandem. But the growth rate may differ within this sector. For instance, e-commerce companies are believed to grow faster than the Internet service providers (ISPs) but slower than the Internet software companies. Even within e-commerce companies, the b2b growth rate is more than the b2c growth rate. But, their movement will be in tune with the growth rate of the Internet.

Maximum exposure to Internet businesses

Majority revenue for the company should come from Internet-related businesses. Incorporating Internet technology into an existing product line will not enable a company to benefit from the growth of the medium to the same extent as those businesses which are fully dependent on that growth.

Possession of minimum tangible assets

A true Internet company will depend on intellectual property rather than on ownership of tangible assets. This requirement will eliminate the shipping or physical distribution companies that have been benefiting significantly from their deployment of Internet-based capabilities, or the retailers that retain networks of physical stores.

Market perception about the company

Last but not the least, investors should perceive the company as Internet related to get high valuation. Investors put Amazon.com in the same league as development of e-commerce. This perception translates into better valuations.

All these features are no doubt are necessary, but they are not always sufficient to accommodate a company into the Internet fold. The features are more qualitative in nature than quantitative. Hence, the emphasis on perception of the company than on anything else.

Internet companies share a number of distinguishing characteristics differentiating them from the others.

An Internet company's cost structure is tilted more towards fixed expenses as a percentage of total expenses. The project cost for any site involves basic design of the site, cost of procuring content, uploading and server charges.

The main recurring costs include: manpower costs, marketing related charges like customer acquisition costs, site maintenance charges and regular uploading charges. Most of these are constant.

The variable charges as a percentage of total expenses or revenue will be considerably low in comparison to fixed costs. Moreover, the recurring charges tend to decline sharply as a percentage of total revenues once the site achieves the inflection point or critical mass. Lower costs over their operating lifetimes will mean consistently stronger operating margins. And the margins will be very high if the Internet company is a market leader.

Thus, for a growing company, a high proportion of fixed costs and consequently higher contribution is more desirable than a cost structure with higher variable costs.

Obtaining market leadership has another significance strategically. It acts as an entry barrier to other companies in that arena. Take the case of Yahoo.com. It will be difficult to replicate a site with similar facilities and to get so many "eyeballs".

The next major step in the process of valuation is to segregate the Internet companies according to their operation. It is not advisable to compare the earnings of Amazon.com (books retailer) with Yahoo.com (portal site). The business model of the portal AmericaOnline.com is different from the model of PriceLine.com (airlines ticket seller). Both cannot be placed on an equal footing for the purpose of valuation.

The entire Internet segment can be further divided into various segments for a detailed analysis. Valuations are dependent on the type of business segment they traverse. The operating realities, margins, business growth and entry barriers differ according to the segment. Broadly speaking, the Internet universe can be divided into six segments:

On-line content companies
These includes companies focussed on the production of on-line content, such as C/NET, Lycos and Infoseek, which are among the strongest of content companies in the US. It is the on-line content which is the most favoured by investors after e-commerce based sites.

In India, there are Indiainfoline (a finance-based site), justdial (an information site), expressindia and indiatimes (news sites).

Sometimes valuation experts include even on-line advertising services companies, such as 24/7 Media and DoubleClick in this category.

Enabling technology companies
Includes companies that provide Internet /Intranet platform of application functionality and enabling technology for on-line communication. Examples are Inktomi, Net Perceptions and Real Networks.

E-commerce companies
Includes on-line retailing (b2c), transaction processing (including b2b), financial services, travel, advertising, marketing, etc. Such companies like Priceline, Ebay, and Amazon have of late managed to grab the investor’s interest. In India we have SKumars.com in this segment.

Within this segment b2b is expected to grow faster than b2c. Hence, investors are betting heavily in this sector anticipating big gains.

Internet service providers
Internet service providers (ISPs) include the connectivity/access companies like Earthlink, Mindspring, PSINet, Prodigy etc., as well as high-speed access companies such as SoftNet and @Home. In India we have VSNL, SatyamOnline, Rolta, etc. Satyam On-line like America On-line (AOL) likes to be called a portal rather than an ISP.

Interactive services companies
Includes companies that provide web page design and web-based support. Examples include Viant and USWeb. Back home, we have expressindia and Rediff.

Multiple operating categories
Under this segment, there are some companies which can fit into more than one segment. As discussed earlier, AOL is an on-line content, proprietary technology company, connectivity provider, as well as a web page design company. Other technological leaders, such as Micro Soft, @Home/Excite, and AT&T, also compete in multiple product categories. In India, Satyam On-line, expressindia and Rediff fall under this category.

As stated earlier, different categories get different discounting. But, it is not possible to equate companies under different categories with the same yardstick. Take the case of web designing and web-based support businesses which have become commoditised. This leads to poor discounting for this segment as compared to the e-commerce companies and portals.

Thus, even within each category companies are valued differently. "The selection of Internet stocks is more qualitative than quantitative," says Andersen Consulting partner in-charge, Pankaj Vaish. Most widely used qualitative factors that determine valuation of the Internet stocks are: early mover advantage, marketing ability, focussed approach, economy of scale, flexibility and the most important one being the ability of the management to survive in a highly competitive environment.

Early movers always get better valuation than the late entrants. It helps them to secure future leadership. As per Walden-Nikko India Management Co., investment manager, TC Meenakshi, "the leader in any segment gets 60 per cent of the traffic, the second best gets 30 per cent while, the rest together share the meagre balance 10 per cent."

No wonder then, everybody wants to be the leader to get the best valuation. And once the leader makes an IPO he goes about acquiring similar sites. He benefits in two ways -taking possession of new eyeballs and snubbing competition.

The best example is Sify’s acquisition of IndiaWorld.com. By this acquisition, Sify could get Indiaworld’s subscribers and could kill competition from this site since both are planning to be a portal site exclusively for Indians and Indian origin outsiders.

Now Sify can approach investors for more funds from a stronger position and acquire more sites to strengthen its position in the Internet market.

Achieving the inflection point gives economies of scale to the company in the valuation process. For instance, AOL in the first quarter of 1999, had little over 13 million subscribers and its market capitalisation was just less than $40 billion. This has grown to $100 billion in the third quarter of this year with an additional 7 million subscribers. And the investors are happy reaping profits through capital gains.

Metcalf's law of increasing returns in a network explains this phenomenon very clearly. It states a particular variant of the economics of increasing returns, that more the units of a network in operation, higher is the value of each unit and the whole. In simple terms, the growth in business which is slow and linear in the initial phase of the life cycle becomes exponential once it attains the critical mass or the inflection point. AOL investors feel that the subscriber base developed over the years could be converted into a revenue centre any time after it attains the inflection point and hence, the rise in market capitalisation in a very short period. Also, the Internet companies should have focussed operations to get better valuation. For instance, Charles Schwab wants to be in e-broking and not in any other type of e-commerce business.

Companies should realise that the business of Internet is more of a marketing game than a technology play. Businesses with a better marketing network will always get a better valuation. Most of the sites focus on building brands. For example, rediff.com has marketed its brand name Rediff more than any other site in India. This has helped the company achieve the highest number of e-mail subscribers in any India-based site.

Above all, quality of the management plays an important role in the success of any company. As per The Indus Entreprenuers (TiE) incubator, Kanwal Rekhi, "As an investor I give more than 50 per cent weightage to quality of promoter."

From the above the general qualitative guidelines to assess the valuation of an Internet stock has become quite apparent. But, at end of it all it is the jugglery of numbers that will decide the value of a stock.

Since most of the companies do not have an "E" in the P/E multiple, analysts substitute it with an "R". Here "R" stands for revenue. Their argument is that in future once the company attains the inflection point then revenues will become earnings very easily. As an Internet analyst puts it, "When a company has achieved critical mass, earnings are merely frostings on the cake."

The problem arises when companies do not have even revenues. Especially in developing markets like India revenues are almost nil. In such a scenario, valuation experts consider popularity of the site to evaluate it. Quantification of this popularity has always created problems for the investors. Earlier, the number of "hits" were considered to determine the popularity. This figure is compared with the hits of another site for which the market capitalisation is known and, then the company is valued appropriately.

If say a site, whose value is to be determined, has 1 million hits as compared to a similar site which has 2 million hits, then the former is valued at approximately half of the latter's market capitalisation. Some investment managers consider "page views" as a better bet instead of "hits". Currently, managers even use "registered users" for better valuation of companies.

However, such comparative valuation methods help an investment manager only to arrive at approximate figures. The precise figure is a function of the quantitative factors stated earlier. As such, this excessive reliance on qualitative factors leads to excessive fluctuation in the valuation process and at the same time, valuations get subjected to excessive criticism in the market.

Consider Sify’s acquisition of Indiaworld.com where Sify will be paying $115 million for the site. Considering the fact that IndiaWorld.com has 450,000 page views then Sify is paying $255.56 thousand per 1,000 page views. Compare this with international figures like $313.76 thousand per 1,000 page views for Yahoo and $ 52.67 thousand per 1,000 page views for Infoseek. The market may consider it to be on the higher side. All such comparisons maybe in place. But, the acquisition is strategically important for Sify. It has erased out competition. Only time will tell who is smart and who is not.