The Little Engine That Could…

At the turn of the millennium, many of the original firms that left their mark on the so-called New Economy (Yahoo!, eBay) had gone from rags to riches. Many had begun to feel that the market had turned by early 2000. The Nasdaq had peaked at over 5,000 and went on a free fall from there.

Nonetheless, no one thought that the era of excess was about to end. Red Herring magazine chronicled the Internet and also became a part of it. Bonnie Azab Powell, a former writer for the publication, recalled spending $3,200 on a dinner when Eric Greenberg, then CEO of the Internet consulting company Scient Inc. was interviewed. "We had sea scallops that had been flown in fresh from Maine that morning, and this dish of tiny, hollowed out squash in lobster broth with truffles," Powell recalled. "It seemed obscene, but obscene within a context of every day obscenity and overspending."

Companies were raising some serious coin based on pure speculation. Not just a lack of profit, but no business model, little execution experience and practically no contingency plan. It became en vogue to make fun of these mistakes: eCompany Now / Business 2.0. came up with a list of 100 top blunders. It is important to note however, that even launching a magazine called eCompany Now was a blunder. Internet firms had to legitimize themselves in the existing corporate landscape and give the Fortune 500 reasons to use their products or services. Creating a separate magazine for "eCompanies" was counter-productive, akin to biting the hand that feeds.

Before the wheels began to come off the dot com train, the financing equation of old did not compute. Nobody could estimate what the real value of an Internet firm was.

An analyst would make a wild boast about a specific stock price in a show of self-promotion and not about investment savvy. One example was Morgan Stanley Dean Witter's Mary Meeker, another example CIBC Oppenheimer and later Merrill Lynch analyst Henry Blodget. Blodget was a former journalist, so he understood how newspapers craved a big headline. He boasted that Amazon would hit $400 a share. Nobody questioned how Blodget came to this conclusion because everyone loved that some young bull would dare put a target on a dot com stock.

Many analysts sought to justify the prices, arguing that the Web would make the Industrial Revolution look meager. But the rationalization and positive outlook was for their own good. The higher the stock prices went, the more money they earned. Their compensation was a function of the underlying value of the deal; regardless of whether the deal was a merger, an acquisition or an Initial Public Offering (IPO).

The madness continued and crossed over to more high tech firms, like Qualcomm. Qualcomm was a star and was the stock of 2000. Analyst Walter Piecyk of Paine Webber set a whopping price target of $1,000 a share. Everyone thought he was crazy, but individual traders were quick to jump on the bandwagon. As you can imagine, the enthusiastic prediction made it onto the Top 100 Blunders of the Web Economy - or something to that effect.

In time, fewer analysts dared express how they projected security prices. Imagine finding yourself in such a financial maelstrom with the task of computing what the fair price of a company is. Would you say anything or keep quiet out of fear?

If you had to report to an experienced manager, would you question the stock price or adopt the institutional imperative and ride the wave?

The question is not how to make sense of it, but rather, how to stand out from the pack of "experienced" webangelists who stood to make a killing by fanning the flames.

You want to know how to stand out? When everyone is talking, whip out a tool you thought was obsolete.

What tool? If a company is trying to raise $50 million, then the implication is that investors are willing to pour money into the firm in exchange for a percentage of ownership.

As you can imagine, owners and management would seek to minimize the piece of the pie that would be traded while potential investors would seek to maximize it.

While people threw out arguments, few had legitimate numbers – what many would consider the backbone of business – to justify them. If anyone could manage to come up with something, anything, to quantify an Internet company's value, then he would get the attention of the business world.

Keep in mind that the dot com economy was odd because although the value of Internet firms was 0, it was perceived value that was at stake.

The tool in question is an extension of the Capital Asset Pricing Model. Some of you may have become familiar with the CAPM. To those who have not, the model is simple. It argues that any company's value is a function of a riskless security adjusted for the risk that the investment carries. In other words, if United States treasury bills return 4%, and the stock market as a whole returned 10%, you would only invest in General Electric (for example) if the incremental return of General Electric over the treasury bills was high enough to compensate for the additional risk of holding General Electric (vis-à-vis a riskless investment like treasury bills).

Using this tool, it is conceivable to argue that this model could be extended to apply to a private firm that was seeking financing. Taking the value of publicly traded competitors, you could benchmark the value of the private firm by comparing users, revenues and other publicly available data.

From there, all you have to do is run a simple multiple analyses and project those multiples over the private firm's respective numbers. And that my friends in finance at its simplest.