Most of the Internet companies were founded only within the past few years, have very rapid rates of revenue growth, and are registering outsize operating losses. Traditional stock valuation methodologies have difficulty in arriving at valuation judgments given such set of circumstances.

Internet stock analysts employed by many of the brokerage firms have come up with a variety of valuation techniques possibly better suited to making valuation comparisons among these companies. Most of these techniques are more art than science and appear to be better suited to making comparative valuation judgments between the Internet stocks rather than absolute judgments given a company's fundamentals. Such techniques are dangerous in that they provide only relative valuations and fail to distinguish when the sector as a whole might be outlandishly valued.

One of the most widely used of these non-traditional valuation techniques is the ratio of companies' equity market capitalizations to their annualized revenues. This approach is flawed in that it fails to recognize that these companies have widely varying rates of revenue growth, levels of profitability and balance sheet strength.

A much better valuation technique is the ratio of companies' market capitalizations to their annualized gross profits. This approach takes into account the widely disparate levels of gross margin inherent in these businesses. In addition, most of these companies have achieved profitability at the gross income level, so few are excluded from comparative analyses by an absence of relevant data.

An even more useful tool is to carry this technique further down into the income statement by calculating the ratio of companies' market capitalizations to their annualized pretax income. This technique takes into consideration companies' varying levels of operating expenses, as well as non-operating income and charges. Many of these companies make a great number of acquisitions, and the charges relating to these acquisitions are considered. The principal drawback to this approach is that few of the Internet companies have yet to achieve pretax profitability. In such cases, investors must rely instead upon one or more of the other valuation measures outlined above.

These models are not meant to be the last word on Internet stock valuation, as there are a myriad of other considerations one should take into account in valuing these companies. Such considerations include the caliber of the management team, number of subscribers and/or customers, trends in revenues per subscriber and/or customer, cash resources, accounting practices, competitive risks, and possibility of technological obsolescence.

The Research Works, LLC

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