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Are tech prices rational?
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February 14, 2000: 8:56 a.m. ET
Net stock prices aren't random, study finds, but are the reasons reasonsable?
By Staff Writer Alex Frew McMillan
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NEW YORK (CNNfn) - There's method to the madness of Internet and tech stock prices, at least according to John Hand.
The dot.com boom has been the lifeblood of the market the last few years. But many experts think it has left the U.S. stock market like an aorta, rushing a bubble right to the heart where it can burst. The prices are irrational, made up, nonsensical.
Many academics feel tech stock prices don't make sense, and might whisper as much in private. But there's very little research proving that's true. That's because the stock boom is such a recent phenomenon.
Performance does drive tech stock prices, "contrary to conventional Wall Street wisdom that there is little or no method in the pricing of Net stocks."
-- accounting professor John Hand
Hand, an accounting professor at the University of North Carolina's Kenan-Flagler Business School, has actually analyzed how tech stocks act. He has noticed some patterns.
"It's not all madness. There is some method there," Hand said. "I don't know how much; that's very hard to calibrate. But it's not all crazy."
Performance has an effect, but not what you'd expect
Hand studied the stock prices of 167 Net companies, a broad range including companies from varied industries, such as AOL (AOL: Research, Estimates), CMGI (CMGI: Research, Estimates), eBay (EBAY: Research, Estimates), HotJobs.com (HOTJ: Research, Estimates), Inktomi (INKT: Research, Estimates), Red Hat (RHAT: Research, Estimates) and Yahoo! (YHOO: Research, Estimates). Hand then looked at their quarterly performance from the start of 1997 to the second quarter of last year.
Hand checked how they performed financially, both revenue and income-wise, and how their balance sheets stack up. He then compared how the companies did against how their market capitalizations -- the number of shares outstanding multiplied by the stock price -- changed.
Those performance factors make a difference for normal companies. "Does that same kind of pattern appear in stock prices for Net companies? The answer is yes," he said. But the answer isn't always what you'd expect.
Hand published his results in his paper Profits, losses and the non-linear pricing of Internet stocks, which he released in January. "Contrary to conventional Wall Street wisdom that there is little or no method in the pricing of Net stocks, I find that basic accounting data are highly relevant," he writes in the report.
The bigger the losses, the greater the stock prices
The first connection Hand found is that for Net companies, the bigger their losses, the larger their market caps and stock prices.
Though that seems counterintuitive at face value, it makes sense when you think about it, Hand said. Tech companies have huge expenditures on R&D and marketing, which often account for 70 percent or 80 percent of their sales. Those are intended to capture future customers and market share, and the expenses create much of the losses.
But unlike costs for items like machinery, which also contribute to future growth and are amortized over years, the marketing and R&D costs aren't spread out over time. They go straight to the income statement.
"The market sees through that," Hand said, and rewards companies that are investing for the future. Basically, it treats the marketing and R&D losses as assets. So while losses for a mature company are a sign of bad management, they can be a sign that a Net company is planning for the future.
R&D expenses have lasting results on the stock price
Hence losses deepen, and the stock price goes up. "The reason it happens is the accounting is very bad," Hand said. He thinks those costs should be amortized over 20 years, like machinery, and be considered intangible assets.
The effect is most pronounced the two quarters immediately after an initial public offering. Over time, Hand found, marketing expenses become less important. The relationship between increased marketing expenses and increased book value stops eight quarters after the IPO, Hand found.
But the relationship doesn't stop for R&D expenses. They always lead to bigger market caps for companies with losses. "It's there at the flotation and it's there for many quarters afterwards," he said.
For companies with profits, then, increased earnings mean higher market caps. For companies with losses, increased losses mean higher market caps. In fact, Hand says that theory even holds for non-tech companies. He also studied a group of non-tech IPOs that went public around the same time as the tech companies, and studied a random group of mature companies. For both groups, he found the same relationships.
Book equity matters, revenue doesn't
Hand also noticed a pattern that seems more sensible. When the book equity, the difference between the company's assets and liabilities, increases, the market cap goes up. Though that inherently makes sense, it also suggests tech prices aren't random.
Hand did, however, find another unusual pattern. In the absence of profits, many tech-stock watchers pay a lot of attention to revenue growth. They examine revenue as a tool to tell if the company is performing well and therefore how much its stock is worth.
Hand expected to come to the same conclusion. He didn't. Stock prices do rise when revenues increase, but factors such as the growing losses and increasing book value are more important gauges of how a stock will perform.
"If you put revenues, expenses for marketing, book value in a horse race, revenues lose," Hand said. It's the worst tool to predict the price. "It doesn't have any importance in separating companies out."
There is a caveat, though. For the small set of companies that actually have profits, revenues do matter, he said. That applies mainly to Internet infrastructure companies such as Cisco Systems (CSCO: Research, Estimates).
Firstly they're more mature businesses, so they're not looking as far out for their performance payback. And second, they don't tend to do nearly as much marketing as other kinds of Net companies, proportionately, given what they do.
Do the prices make sense? Hand isn't sure
One point Hand hastens to convey is that, while he has found how a tech company's performance and balance sheet affect its stock price and market cap, he does not know if the tech stock prices make sense.
"My guess is that prices are still too high for these Net companies and tech companies," he said. "But my study doesn't speak to that." In scientific-speak, he does not know if the prices are "fully rational." He just knows there is some rationality behind them.
Conventional stock price valuations take the future cash flows and discount them back to today. But stock watchers have had to throw conventional ways of pricing stocks out the window, according to Ivo Welch, a professor of finance at UCLA's Anderson Graduate School of Management.
Though he had not read Hand's paper, he thinks financial statements are poor guides of the future performance of tech stock prices. "You're gambling on what's happening five years from now. Financial statements almost by their very nature are backward looking," he said.
He isn't sure how you can break down tech-stock prices, which he thinks don't make sense. "Most finance professors in the back room, where their name isn't quoted, would tell you they think the market has gone crazy," Welch said. But most won't say it publicly because they have yet to prove it.
For many companies, we may never know
And, in fact, they may never prove it. It will take at least 10 years before it's clear whether high-tech stocks are worth the massive prices people are paying for them now, "if at all," according to Richard Thaler, an economics professor at the University of Chicago's Graduate School of Business. "Suppose you thought Netscape was worthless? Well, AOL bought it. So now we'll never know," he said.
Then consider AOL's proposed buyout of Time Warner, parent of CNN and CNNfn, he said. "Let's suppose that CNN is the crown jewel worth $200 billion, and AOL is worthless. The combined company will turn out to be a success, even though AOL was worthless." So in many cases, Thaler said, we'll never be able to tell if tech stocks are worth what people are now paying for them.
Thaler agrees that tech stocks are overvalued but he doesn't know that scientifically. "At the moment no one can prove that these Internet stocks are overpriced. But many of us have deep suspicions," he said.
Last summer, Thaler did poll financial advisers to see what they considered the intrinsic value of a portfolio of five tech stocks, Amazon.com (AMZN: Research, Estimates), AOL (AOL: Research, Estimates), eBay (EBAY: Research, Estimates), Priceline.com (PCLN: Research, Estimates) and Yahoo! (YHOO: Research, Estimates). The median, or middle, answer was that the portfolio was intrinsically worth 50 cents on the dollar.
But they thought that wouldn't stop people from buying them. "The median person still thought that their prices were going to go up," Thaler said. "That's the definition of a bubble." 
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