The Guardian June 7, 2000


The laws of gravity and the dot.com balloon

by Prabir Purkayastha

The Internet has seen some strange phenomena. The strangest is the rise of 
the stock-price of a number of Internet companies to stratospheric heights 
in the global stock market.

The Internet is creating instant billionaires. Kids barely out of high 
school, are now worth millions. And in India, home-grown Azim Premji 
became the second richest man in the world after Bill Gates. What are the 
billions that Bill and Premji of Wipro are supposed to own?

Normally, when we talk of wealth, we mean assets. For the businessman, 
this has generally meant productive assets  real products, factories, 
offices and of course people who are employed in their companies.

However, the kind of wealth that Bill Gates and Azim Premji possess, has 
little to do with such tangible assets.

Their "assets" are the market value of their share holdings. 
Hypothetically, if Microsoft has issued 100 million shares and Microsoft 
stock is trading on the stock exchange at $10 a share, Microsoft market 
capitalisation is one billion dollars. If the selling price of its shares 
goes up to $100 a share, Microsoft market capitalisation increases to $10 
billion. If it goes up to $1000 a share then Microsoft's market cap goes 
to $100 billion. And if Bill Gates owns 40 per cent of this stock, he is 
now said to be worth $40 billion.

Today, Microsoft's market capitalisation is $473 billion and Bill Gates, 
by virtue of his holdings is worth $102 billion.

The Wipro stock is very similar except that the rise of Wipro's stock 
price has been even steeper. Wipro was trading last year at Rs.604 per 
share. It rose to a high of Rs.10,350  a dizzying growth of 15 times its 
share value in less than a year. 

And Premji, by virtue of his 75 per cent holding in Wipro, is now "worth" 
an astounding $37.5 billion.

While the growth of software companies such as Microsoft and Infosys have 
been spectacular, their turnover is nowhere near their market cap. 
Microsoft, with a market cap of $473 billion, has a turnover of only $20 
billion. Similarly, Infosys, with a turnover of $220 million, has a market 
cap of a couple of billion. 

Their large market gap comes from the high probability of software ventures 
and the belief that this profitability will translate into future dividend 
payments for the shareholders. However, it has been argued that the future 
profitability of this order is unlikely and these stocks are highly over-
valued.

Microsoft, in trouble over its monopoly practices in the US courts, is 
seeing a sharp fall in its stock price.

It lost a whopping $79 billion in one day (Monday, April 3), dragging all 
information technology shares down as the talks between it and the Justice 
Department broke down.

Software companies have at least some "assets"  their software and the 
skill of their employees.

With their monopoly profits protected now by stringent Intellectual 
Property Rights under the new WTO regime, they can claim continuous future 
earnings. The Dot.com companies are, however, a completely different 
kettle of fish.

Internet "sites"

The Internet allows individuals and small companies to construct "sites" 
in cyber space. This means registering a name for the entity  company, 
individual or product  and then creating pages of information that can 
be put on a computer connected to the Internet.

This becomes a "site" that can be accessed through the Internet by 
anybody. There are "Search Engines" on the Internet (also called the web 
from its name of World Wide Web), which can use certain key words and site 
information to locate this site for the interested users.

Instead of sending information back and forth, Tim Berners-Lee, the 
creator of the Web, hit upon the idea that the information could be put up 
in cyber space on computers connected to the Net. People could then 
download whatever they found interesting. Of course, the actual process was 
nowhere near as simple as it is made out here. However, this idea is the 
essence of the Internet or the World Wide Web.

The commercial use of the Net followed soon after it was realised that the 
World Wide Web was growing exponentially. The dizzying growth of the Net 
made it possible to use the net to market products and services.

Two of the biggest commercial success stories are Amazon.com and 
Ebay, both of which have grown to tens of billion of dollars in 
market caps within the last two years. Amazon.com is essentially an 
internet bookshop, which allows you to search through their list of books 
and purchase on-line whatever you want.

Once the transaction is complete  you pay through your credit card and 
the book is shipped to you within a few days. Amazon.com could store far 
more titles on its virtual shop than any bookshop in the real world. Search 
tools on its site tell you what other books are similar in content, other 
books by the same author and lets you search by subject or using key words.

As books reached the buyers quickly enough, Amazon.com did booming 
business. When it went public, the market cap of Amazon.com rapidly rose 
to $35 billion.

Ebay has a different profile. It started as an auction house. It would 
make possible a whole range of goods  from Hitler and Marilyn Monroe 
memorabilia to more mundane goods  to be exchanged without storing any 
goods, unlike a physical auction house. Ebay's market capital is also in 
the range of $17 million. While Amazon.com and Ebay are the most successful 
companies, there are a whole range of companies who have netted a windfall 
on the Net.

Thus, Yahoo.com used the popularity of its search engine to launch an 
electronic magazine and provided advertisers with "space" on their site. 
Yahoo.com has also a market cap in billions.

Make-believe wealth

The Dot.com, called so because all commercial sites on the web have to end 
with a .com in their address, has become the driver of the new economy, 
funnelling in venture capital on a very large scale. 

Currently, it is much like the California gold rush, where everybody who 
had a spade thought they were going to become instant millionaires.

The dot.com companies are rushing in  providing content that hook people 
on to their sites, allowing them to sell "space" to advertisers, or "cyber 
markets" selling a variety of goods on-line.

The key issue is whether these companies, which have a market cap of 
billions, are going to earn the profits in the future to justify their 
share prices?

At some point in the future, the shareholders that are buying these stocks 
today, will expect dividend payments that justify the price they are 
currently paying.

None of these Internet companies have made any profits. Most have 
already totted up huge losses. The argument is that if they have market 
share today, this will translate into profits in the future. However, all 
calculations show that there is no possibility of ever recording profits 
to justify their current huge market caps.

It is important to note that unlike the software companies, which own some 
software products, the Dot.com companies only "own" real estate in cyber 
space.

Thus, while the software companies own intangible assets which may be 
overpriced and make super profits in terms of monopoly rent, the dot.com 
companies do not have even that.

They do not add any value to the products that they sell  they 
facilitate the transfer of goods from producers to buyers and therefore act 
essentially as traders. They are just giant super markets in cyber space 
marketing a whole range of goods with virtually no overheads.

To understand the success of the dot.com companies, one must understand 
the nature of mark-ups in retail trade. It is well known that goods, which 
are priced at 50 to 60 dollars in the US, cost 5-6 dollars to manufacture 
(for example, Nike shoes). Wholesale and retail traders have huge margins.

By marketing in cyber space the seller does away with costly retail 
traders and allows greater margins to be retained by the company marketing 
the product.

The advertising budget of companies in the US alone was $33 billion in 
1996, the major share going to television. In contrast, Internet 
advertising had a share of less than 250 million dollars that year.

Considering that the number of users visiting a site is comparable to that 
of television viewers, there is considerable scope of tapping into these 
huge advertising budgets.

Cyber trade

However, can cyber trade provide future profits of this magnitude? Various 
experts have already computed the cash flows that these dot.com companies 
will need in order to survive.

If this is financed through either loans or through new capital infusion, 
there is no way that these companies can earn the profits that justify the 
current stock prices.

If the future earnings are nowhere near the requirement to sustain current 
stock price boom in these companies, why did these prices rise to these 
levels in the first place?

Here the role of venture capital and mutual funds is important. These are 
essentially speculative capital that comes in to fund new companies. If 
accompanied by the type of hype that we have seen associated with the Net, 
this can then lead to a huge number of small investors all trying to make 
a killing.

Once the market has reached new heights, the speculative capital leaves by 
selling its stocks at 10 to 100 times their initial value. In the end, it 
is the small investor who are left holding the bag when the stock market 
bubble bursts. This is exactly what is happening today. 

All the get-rich stories in the media pull in investors eager to make 
money from the Net.

When the market starts to fall, as it is doing now, the speculative 
capital pulls out leaving the small investor holding pieces of junk paper.

Ultimately, it is real productive assets and real products that 
limit growth in the virtual world as well.

New economics

The new economic "pundits" have been preaching that the "new" economy has 
new economics and that growth in cyber space is not limited by the amounts 
of goods produced in the "old" economy. However, the truth is that the 
virtual world of cyber space does not add any value: it only facilitates a 
transaction that must be accompanied by the transfer of goods from 
producers to users. Thus, the limits to cyber growth come from the 
limits in the real world. If the economy is not growing in real terms, the 
virtual world will reflect this, sooner rather than later. The infotech 
stocks, the darling of the global stock markets, are now falling rapidly.

The law of gravity  what goes up must come down  is finally catching up 
even in the cyber world.

While the economic pundits will call it a market correction, one thing is 
sure  it is the small investor who will be burnt. The smart money, which 
created the internet hype in the first place, has already pulled out of 
the infotech stocks. 

* * *
From People's Democracy newspaper of the Communist Party of India (Marxist)

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