Dot.Com Bubble

R&D, Advertising and the Market Value of Internet Firms By Damir Tokic Outline 1. Introduction 2. Article Summary 3. backchat 4. Conclusion Introduction During the Dot-com spill the beans, meshwork firms were senior highly observed compared to old economy firms. Internet firms stock prices were unrealistically high. Most of those firms were operating beneath loses and no tangible pluss to warrant those prices. Analysts reassert those prices and recommended buy ratings but later a crash followed. Article SummaryThis article explains the relationship between intangible assets (advertising and R&D) expenditures and internet firms market place prize during 1996-2000. The author familiarises two opinions in regard to internet stocks valuation. The first theory is based on DCF methodological analysis and asserts that due to poor earnings and low earnings visibility, internet stocks were irrationally overvalued in 1999. Secondly, based on the option set theory, it can be justifi ed that the prices were warranted due to evolution of those firms and volatility as primary value drivers.The article details five literature reviews on valuation (1) Investment opportunity appeal to valuation and more especially growth firms, (2) The life cycle theory, (3) The effects of intangible assets (R&D and advertisement) to market value, and (4) Valuation of internet firms using real options. ground on the life cycle theory, as the firm grows and matures, managers have a tendency to pursue growth rather than stockholders welfare. Those with comparative advantage over the emulation tend to invest more in the growth stage to expand their operations.Under this theory, the value of the firm is divided into (1) option value of growth opportunity, (2) present value of cash flows from asset-in-place. This model is based on the idea that the firms life cycle determines its expected re numbers. Expected return attributable to each dowery of value largely depends on the growth stage of the firm. Like in old economy firms, mature firms have all of their value in the present value of cash flows from the asset-in-place component while growth firms, their value is concent lay outd in the growth component.The author argues that intangible assets (i. e. advertising and R&D) greatly make sense value and since their benefits are mainly realized in the prox, they should be metropolisized rather than outlayd. They positively impact the value of the market as they give some signals of future(a) profitability. Therefore, increase in these assets has consistent effects on profits. The author points out that the market reacts more favorably to high-tech firms when R&D expenditures are announced than to low-tech firms.This is based on the hypothesis High-tech firms have promising growth opportunities whereby investitures in R&D positively affect the market value. On the other hand, Investments in low-tech firms negatively affect the value due to no or negative gr owth opportunities. The author as well as points out that the economical market does not capture advertising and R&D in the firms stock price because these investments are expensed rather than capitalized and therefore funk the profits making the financial statements to be misstated.It may be possible that R&D intensive firms may be underpriced because investors focus on write up discipline failing to see the future benefits of the R&D investments. On the other hand, especially for those firms with negative earnings, cocksureness investors allow overestimate the future benefits from R&D investments thus causing overvaluation. Maintaining R&D and advertising intensity provides the positive signal that management are overconfident in future prospects and the market tend to overlook those signals making it possible to realize abnormal returns.The author also explains the real option valuation model which he blames on the high valuation of internet stocks during the bubble perio d derived from the Black and Scholes option pricing theory. This theory suggests that it is possible to undertake signly unattractive projects which the traditional DCF model will reject. It may pay off to undertake R&D investments in a project with negative value if the early investments provide sufficient information about the future benefits of a project. The value of an internet firm is largely dependent on (1) firms ability to adapt to enormous ncertainty, (2) competitory landscape paced with technology innovations,(3) changing market conditions and (4) costs of searching for a profitable business model. Valuations can be extremely high if the initial growth rates are high and if there is enough volatility in this growth over time, The authors argument is that high valuation of internet stocks is attributed to the investment opportunities approach. This approach suggests that the presence of growth opportunities to invest new capital results to projects with a promising rate of rate return higher than normal.The investment opportunities approach states that value of a growth firm is equal to the PV of cash flows from assets in place and the present value of growth opportunity (Vj = V1 + V2). It suggests that investors should pay a subvention for earnings of a growth firms relative to mature firms due to the presence of profitability multiplier in growth firms. The author proposes a modified investment opportunities approach which incorporates advertising and R&D into the equation when valuing growth firms V = E/k m + RD+A/k (m-1).This is because total investments of growth firms is a combination of retained earnings and investments in intangible assets (advertising and R&D), thereby directly adding value to the firm. Discussion Valuation is the key to the survival of a firm. defective valuation can lead to overvaluation or undervaluation. In the case the dot-com bubble it is apparent that those firms were overvalued partly because of the valuation mod els used and the market reaction. I think there was high excitement of the new economy which led to high speculations.Investors were very overconfident that those firms will make profits in the future due to growth opportunities readily available. A combination of increasing stock prices, market overconfidence, individual speculation in stocks, and widely available venture capital created an environment in which many investors were willing to overlook traditional metrics such as P/E ratio in favor of overconfidence in technological advancements. The author explains how intangible assets like R&D and advertising of growth firms have positive effect on market value due to future profitability.It therefore means that growth firms will invest more in R&D and advertising in order to maximize the growth opportunities. The life cycle theory suggests that at a maturity, increasing R&D and advertising have diminishing utility and managers have a tendency to pursue growth during the growth st age rather than stockholders welfare. During the bubble, it is clear that firms were chasing growth with high intensity in R&D and the market reacted positively to it. Financial analysts based their valuations solely on the growth and expectations of future earnings.This is why behavioral finance plays a role in trying to explain efficacious market. In an efficient market, stock prices fully incorporate the value of intangible investments and therefore there should be no association between R&D intensity and future stock returns. But as the author suggests, firms with a high proportion of intangible assets are highly volatile because their future success is tied to the success of R&D projects. Another problem is that R&D and advertising are expensed under US GAAP significantly decrease the profits and misstating the accounting book value.If these expenses were capitalized, probably those growth firms would have seen some profits and may be that is why investors did not care about their losses. Louis, chan & Theodore (2001) also advocate that companies with high R&D and advertising earn large excess returns and R&D intensity is positively associated with volatility. I tend to call up that in some cases, investors overestimate the benefits from R&D investments, especially for firms with negative profitability, which causes the overvaluation.The markets underreact to managers overconfidence to keep heavy investments in R&D at the expense of current profitability. In my opinion, I dont think investors should overreact positively to heavy investments in R&D. In an efficient market, this intangible asset will fully be incorporated in stock prices. The author mentions that financial analysts justified the high valuations of internet stocks using the models derived from Blank and Scholes option pricing theory. During the bubble real option value was integrated in valuation of those firms.I agree with the author that real option itself has value if a firm undertake s initially negative NPV just to position itself in a growing industry. This real options is what made analysts overconfidence that the negative profitability or negative NPV will turn positive in the advanced stage of development. But there is a high uncertainty when using this model which translates to high value. As the author suggests, if the initial growth rates are sufficiently high and there is high volatility in this growth over time, valuations can be unrealistically high.Analysts believed that there were many options at the disposal of those firms and the negative profitability did not shake their high valuations Investment opportunities approach to valuation of internet stocks is seen as the cause of the bubble too. Under this approach analysts believed that the internet firms have many opportunities to invest new capital in projects promising rate of return higher than normal. Therefore, in summation to present value of cash flows from assets in place, those firms also had another value from growth opportunities. The present value from growth opportunities is what gave those firms high values.The investment opportunities approach was even modified by the authors to include R&D and advertising which even made those values extremely high. Conclusion I believe that in a well-functioning system, with the incentives of intermediaries fully aligned in accordance with their fiduciary responsibility, public markets will correctly value companies such that investors earn a normal required rate of return. Financial analysts should incorporate the value of earnings in their valuation targets that were previously based solely on the growth and expectation of future earnings.This will booster reduce the value of firms that lack profitability and prevent another bubble. References Chan, L. K. C, Lakonishok, J. , & Sougiannis, T. , (2001). The Stock Market Valuation of Research and Development Expenditures. The Journal of Finance. 56(6), 2431-2456. doi 10. 1111 /0022-1082. 00411. Palepu, K. G. , Healy, P. M. , (2008). Business compendium & Valuation. Mason, Oh South-Western Cengage Learning. Tokic, D. , (2004). R&D Advertising and the Market Value of Internet Firms Part 1. Journal of Internet Commerce. 3(2), 21-79