Fool's Gold: Are Internet stocks really worth it?

Since late summer 1998, the share prices of Internet companies have gone into a frenzy. It seems companies like Amazon.com can do no wrong. Despite continuing losses, its market value has climbed to dizzying heights, taking the share price of other Internet companies with it.

At the beginning of this year, analysts were predicting the bubble would burst and Internet stock prices would plummet. Many cited the case of the Amsterdam tulips in the 17th Century - they were worth a fortune until people lost interest. Then prices crashed.

So will Internet companies suffer the same fate? The whole issue is complicated by which definition you use. There is a big difference between a company's intrinsic value and its market value.

The intrinsic value of a company is the value of potential cashflow after cost and risk have been deducted. So companies like Amazon.com, which are operating at a loss, should theoretically have a low intrinsic value. However, there is also market value to consider - market value being the price someone is willing to pay for a product. And the past few months have shown that people are still willing to pay a very high price based on the speculation that in the long-term the intrinsic value will rocket.

Dr Gordon Edge, chairman of the Generics Group and veteran UK entrepreneur, told Silicon.com: "Many Internet stocks are overpriced, but not overvalued. The prices which people are paying for stocks in these companies are based upon speculation and not upon an underlying value. There is a high intrinsic value but it is not matched by the price."

But capital investors need short term return on their money. As one Silicon.com viewer pointed out: "The problem with market value is that it's based largely on emotion. With little in revenues, profits or cash to support those values the speculative bubble could burst." So it seems that unless Internet companies start reporting profits soon, the tulip syndrome could be just round the corner.

But Damon Oldcom, managing director of PhoneMe UK, argues that the potential of the market is great enough to sustain today's prices. "Given the immensity and scale of the Internet market, nobody can really tell what the end point is going to be."

'Real world' companies have only just started drawing up ecommerce strategies. The foundations of the Internet in terms of security, regulation and taxation are still being wrangled over. Once they are in place, who's to say the online-only pioneer companies won't dominate the new world order?

Another factor accredited for the high market value of many Internet companies is the emergence of a new type of investor - the online retail investor. Companies such as E*Trade and Charles Schwab have taken the mystery out of trading and significantly reduced the cost, enabling private investors to influence the market value.

There is also a third factor to consider: basic economic theory. A study by the Stanford Business School in the US in April found that Internet stock prices are better explained in terms of supply and demand than long-term value. At the moment there are relatively few Internet companies and "shortages of stock are driving much of the rise in Internet stock prices", the report concluded. "The market is very much at the mercy of supply, demand and the whims of the retail investor."

At the end of January this year Alan Greenspan, chairman of the Federal Reserve, addressed the US Senate Budget Committee about the frenzy surrounding Internet stock prices. He admitted there was an element of hype and 'craziness' - but added that without a sound basis, the hype just wouldn't exist.