The Hidden Costs of Overvalued Net Stocks

The Hidden Costs of Overvalued Net Stocks

The Hidden Costs of Overvalued Net Stocks

Moneybox
Commentary about business and finance.
Dec. 1 1998 11:44 AM

The Hidden Costs of Overvalued Net Stocks

The Internet stock bubble was burst yesterday, for the zillionth time in the last 12 months. Some of the sketchier online stocks, which had soared the week before, were crushed, with Onsale falling 36 points, Books-a-Million (which had risen from 4 to 39 the previous week) tumbling 25 percent, and Egghead tumbling 20 percent. And even industry bellwethers like Amazon, Yahoo, and AOL took sharp hits. Rather remarkably, some market commentators attributed the general sell-off in the market to the reversal in fortunes in Net stocks, which may say something about how absurd the trading in this sector has become.

Advertisement

Why did the tumble occur? Bloomberg News said the stocks fell because investors became concerned that the run-up in share prices "wasn't justified since many of the companies won't report a profit for the next two years." Well, duh. Considering that these companies were just as unprofitable on Friday as they were on Monday, that doesn't really explain anything. More relevant, probably, was the fact that a number of brokerage houses raised their margin requirements on Net stocks, forcing speculators to reduce their leverage.

In any case, what's more important about the recent volatility in Net stocks is that the run-up in seemingly obvious dogs like Onsale and Books-a-Million has forced even the most avid fans of the Net to step back and say, "Slow down." Over the past few months, the argument that traditional methods of valuation simply do not apply to Internet companies has been made with increasing energy. The sheer amount of money that people have made in Internet stocks has led to the assumption that we're dealing with a new paradigm here. Old ideas of valuation--perhaps the idea of valuation itself--should be abandoned, we were told. Only in the last few days have the consequences of that idea really seemed obvious.

These attacks on the importance of valuation have seemed to presume that critics of Net stocks hold valuation up as some moral principle. In other words, we keep saying Net stocks are overvalued because our sensibilities are offended by all the hysteria. But valuation is important not because it provides a sense of order in a chaotic world. Valuation is important for a very simple reason: It lets you know when it's time to sell.

You can say that the Net shatters all rules, after all, but how does that assertion let me know whether I should buy Amazon.com at $225 a share, or whether I should sell it at $300 a share? Valuation is not an easy process, especially with companies whose futures remain so uncertain. But to say it's not an essential process is essentially to say that investing is just a crapshoot. (Which it may be, but in that case you should be in an index fund and not investing in Net stocks.)

The other thing to keep in mind is that there are broader consequences than just the making or losing of money by individual investors. Companies with overpriced stocks can do lots of things they shouldn't be able to do (buy companies they shouldn't be able to afford, for one). As a result, they're put in a position to destroy much more capital than they otherwise could. That's what bad companies do: They destroy capital and make society as a whole less productive and less efficient. And that's why speculative bubbles are bad, not because they're morally offensive but because they represent an inefficient allocation of capital. Investment isn't just better than speculation for the investor. It's better than speculation for the economy.