Price to What?

Richard Parsons, chairman and former CEO of Time Warner, visited the Rockefeller Center at Dartmouth yesterday to meet with students and give a public lecture on "Entrepreneurship in the Digital Age."  There is no one who has been closer to the interface between the old and new economies over the last decade, and his remarks did not disappoint.  The theme of the talk is well summarized by this passage from the story in this morning's issue of The Dartmouth:

Parsons also spoke on how the Internet has lowered the entry barrier for new ideas, leaving the marketplace “wide open for entrepreneurs.” While investment capital for new ideas has spread since the 1990s, he said, technology has simultaneously made that capital less necessary.

“The way AOL got started was, they rolled over the existing telephone lines,” Parsons said. “Nowadays, you don’t have to even have servers and routers and other forms of infrastructure. If you have software development skills, you can essentially use someone else’s infrastructure to create the business.”

Many of the most inventive entrepreneurs are more interested in creating an attractive and revolutionary product than creating a useful business model, Parsons said. The difficulty, he added, is attracting young people to companies and employing their idealism for a practical purpose.

“Who among the young nowadays doesn’t fundamentally want to work for themselves? They don’t want to be shackled by some chucklehead like me,” he said. “They want to go into a place of employment where they can be free … and get rewarded for it.”

During his talk, I found myself thinking of the way I explain the Internet bubble in the stock market to my students.  In a nutshell, when there is an innovation in an industry, the benefits can accrue to three main groups: current firms in the industry, firms that will enter the industry, and consumers of the products that utilize the innovation.  I think we get bubbles when too much of those benefits are attached to the value of the current firms in the industry.

That misvaluation requires some willfulness on the part of investors.  The classic valuation method suggests that the key ratio should be (stock) price to dividends.  But lots of firms don't pay dividends.  Enter price-to-earnings.  But some firms, including many of the new ones with interesting innovations, don't have positive earnings.  Enter price-to-sales.  And guess what?  With some of the examples Parsons cited, even sales are too close to zero to give a sensible multiple.

It seems strange but true that seven years after the bursting of the Internet bubble, we still don't have a valuation method for technology companies that could be used prospectively with any reliability.