A Rude Awakening: Internet Shakeout in 2000

Abstract

This study explores the major value-drivers of business-to-consumer ("B2C") Internet companies' share prices both before and after the "bursting of the Internet bubble" in the spring of 2000. Although many market observers had predicted that the bubble would eventually burst (e.g., Perkins and Perkins 1999), the ultimate and previously unanswered challenge lay identifying which stocks would fall and which ones would survive the shakeout. We develop an empirical valuation model and provide evidence that the Internet stocks that this model suggests were relatively over-valued prior to the Internet stock market correction experienced relatively larger drops in their price-to-sales ratios when the bubble burst. This result is robust to the inclusion of competing explanatory variables suggested by the economics literature related to industry rationalizations.

We also investigate a number of additional issues related to the rapidly changing Internet world. First, we provide descriptive evidence of the correlation between monthly stock returns and contemporaneous and lagged Nielsen/Netratings web traffic metrics (both levels and changes). We then undertake a factor analysis on the set of Nielsen/Netratings raw web metrics with a view to synthesizing the data into a parsimonious set of orthogonal web performance measures. Our factor analysis results in the extraction of three factors that capture the most relevant dimensions of website performance: (1) reach, (2) "stickiness", and (3) customer loyalty. Our findings suggest that all three web performance measures are value-relevant to the share prices of Internet companies in each of 1999 and 2000. Our findings of significance for the year 2000 contradict the recent claims of some analysts that web traffic measures are no longer important. We also explore the valuation role of our proxy for B2C companies' ability to sustain their current rate of "cash burn" and find that this proxy is a significant value-driver in each of 1999 and 2000. Finally, our results suggest that investors adopted a more skeptical attitude towards expenditures on intangible investments as the Internet sector began to mature. Consistent with the results of prior studies in other knowledge asset based industries, we find that investors appear to implicitly capitalize product development (R&D) and advertising expenses (customer acquisition costs) during the "bubble" period when the market was more optimistic about the prospects of B2C companies. However, neither marketing expenses nor product development costs are implicitly capitalized into value, on average, subsequent to the shakeout in the spring of 2000. Overall, our study provides a preliminary view of the shakeout and maturation of one of the most important New Economy industries to emerge to date - the Internet.