What it means
In the late 1990s, the spread of the web convinced investors that online businesses would transform entire industries. Money poured into start-ups, many of which had no profits and some of which had barely any revenue.
Stories of fast fortunes encouraged still more people to join in. Traditional measures such as earnings were often dismissed as old-fashioned.
Investors and analysts instead used new yardsticks, such as the number of website visitors, and justified high prices with the idea that growth would eventually produce profits. Companies found it easy to raise money.
Initial public offerings, in which a private firm first sells shares to the public, often saw the share price jump on the first day, and some firms spent heavily on advertising and expansion before proving that customers would pay. The turn came when investors began to ask when profits would arrive.
Technology shares fell sharply from their peak in early 2000, funding dried up, and many companies ran out of cash and closed or were sold at a fraction of their former value. The aftermath was lasting.
Regulators and auditors paid more attention to accounting and research standards, investors returned to cash flow and profit analysis, and the surviving companies, some of which became very large, showed that the technology itself was real even though many valuations were not. The nuance is that a bubble does not mean the underlying idea was wrong.
The internet did change commerce and communication, but the prices paid for shares in many companies assumed success on a scale that few of them could achieve.
In practice
Real-world examples.
Example
An investor in the late 1990s buys shares in a company that sells pet supplies online. The firm has no profit and heavy spending on advertising, but its share price triples in a year, and friends tell the investor that he is lucky to have got in early. The investor assumes the trend will continue and does not examine the company's cash burn.
Example
A venture capital fund backs a start-up that plans to deliver groceries within an hour. The valuation rises at each funding round despite continuing losses. When funding dries up, the start-up cannot raise more cash and shuts down, and the investors lose almost all of the money they put in.
Example
A finance director at an established company sees rivals using high share prices to buy other firms. She warns her board that the prices are unsustainable and keeps the company's balance sheet conservative. When the bubble bursts, her company is able to buy assets cheaply, including a strong software team and some useful customer contracts.
Formula
Calculation
Price-to-sales ratio = Market value of the company / Annual revenue
Suppose a fictional online retailer has a market value of $2,000,000,000 and annual revenue of $20,000,000. Its price-to-sales ratio is 2,000,000,000 / 20,000,000 = 100. A mature retailer might trade at a ratio of 1 or 2. At a ratio of 100, the company would need to grow revenue enormously and earn healthy profit margins just to justify the price paid today.Case study
Seen in the real world.
This is an illustrative story about a fictional start-up, Webwagon Online, that sold furniture on the internet. It listed its shares on an exchange at a high price after only two years in business, with a market value of about $1,500,000,000 despite annual sales of just $15,000,000.
The company used the money raised to buy advertising and expand warehouses before it had proven that customers would return. Costs exceeded revenue each quarter, and the cash reserves began to shrink.
When the market turned, new funding became impossible, and Webwagon's share price fell by over 90%. The illustrative company was wound down, and a larger retailer bought its customer list for a small sum. The story shows how valuations built on hope rather than earnings can disappear quickly. Employees who had been paid partly in shares watched the value of their holdings fall with it.
Watch out
Common mistakes.
- Believing the internet itself was a fad. The technology was real, but share prices ran far ahead of the profits it could produce.
- Using visitor numbers as a substitute for profit. Traffic only has value if it can be turned into sales and cash, and many sites found that visitors would not pay for what they offered.
- Assuming a bubble is obvious at the time. Prices can keep rising for years before they fall, so timing is very hard.
Questions
People also ask.
What caused the internet bubble?
A mix of real technological change, easy funding, investor enthusiasm and a belief that old valuation rules no longer applied.
How did it end?
Investors lost confidence as profits failed to appear, funding dried up and prices fell sharply, with many companies failing.
What can business leaders learn from it?
Valuations should be anchored in cash flow and realistic growth, and a business needs a path to profit before it runs out of funding.
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