In the last article, we mentioned that traditionally, a stock is considered overvalued if it trades at a price greater than 15 times earnings, for more than a year. By our calculation above, we see that Yahoo is trading at 1601 times earnings, but before we make a decision, lets take a look at one year ago:

Price: 275.375
Divided by earnings: 000.210

One year ago, we see that Yahoo was trading at 1311 times earnings. So, traditional measures alone would suggest that Yahoo Inc is overvalued. However, many Brokers have YHOO listed as a `strong buy'. Why? Let's think about it from the perspective of a traditional Analyst:

Traditional companies that sell their products and services in stores, malls or even through catalogues I will classify as `Brick and mortar' businesses; they operate in the real world (although many are building an online presence).

Cyber-Businesses are those, like Yahoo Inc. that operate online only. Some of these `Native' Internet companies make financial analysts worry for several major reasons:

• Low Earnings: They have very low earnings in relation to the value of the company. Yahoo had net income in the neighbourhood of $60M for the '98 Fiscal year, and a Market Cap of $100Billion.
• Burn Rate: Native internet businesses tend to spend more money than they make: In the first quarter of 1999, iVillage had revenues totaling $6M, and expenses totaling $24M
• Competition: There are zero barriers to entry for competitors to enter the market space of a Native `Net business. Thus, a traditional analyst sees potential for an unlimited number of future competitors.

But this doesn't answer our question: Why are companies like Yahoo valued so `inexplicably' high? That's because the `traditional metrics' don't really apply.

"First Mover Advantage": There is a significant advantage to being the first business in a specific market online. This advantage is so great, in fact, that it has spawned several terms: To be `Delled' or `Amazoned' is to wade into a market space that is completely dominated by the first mover, that it is impossible to compete. For example, Amazon is the first mover in the online book retail market. Sure, others will try to compete, and have some success at it (like B&N) but no other online business will come close to generating the same amount of money from sales as does Amazon, because Amazon has a unique advantage.

When iVillage went public in March (the same quarter they burned 4 times what they earned), high demand for shares drove the value of the company up to $1.6Billion. Obviously traditional math wasn't on their side, but market share was. For one, iVillage was a first mover in their market space, but even more importantly, they were making key acquisitions. The $24M they spent mostly covered the cost of buying up small competitors, and other sites that would help them grow. In the eyes of the investor, steps taken to gain control of a market space looks like a competitive advantage.

An Internet business that does some thing new, something completely different is considered valuable. When Yahoo went public, they're competitors were still operating as pure search engine services. Yahoo was doing something different: they were (and still are) and `directory service' that accumulated web content. They served their users better, and earned money faster than their competitors-making them appear competitive in the long run, and attractive to investors.

The long and short of this confusing situation is this:

A Native Internet Business will be successful, and most likely garner a high valuation if

• Someone needs what they provide
• They have a competitive advantage that is sustainable
• The business model will lead to profitability (eventually, they will earn more than they spend)
• Strong, qualified management with a clear vision for the future of the company

In Part Three of the series, we will look at what wide-spread `Internet fever' can do to the Market as a whole. Look for this article to be posted Monday

As always, if there is something I've said that doesn't jive, post your two cents on out Bulletin Board System.