An academic study, published several years after the peak of the dot-com bubble in March 2000, accurately described just how whacky internet valuations grew until the bubble burst. The study’s first sentence basically stated that valuations lost touch with reality. During the internet frenzy, there was mention of “new economy” stock references to new valuation zones that should be considered reasonable. At the time, valuation metrics included measures such as customers per click, measuring “eyeballs” or time spent visiting a website.

Most of the baseless new economy metrics have thankfully vanished, and the internet industry has matured greatly since the height of the bubble. Many firms have survived, and quite a few have developed into market leaders with bona fide business models. Below is a more grounded overview of how to properly value an internet stock, including those closer to the start-up stage.

A Durable Internet Valuation Approach
Many firms that survived the dot-com bubble have since developed sustainable business models. Companies in this category include Cisco, Amazon, Priceline and even The quick answer to valuing these types of firms is to combine traditional valuation metrics with those more specific to the industry.

The three primary valuation methodologies include a discounted cash flow, or DCF analysis consisting of estimating a firm’s future cash flows and discounting them back to the present for a current value estimate. The comparables approach consists of using comparable companies and calculating comparable multiples, such as enterprise value to sales (EV/S), price to earnings (P/E) and price to free cash flow (P/FCF). This approach can also look at comparable buyout transactions to help determine what a company is worth. Finally, the cost approach consists of estimating a fair value for all of a company’s assets and subtracting a fair value estimate of its liabilities to determine a net worth under a liquidation scenario.

The ideal valuation method for internet stocks consists of combining a mix of the above approaches with those more specific to running online businesses. The metrics of studying and tracking internet traffic should not be relied on as exclusively as during the dot-com bubble, but are still valuable to track. This includes measuring reach, which refers to the number of unique individuals on a site and can be compared to the total number of internet users on that site. Stickiness and customer loyalty are closely related and refer to the likelihood of a current user to stay on the site and generate advertising dollars, or make actual purchases on a respective website.

For new internet firms, valuation metrics that don’t rely as heavily on current profits or cash flow could be warranted. The concept of seller’s discretionary earnings (SDE) consists of taking a more standard profit figure, such as net income or free cash flow, and adding back items that company owners and insiders might take as compensation. This could include items such as salary, corporate perks such as a company jet or car, and other items such as expensive health insurance - any expense that is considered personal. This approach is quite valuable for private companies that might be run by a limited group of insiders, such as a family, but can also apply to a smaller internet startup that might be transitioning to being publicly traded.

What Have We Learned?
An important lesson from the dot-com bubble is to be extremely wary of paying up for highly optimistic outlooks on a company’s growth and profit potential. A number of social media firms like Pandora, LinkedIn and Facebook have gone public at sky-high valuations. Facebook went public with a total company valuation close to $100 billion in mid-2012 despite the fact that Facebook reported only $5 billion in sales during 2012.

The valuation of an internet company can be as much art as science. Most of the valuation techniques mentioned above require historical information to come to a reasonable estimate of firm value. This can be problematic for a rapidly growing internet firm, because its past track record will greatly underestimate how much it will grow years down the road. Google, which had an IPO in 2004 following the bursting of the dot-com bubble, is still a great example. It went public at $85 per share for a total market capitalization of $23.1 billion. This seemed outrageous at the time, because Google reported only $1.5 billion in revenues prior to its IPO. But revenues and profits skyrocketed afterward. With the benefit of perfect hindsight, Google shares were a steal when they went public and should have been bought aggressively. Facebook shares could be equally compelling – provided growth comes in as needed.

Final Considerations
The above valuation recommendations focus on crunching numbers, or the quantitative aspects. But as the Google example illustrated, the qualitative aspects can be equally important. This may include studying a firm’s business model, determining if it has a growing or sustainable competitive advantage, and where its business might lie in the industry life cycle that includes multiple phases including startup, growth, maturity, and decline.

Bottom Line
Given the relative youth of internet firms, it is advisable to uncover newer metrics to apply to newer business models. But don’t forget the tried and true strategies. Namely, look at profits and cash flows, and do your best to not overpay for a new or hot idea. Finally, do your best to project trends as well into the future as reasonably possible. The bottom line for investing in younger internet firms may be to use a small percentage of a portfolio on these more speculative ideas, and invest the rest in those that resemble real businesses with a track record of profits, and steadier growth, such as the internet firms that sailed through the dot-com bubble with then-unproven business models.

Related Articles
  1. Investing Basics

    DCF Valuation: The Stock Market Sanity Check

    Calculate whether the market is paying too much for a particular stock.
  2. Personal Finance

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
  3. Markets

    How To Choose The Best Stock Valuation Method

    Don't be overwhelmed by the many valuation techniques out there - knowing a few characteristics about a company will help you pick the best one.
  4. Bonds & Fixed Income

    Equity Valuation In Good Times And Bad

    Learn how to filter out the noise of the market place in order to find a solid way of determing a company's value.
  5. Entrepreneurship

    From The Printing Press To The Internet

    Find out how this invention contributed to the development and evolution of the U.S. economy.
  6. Markets

    Investment Valuation Ratios

    Learn about per share data, price/book value ratio, price/cash flow ratio, price/earnings ratio, price/sales ratio, dividend yield and the enterprise multiple.
  7. Economics

    The Truth about Productivity

    Why has labor market productivity slowed sharply around the world in recent years? One of the greatest economic mysteries out there.
  8. Investing News

    Is It Time To Sell Technology Stocks? (LNKD, AAPL)

    Technology stocks have taken a drubbing in recent days. Is it time to sell them?
  9. Stock Analysis

    Drone Wars: DJI Vs. Intel (INTC)

    Find out which drone technology leaders, Intel Corporation or DJI Innovations, is most likely to emerge victorious in the coming drone wars.
  10. Stock Analysis

    4 Best Drone Stocks to Invest in for 2016 (AMBA, ESLT)

    Find out which companies' stocks are set to lead the growth of the potential $100 billion industry of drone makers in 2016 and beyond.
  1. What are the pros and cons of downround financing?

    Down round financing is often reflected in very negative terminology. In some cases, it can be very bad for existing shareholders. ... Read Full Answer >>
  2. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  3. Is Apple Pay safe and free?

    Apple Pay is a mobile payment system created by Apple to reduce the number of times shoppers and buyers have to pay for goods ... Read Full Answer >>
  4. Do you discount working capital in net present value (NPV)?

    Net present value (NPV) calculations should include the discounted value of changes in working capital. This treatment of ... Read Full Answer >>
  5. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
  6. How do I use discounted cash flow (DCF) to value stock?

    Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center