How much is any business worth?

by Jean Pousson

The plunge in the Nasdaq and high tech and telecom stocks is already well documented. Even heavyweight Cisco (at one time the world's biggest company) has seen its share price plummet to $17 from a high of $70. Across the world millions have been wiped out from stock market capitalisation as investors run for cover fearing a full-blown recession.

What went wrong?

After all broad economic fundamentals, until recently, had not changed that much. The U.K. and Europe tag along with reasonable certainty while South East Asia (with the exception of Japan) has recovered pretty well from their difficulties of a few years ago. The main concern of course remains the turnaround of the American economy, which if it deteriorates any further might infect other economies.

Caught in the euphoria of New Economy and dot.com frenzy investors lost sight of basic investment fundamentals as they searched for new untested valuation models to justify the premium prices. Market share eyeball hits, intellectual property became the new valuation tools. Due diligence decreased in importance as irrational exuberance took over.

Fuelled by high stock prices acquisitions became easy and high premium continued to be paid regardless of traditional rational principles. Cisco Systems alone bought more than 70 companies since 1993.

Indeed the fact that some companies were not making a profit, and gave no indication of when they were likely to break even (never mind to become profitable) did not seem to matter any more. Torrents of money pumped in by equity investors and venture capitalists kept driving valuations up. And again everyone seemed to miss the point (i.e. you cannot create value by not making money and by continually bleeding cash).

The entrepreneurial spirit took over. MBA students (particularly in the USA) became less interested in portfolio management, globalisation and organisational behaviour, but became restless to start their own company and look for an initial public offering (IPO). Venture capitalists could not keep pace with all the unsolicited proposals hitting their desks.

Warren Buffet the legendary U.S. investor captured the mood very well in this year's annual address to shareholders of Berkshire Hathaway, his investment company: "Overstaying the festivities".will eventually bring on pumpkins and mice".but they nevertheless hate to miss a single minute of what is one helluva party".

As far back as 1999 he refused to invest a single penny into high tech, dot.com wannabees. His reasoning was simple "We donìt invest in any business that we do not understand. And we do not understand any of these businesses".

The Financial Times ahead of Lastminute.com's flotation issued an investors beware statement. Despite having some very hard working and ingenious people with a good idea this was not enough. Using Porter's famous Five Forces Model indicated high levels of risk on threat of new entrants, bargaining power of suppliers and customers, substitution and competition. The basic model was a high risk one. This did not seem to deter investors as the issue was well oversubscribed.

Sublime naivety was once more illustrated by the retailer Boo.com, one of the early casualties, who never made a profit, had lots of fun until the cash completely ran out. Anybody involved there surely should have been spotted that a call centre in Carnaby Street London at premium rentals, was not clever.

In summary, greed, dot.com fever and the promise of quick and easy riches elbowed out well-proven investment principles.

The last words should perhaps belong to Mr. Buffett who preferring known cash flows from predictable businesses, borrowed a dictum from his grandson: "A girl in a convertible is worth five in the phone book".

"We have embraced the 21st Century by entering such cutting edge technologies as brick, carpet, insulation and paint. Try to control your enthusiasm!"

Jean Pousson is the managing partner of Jean Pousson and Associates, a management consultancy dedicated to training and consultancy in the fields of finance, strategy, and banking. He can be contacted at jpassociates@compuserve.com.