Click Here For Wacky Valuations

The latest buying frenzy overinflates most Net stocks' potential

Just when you thought Wall Street's worship of the Web couldn't get any wackier, Internet stocks take off again--on another gravity-defying streak. Look at Yahoo! Inc. In early June, its shares sold for $104, 12 times its initial-offering price in 1996. From there, it streaked to a record of $199 on July 6 before settling down to $186 on the 8th--leaving it with a market cap somewhere north of $9 billion. This for a company that analysts say might earn 45 cents a share. That translates into a price-earnings multiple of 413.

Still, Yahoo! is practically a blue chip compared with other Net issues: At least it has earnings. Many of the shares enjoying similar runups don't even have much in the way of revenue.

So, why the latest outbreak of Web mania? One factor, say analysts, is that small investors are piling into Internet-related stocks almost indiscriminately in an attempt to catch the next big wave. In the process, they are sending small-cap issues into uncharted regions at mind-boggling velocities. Take Inktomi, a provider of search-engine technology for companies that include Microsoft Corp. Its shares traded publicly for the first time on June 10 at 18. Now, it's trading at 73 1/2. All sorts of Internet-related stocks have been on a similar course, driving the Hambrecht & Quist Internet Index from 141 on June 1 to a record 208 on July 6.

The new prices have even enthusiastic analysts scratching their heads, trying to come up with valuation methods to explain them. "If there is a valuation model, it's so obscure that it defies me," says Andrea Williams, an analyst at Volpe Brown Whelan & Co.

But there's something more than investor frenzy at play. While current valuations will almost certainly prove unsustainable--some of the surge is driven by speculation about takeover deals that may never come off--beneath all the froth is the recognition that, at least for some well-positioned companies, the Web is about to start delivering profits.

By 2002, there will be 62 million households online, and consumer E-commerce will hit $22.6 billion a year, according to Forrester Research Inc. That means the Web will finally emerge as a mass medium for information, entertainment, and E-commerce. And companies that now operate popular "portals" or that have proven their ability to sell online are set to start reaping the rewards.

SOLID SUBSET. Yahoo!'s recent climb, for instance, was inspired by analyst predictions that the company would beat projected 9 cents per share earnings (before charges) in the June quarter. On July 8, Yahoo! reported pro forma results of 15 cents per share. "A subset of the very many Internet companies are real companies building real businesses," says David V. Crowder, a managing director at NationsBanc Montgomery Securities. "Yahoo! has grown faster and become profitable much more quickly than people thought it would."

Indeed, Yahoo! has evolved into the Net's top portal, drawing more than 40 million users a month. It keeps them coming with free E-mail and other goodies--and advertisers who want to reach them follow. Yahoo! also gets E-commerce revenue. The result: Analysts predict earnings per share to jump to 75 cents on revenue of $229 million in 1999.

Who else will be able to deliver profits as well as promises on the Net? In addition to Yahoo!, and America Online have carved out strong positions. Online titan AOL is now the single most traveled route to the Web. And Amazon has emerged as the most adept cybermerchant. The online bookselling pioneer has branched into music CDs, and analysts anticipate moves into toys and videos. Revenue is projected to reach $1.3 billion in 2001, the year it sees profits, with earnings of 86 cents a share, predicts Jamie Kiggen, an analyst at Donaldson, Lufkin & Jenrette Inc.

But BancAmerica Robertson Stephens analyst Keith Benjamin says that even the top companies are overvalued by his generous yardstick--selling for more than 50 times his estimate of their earnings per share in 2001. Amazon's stock has almost tripled since June, to 114 1/8 on July 6, before falling back to 107 on July 8. This gives Amazon a market cap of $5.3 billion. That compares with Barnes & Noble Inc.'s market cap of $2.9 billion on revenues of $2.8 billion last year.

Can those values hold? Not likely. But, now, any company that can identify itself with the Web has a winning stock--from Audio Book Club to Zapata Corp. On July 6, fish processor and food-package-material maker Zapata said it would split into two companies, with one focused on investing in Net sites. Zapata shares doubled, to 21 1/2, in one day--even though, Montgomery's Crowder points out, it really isn't in the portal business--it just plans to be.

BIG BETS. "Portal" is the magic word, however. With media companies on the prowl for portals to the Web, investors hope to cash in on those deals. NBC kicked off the rush on June 9 when it bought 19% of Snap!, a portal site put together by Internet news publisher CNET Inc. The next media company to bite was Walt Disney Co. On June 18, for $70 million and its controlling stake in Web site publisher Starwave Corp., Disney acquired 43% of Infoseek.

Now, investors are placing bets on who will be next. Netscape Communications Corp. shares leaped 53% on July 1-2 after an exec told a TV interviewer that the company was talking to media companies about publishing content on its Netcenter, giving it more portal potential. And shares of Lycos Inc., the No.4 search engine, have risen as the company negotiates with major media companies, including CBS and Time Warner Inc. But nothing is imminent, say sources close to the company.

But many analysts warn that the deal angle may be a sucker bet. Prices have already risen so high for portal plays that outright buys have become prohibitive. Once that sinks in, valuations of such companies could begin to drift down--which has some investors shifting their focus to E-commerce, where profits may come sooner. A new joint study from International Data Corp. and RelevantKnowledge Inc. says that by 2002, half of the 102 million people in the U.S. who use the Net at home will be shoppers.

So investors are turning to cheaper E-commerce stocks. Those include music retailers CDnow Inc. and N2K, both valued at less than two times 1999 revenues, vs. almost nine times for Amazon, says Volpe's Williams. E*Trade has also been left behind because of concerns over rising competition in online brokerage. But Anurag Pandit, portfolio manager for the $600 million John Hancock Emerging Growth Fund, says E*Trade is a category leader: "They're redefining the process of investing."

For now, however, you can forget fundamentals. What is lofting Internet stocks--and could quickly bring them back to earth--are forces within the equity markets. Most basic are the laws of supply and demand. Investors continue to chase a scarce supply of shares. Excite, for instance, has 7 million publicly-traded shares. That makes for a lot more volatility than, say, Disney, which has 671 million. The small float exaggerates short squeezes, too--when short sellers scramble to cover their positions and push prices up. In June, short interest in Amazon hit 8 million shares--out of about 16 million.

Another huge force: institutional investors. Ominously, some have been selling Internet shares recently. "The group has gone to valuations that aren't sustainable," says Michael P. DiCarlo, a partner at DFS Advisors, which holds AOL, CDnow, and E*Trade, after taking profits in Lycos and Infoseek.

How far could Internet stocks fall? Some analysts are bracing for a 20% to 30% correction after second-quarter earnings announcements. That could induce the flip side of this stock-buying mania--Web depression.