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Chapter 4. Inflating the Bubble: the Fin... > Why the Huge Valuations for Internet...

Why the Huge Valuations for Internet Companies?

People who have an interest in driving up the prices of stocks understand that financial value cannot be made to exceed economic value for very long. Generally, accurate information about the company will emerge, its economic value can then be determined, and if the share price is too high, it will fall. Hence, to get and hold a financial price, it must be made to appear that the economic price is at that level. To inflate financial value over real value requires that real value be measured as more than it is, and there are often imaginative schemes to achieve this. In fact, this is a frequent practice in the capital markets.

For example, during the late 1980s, manufacturers spun off money-losing divisions as independent companies, and bank analysts repeatedly came up with positive reports for investors on the new firms. This was also done to support recapitalizations of airlines and other types of firms. The method of obtaining positive recommendations was to assume that labor productivity at the division or the airline would rise dramatically in the future. The rationale for this assumption was usually new management or an employee stock incentive plan. Enhanced productivity would result in lower costs to the company, which would then generate a profit. The profit could be forecast to grow in the future, permitting a positive discounted present value to give economic and hopefully financial value to the firm. Shares in the firms or bonds were then issued and sold to the public. In the actual event, however, most of the assumed productivity improvements never occurred, the companies made no profits, and therefore had no economic value so that their financial value collapsed. Investors took a bath.


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