Personal finance: Too high with no safety net

Investors scrambling to buy Internet-related shares should be prepared for burnt fingers

ONE OF the things that has always intrigued me about the stock market is how two people can interpret the same observable situation in quite such diametrically opposed ways. In many areas of life, it is often difficult to reconcile the views of a chronic optimist and a confirmed pessimist, and all markets depend to varying degrees on the existence of participants with different perspectives. Difference is what makes the market mechanism work so well and defines its great appeal (although, as Galbraith observed, one of the great mysteries of economics is why, in a market system, there should be a buyer for every seller).

But saying markets thrive on a variety of opinion is one thing, explaining the huge dispersal in sentiment in the stock market at any one time is quite another. Not least because, in principle, there is no mystery about how companies or markets should be valued. The theory of how to value shares has been out since at least the 1930s, when an American called J B Williams first enunciated the principles of security valuation. He laid out for all to see how the value of a share (or a market) can be derived by discounting the expected future stream of dividends or earnings at an appropriate rate of interest (the discount factor).

It really is not a difficult concept to grasp, and even the maths is not too difficult. The real difficulties arise from two sources. One is that estimating any future stream of income is difficult, for obvious reasons. The future may be predictable, but it is not certain: you may be able to guess, for example, what share of the mobile phone market Orange is going to win in the next 10 years, and how much it stands to make per phone installed, but nobody can be sure today if you are right or wrong.

The second problem is that even if the numbers can be broadly agreed on, the Williams methodology fails to take account of swings in sentiment - the fact that nearly all of us behave differently when in a crowd than when we are acting on our own. For some reason, in financial markets, these differences in opinion, and the prevalence of herd behaviour, tend to be particularly extreme.

One current example of this phenomenon is the fad for Internet stocks. Rupert Murdoch says that Internet stocks are overvalued on any rational criterion, and he is clearly right. While it is possible that two or possibly three of the hot Internet stocks now setting daily new highs on the American stock market may be worth their current lofty valuations, it is simply impossible that all of them collectively can be worth the price being put on them by the stock market in today's feverish climate.

The search engine company Excite was valued at nearly $4bn (pounds 2.4bn) in a bid from a telecoms company called At-Home this week, and it is only one of the secondary players in that segment of the market, after Yahoo and Netscape. Yahoo now has a market capitalisation greater than General Motors, the largest carmaker in the world, and carries the distinction of being one of the few Internet companies which have actually made a profit - although it was only last year that this happened.

In fact, as those with long memories are prone to point out, anything with the word net or the suffix .com associated with it seems to be valued immediately these days on a stratospheric earnings multiple, just as any company with a whiff of electronics about it was in the late 1960s. It is not just in New York that the phenomenon can be seen. On the London stock market, a tiny company called On-Line, which makes a computer submarine game for the Internet, saw its shares jump by 60 per cent on Wednesday, not because of any change in its trading performance, but purely on the strength of its involvement in the Internet. The shares have now risen more than 10-fold in two weeks! Another company, Netcall, said it had no knowledge of why its shares had jumped 40p to 90p before lunch. There are many other examples. Dixons and even W H Smith are benefiting from the surge in Internet mania.

All the signs are that the market is seeing in Internet stocks the start of a classic speculative bubble. It is certainly reminiscent of the late 1960s, when electronics was the big buzzword and any company with the suffix -tronic was valued at 50 or even 100 times its current earnings (assuming that it had any earnings, which was far from certain, just as with today's Internet stocks).

The fact is that you have to plug in some highly optimistic projections in order to arrive at a value for many of these companies which is even remotely justifiable on the basis of a Williams-style valuation equation. In one or two cases it will be justified - there is no doubt that the Internet is a growth business and one day some companies will make a lot of money from it - but there won't be many, and it is far from certain that out there in cyberspace is the next Microsoft waiting to make investors a long term fortune. The Internet is a very competitive place to do business, and entry barriers are low. Just as certain is that many hot stocks of today will end in disaster, leaving behind the smell of charred fingers.

Many professional investors know that these valuations are absurd but momentum investing (if it moves, buy it) has not been as prevalent as it is today for a long time. The implicit rationale behind those who are buying Internet shares today, despite their stretched valuations, is the confident belief that they will be able to take their profits and get out of the shares before the bubble bursts. That is fine as far as it goes - except for the uncomfortable fact that by definition not everyone can hope to get out alive. Someone must be left holding the baby.

The motto for investors must be: enjoy this while you can (if you want to dabble in speculative shares), but don't forget that in the end, method, J B Williams-style, must always win out over madness.