DOT.
COM BUBBLE
BRIEF HISTORY/BACKGROUND
In the mid-1990s, the internet emerged as a groundbreaking technology, sparking
excitement, opportunities, and possibilities across business, media, and everyday life. The
introduction of Netscape Navigator simplified online navigation, leading to a surge in dot-com
companies with visions of internet dominance. The dot-com bubble is an example of an
asset bubble. An asset bubble happens when the price of an asset rises dramatically over a
short period of time and trades considerably higher than its fundamentals indicate.
During the late 1990s, economic policies further fueled this sense of optimism.
Additionally low interest rates from 1998 to 1999 made borrowing more affordable. Investors
were eager to invest in dot com startups to take advantage of the internet’s potential,
envisioning a future where it would become as essential as electricity in life. This led to a
surge in businesses with names ending in ".com " indicating their involvement in the growing
market. One example is the Nasdaq Composite Index, which included many tech startups,
surged to new highs, and media coverage highlighted stories of companies making huge
profits overnight.
However, the economic policies designed to stimulate growth also had
consequences. The Tax Relief Act of 1997 and low interest rates had boosted consumer and
business spending, but this surge in demand outpaced supply, leading to rising inflation. To
address this inflation, the Federal Reserve raised interest rates around the turn of the
millennium. This move was intended to cool the overheated economy by curbing inflationary
pressures created by earlier low rates and high spending. Consequently, investment slowed,
and higher interest rates revealed the vulnerabilities of many dot-com companies. While
these companies had once been highly hyped and their stock prices soared, many had
unviable business models and lacked a path to substantial profitability.
High-profile failures, such as Pets.com, starkly exposed the gap between speculative
investment and financial reality. The bubble, which had inflated for years, eventually burst.
Stock prices crashed, and the Nasdaq index fell sharply, plunged 76.81% from its peak of
5,048.62 on March 10, 2000, to 1,139.90 on October 4, 2002. The technology sector was
badly bruised, with many companies filing for bankruptcy or facing severe financial distress.
Despite the widespread failures, there were notable success stories. One such
example was Priceline, founded by Jay Walker in 1998. Priceline revolutionized the travel
industry by allowing customers to name their own prices for unsold airline seats. The
company's aggressive marketing strategy and innovative business model quickly gained
traction, and it became one of the most recognized internet brands by 1999. Priceline's
successful IPO valued the company at $9.8 billion. Today, as part of Booking Holdings,
Priceline continues to thrive, working with thousands of hotels worldwide and demonstrating
consistent revenue growth. As of October 2023, Priceline's shares are trading around
$2,800.
The dot.com bubble serves as a cautionary tale about the risks of speculative
investment and the importance of adhering to fundamental business principles.
Understanding these lessons is crucial for avoiding similar pitfalls in the future.
FORGOTTEN PRINCIPLES
1. EFFICIENT CAPITAL MARKETS/EFFICIENT MARKET HYPOTHESIS
Let’s now move on to some principles that were not applied to the dot.com bubble
and resulted in instability. One principle that is essential to structured financial management
is Efficient Capital Markets. Efficient Capital Markets or Efficient Market Hypothesis (EMH)
suggests that prices for financial instruments reflect all available market information and that
markets are efficient. This further explains that excess profits have no room since stocks are
traded fairly and accurately at market value, minimizing investors’ edge towards each other.
What happened in the DotCom bubble highlights the lack of efficient capital markets.
This DotCom bubble simultaneously occurred with the longest economic expansion in the
United States. From October 1998 onwards, the IPOs of dot-com firms emerged, causing
rapid retail and institutional investors to purchase over-the-counter equities in hopes of
selling them at much higher prices, despite the huge market capitalizations.
Initially, capital markets effectively funded new dot-com businesses. However, the
influx of venture capital led to excessive funding for start-ups with unconventional and
unproven business models, confusing traditional investors. This misallocation of resources
continued despite the lack of proven success. Dot-com companies had low costs, making
their value hard to measure, and investors had no previous benchmarks due to the Internet's
novelty.
The pursuit of high returns drove investors to make risky financial decisions, resulting
in large investments in companies with little revenue. This led to rapid, unsustainable growth
and inflated valuations, contributing to the dot-com bubble burst.
If markets had been more efficient, investors might have been more cautious,
avoiding investments in shaky business models. Learning from past mistakes and having
tools to identify overpriced stocks could have prevented the hype and led to more stable
growth. The bubble's burst was partly inevitable due to the newness of the Internet, but
better market efficiency could have reduced the excessive speculation and unrealistic
expectations.
2. INCREMENTAL CASH FLOW
Next is Incremental Cash Flow. It is a financial management principle that refers to
the additional cash flows that a company anticipates to produce from a new project or
investment. These are the net cash inflows or outflows that follow directly from the choice to
pursue a specific course of action, and they are crucial in determining the financial viability of
investments.
Many DotCom companies forecasted large future cash flows based on excessively
optimistic growth and market dominance predictions. They expected that their expenditures
in technology would result in massive revenue growth. However, most companies did not
use feasible business models, such as cash flow generation, hence they were overvalued
and very speculative. As stated in the first principle discussed, these start-ups have different
business models and questionable, unproven concepts. As a result, for many DotCom
businesses, their incremental cash flows turned out to be negative. While they made
significant investments in technology, marketing, and expansion, the promised additional
revenue did not materialize as expected. The expenses incurred exceeded the income
earned, resulting in considerable cash burn.
Furthermore, during the bubble, companies prioritized market share and user growth
over creating positive incremental cash flows. This focus resulted in the rejection of standard
financial indicators, and companies ignored the lack of cash flow in favor of potential market
dominance, motivated by the fear of missing out and the hope that these enterprises would
eventually become profitable. As a result, stock prices skyrocketed. However, when the
bubble burst, it became clear that many DotCom companies were unable to sustain their
operations due to a lack of positive additional cash flows. Companies that failed to earn
enough cash to pay their expenses quickly ran out of funds, resulting in numerous
bankruptcies and large losses to investors.
The application of incremental cash flows during the DotCom bubble demonstrates
the need to conduct realistic and grounded financial research. Failure to appropriately
analyze and prioritize positive additional cash flows resulted in widespread overvaluation,
excessive risk-taking, and, eventually, the collapse of the DotCom market.
3. THE CURSE OF COMPETITIVE MARKETS
Lastly, The Curse of Competitive Markets. In competitive markets, extremely large
profits simply cannot exist for very long. Given that somewhat bleak scenario, how can
managers find good projects – that is, projects that provide more than their expected rate of
return given their risk level?
As competition makes these projects difficult to find, managers must invest in
markets that are not perfectly competitive. The two most common ways that firms can make
markets less competitive are to differentiate the product in some key way or to achieve a
cost advantage over competitors where it can produce a product or provide a service at a
lower cost than its competitors.
The bubble started when many businesses responded to the new opportunities made
possible by the Internet's commercialization and the expansion of web-based commerce
during 1995 and 1997. This included people and companies who had never used the web or
the Internet before embracing it. It involved investing in these businesses and constructing
ISPs and traffic-carrying lines. It included the substantial investments made by
already-established businesses to integrate and improve electronic commerce into their own
processes, whether for back-office functions, input supply reorganization, or the creation of
new sales and distribution channels. It also involved the establishment of numerous new
businesses that provide electronic services.
With capital markets throwing money at the sector, start-ups were in a race to quickly
get big. Companies without any proprietary technology abandoned fiscal responsibility. They
spent a fortune on marketing to establish brands that would set them apart from the
competition. Some start-ups spend as much as 90% of their budget on advertising. The
growth of the Internet created a buzz among investors, who were quick to pour money into
startup companies. These companies were able to raise enough money to go public without
a business plan, product, or track record of profits. These companies quickly ran through
their cash, which caused them to go under.
As competition makes these projects difficult to find, managers must invest in
markets that are not perfectly competitive. The two most common ways that firms can make
markets less competitive are to differentiate the product in some key way or to achieve a
cost advantage over competitors where it can produce a product or provide a service at a
lower cost than its competitors.
The dot-com bubble still stands as a strong lesson learned regarding excessive
speculative investments and has brought to the forefront the need to build sustainable
business models. From the initial excitement over the Internet, the chain of events of the
dot-com bubble and its subsequent bursting is a dramatic chapter in the history of
technology and the economy.
