If 1999 was the year of the dot-com and 2000 is the year of the dot-bomb, what will 2001 bring? Analyst John Del Vecchio offers a more rational approach to assessing e-businesses.

	Email this page Format for printing Reuse/Reprint

By John Del Vecchio (TMF Fuz)
November 14, 2000

If investors remember 1999 as the year of the dot-com, then they will certainly dub 2000 as the year of the dot-bomb. By the time April 2000 rolled around, prior years' euphoria began to wear off and investors were reassessing their portfolio holdings. In 2001 and beyond, investors will return to a more rational assessment of the quality of businesses and the price they pay to own a stake in them. There are many factors that will come under the microscope, but five primary issues are likely to get the most attention: competitive advantage, experienced management, profitability, cash flow, and valuation. Let's take them one at a time.

Competitive advantage
There was a time, not too long ago, when a company could launch a website and quickly garner a multibillion-dollar valuation. However, an unattractive offline business is not necessarily an attractive online business. If a company sells products for 90 cents on the dollar, it is a losing proposition both in the real and virtual worlds.

Many companies were lured by the appeal of having their stores open 24 hours a day, seven days a week. But they forgot about the "back-end" systems such as inventory, distribution, fulfillment, and customer service, among others, required to run a successful business. To be sure, the Internet has created companies with enduring competitive advantages. For example, eBay (Nasdaq: EBAY) exists and thrives because the Internet facilitates a large community of buyers and sellers that can congregate and trade. eBay's large and growing base of users has created a powerful network effect that is unlikely to be eroded by competitors. So, when assessing the quality of a business, pay close attention to its ability to sustain its competitive advantage.

Experienced management
College dropouts like Bill Gates of Microsoft (Nasdaq: MSFT) and Larry Ellison of Oracle (Nasdaq: ORCL) are exceptions, not the rule, when examining a company's management team. Throughout the dot-com craze of the last two years, it was not uncommon for a relative unknown with no start-up experience to write a business plan and obtain millions of dollars in venture capital funding. Entrepreneurs are likely to continue to fuel innovations in the future, but investors acquainted with the ups and downs of tech start-ups are going to pay much closer attention to the experience and quality of the management teams behind these firms. The focus should be on entrepreneurs with solid track records within the industry, a history of entrepreneurship, experience in turnaround situations, and the ability to bring together an open and honest management team.

Profitability
Believe it or not, over the past couple of years, investors have frowned upon the prospect of profitability, savoring other factors instead. Growth at all costs was a key driver in sky-high market capitalizations. This led to dubious and expensive marketing campaigns, out-of-control hiring, and an overall disregard for financial control. Today, investors will still back companies that are unprofitable, but it must be clear when a company is likely to turn the corner.

Some businesses require large upfront expenditures, such as communications and software, but the underlying business models are attractive and should lead to profits sooner rather than later, while other businesses will toil in the red indefinitely. Any business that portends a downturn in earnings growth in upcoming quarters has been punished severely in this market climate. The laws of economics will not be repealed. Profits are very important.

Cash Flow
Some companies will take longer than others to reach profitability, but the cash dynamics remain essential. Reinvestment in working capital and fixed investments are crucial factors in cash flow. Companies will need to reach and maintain positive cash flow to fund their growth because the financial markets have turned off the tap for continuously raising capital. While external sources of funding such as convertible bonds have become popular, many firms are using the cash inflow to finance operations rather than capital expenditures. If a company has been using its cash inflows to pay salaries rather than grow the business, then long-term survival is questionable.

Some firms such as Furniture.com and Pets.com (Nasdaq: IPET) met their demise because, among other things, they could not raise capital to continue operations and didn't have the cash flow to keep afloat. Even Internet stalwarts like Amazon.com (Nasdaq: AMZN) are boxed into a corner. Concerns from analysts about its cash balance and credit quality have sparked a dramatic decline in market value.  

Valuation
Yes, price does matter. When you buy shares of stock, you buy a piece of a business. To think that you can pay any price for this business is absurd, no matter how great the concept. Great businesses do not necessarily make great stocks.

One traditional valuation model defines a company's worth as the present value of its future cash flows. To complicate matters, many businesses today create value from the intellectual capital of their employees rather than physical assets. The current accounting system lacks a viable way to value intellectual assets. However, investors can at least attempt to understand the sources of value creation, assign probabilities to potential outcomes, and measure the future expectations that are reflected in today's stock prices to determine if they are reasonable.

As we turn the corner toward 2001, investors need to pay more attention to these factors as well as many others when buying and selling stocks for the long-term. Still don't get it, or just don't have the time to do the research yourself? Don't despair! The Motley Fool is focused on 2001 as well. Our comprehensive guide, Industry Focus 2001, outlines 17 industries with stock selections that we think offer opportunity for investors over the coming years and serves as a valuable resource in your efforts to invest successfully.

Related Links:
How to Value Stocks
Introduction to Valuation
Cash Flow-Based Valuations

Do you Fool around?
Register at the Fool today and receive many great benefits such as full access to the Fool website, free offers, the 13 steps, portfolio tracking, and My Fool for a customized experience. It's fast, easy, and registration is free! Become a Fool today!