R&D, advertising and the market value of Internet firms

The purpose of this study is to explain the valuation of Internet firms during the valuation "bubble" period from 1996 to 2000. The theoretical foundation of the study is the investment opportunities approach to the valuation of growth shares. Consistent with predictions of the investment opportunities approach, the results show a positive and statistically significant relationship between the market value of Internet firms and investments in R&D and advertising in each year of the sample period. These findings strongly support the view that R&D and advertising are intangible assets.;The investment opportunities approach also predicts a positive relationship between market value and volatility, and between market value and earnings. During the peak valuation period of 1998--1999, volatility positively and significantly affected the value of Internet firms. However, it turned negative in 2000 when prices sharply decreased. The earnings coefficient was positive and significant from 1996 to 1998. However, opposite to predictions of traditional valuation discounted cash flow approaches and the earnings portion of the investment opportunities approach, earnings had a negative and significant impact on the market value of Internet firms in 1999 and 2000. These results suggest that, during the 1999--2000 period, investors valued Internet firms using the models based on the option pricing theory.;The major shortcoming of option pricing based valuation models is that they ignore the value of earnings in their valuation projections and consider growth and volatility as primary value drivers. A number of academic studies argued that option-pricing models are superior to traditional valuation models in pricing Internet stocks. Also, during the same period, financial analysts based their value projections solely on growth, ignoring the negative profitability of Internet firms. The investment opportunities approach closes the gap between the traditional valuation approaches and the option pricing approaches by proposing that the value of a growth firm is a sum of present value of earnings and the value of growth opportunity. The lesson learned during the dot.com valuation bubble is that the value of a growth firm is a function of, not only growth opportunities, but also the ability to create consistent positive earnings.