New businesses take time to get established, and the new Internet firms of the late 1990s were no exception. Internet portal firms and e-commerce firms traded at high multiples of sales on the promise of large profits, but most of them were generating losses from their sales.
In statements to the press, these firms maintained that their" business model" required them to incur substantial losses in order to generate future profits. Investments were required in infrastructure. Considerable expenditure was required for advertising and promotion to establish a customer base and to create brand recognition. So these firms appealed to investors to ignore the bottom line and focus rather on their ability to generate revenues.
Accordingly, the price-to-sales ratio became the typical multiplier that investors referred to. And analysts referred to other indicators like" hit rates" and" page views"(on Web sites) to assess the price-to-sales ratio.
In arguing that the losses they were reporting were not indicative of the value in their business model, Internet entrepreneurs argued that the GAAP accounting they were required to use was of low quality. But clearly investors were left with the question of whether these firms would actually become profitable in the end and whether the size of the profits would justify the high stock prices at which these firms traded. Rather than the crude indicators like hit rates, they looked for more substantial financial analysis.
A. Why are the earnings reported by start-up firms considered to be a "low quality" number?
B. Why should investors be wary of price-to-sales ratios? Why should they be skeptical about hit rates and page views on Web sites?
C. Develop an analysis that tests E*Trade's business model with the marketing information in the case.
D. E Trade Group traded at $25pershare at the end of September 1999, giving it a price to- sales ratio of 10.5. Given your analysis in part (C), was the firm appropriately priced at the time?
E. What other strategies might E*Trade pursue to add value?
F. By early 2000, the number of online brokerage firms had exploded to about 140 and competition was fierce. The industry needed consolidation, it was said, to deal with the glut in capacity. Should E*Trade consider acquisitions to consolidate the dominant position it holds and compete more effectively with Charles Schwab? Stock market values for the larger online firms in the preceding table were such as to value each customer account at about $3,000 each.