R&D, Advertising and the Market Value of Internet Firms
By: Damir Tokic
2. Article Summary
During the Dot-com “bubble”, internet firms were highly valued compared to “old economy” firms. Internet firms’ stock prices were unrealistically high. Most of those firms were operating under loses and no tangible assets to warrant those prices. Analysts justified those prices and recommended buy ratings but later a crash followed. Article Summary
This article explains the relationship between intangible assets (advertising and R&D) expenditures and internet firms’ market value during 1996-2000.The author presents two opinions in regard to internet stock’s valuation. The first theory is based on DCF methodology and asserts that due to poor earnings and low earnings visibility, internet stocks were irrationally overvalued in 1999. Secondly, based on the option pricing theory, it can be justified that the prices were warranted due to growth of those firms and volatility as primary value drivers. The article details five literature reviews on valuation – (1) Investment opportunity approach to valuation and more especially growth firms, (2) The life cycle theory, (3) The effects of intangible assets (R&D and advertisement) to market value, and (4) Valuation of internet firms using real options. Based on the life cycle theory, as the firm grows and matures, managers have a tendency to pursue growth rather than stockholders’ welfare. Those with comparative advantage over the competition tend to invest more in the growth stage to expand their operations. Under this theory, the value of the firm is divided into: (1) option value of growth opportunity, (2) present value of cash flows from asset-in-place. This model is based on the idea that the firm’s life cycle determines its expected returns. Expected return attributable to each component of value largely depends on the growth stage of the firm. Like in “old economy” firms, mature firms have all of their value in the present value of cash flows from the asset-in-place component while growth firms, their value is concentrated in the growth component. The author argues that intangible assets (i.e. advertising and R&D) greatly add value and since their benefits are mainly realized in the future, they should be capitalized rather than expensed. They positively impact the value of the market as they give some signals of future profitability. Therefore, increase in these assets has consistent effects on profits. The author points out that the market reacts more favorably to high-tech firms when R&D expenditures are announced than to low-tech firms. This is based on the hypothesis High-tech firms have promising growth opportunities whereby investments in R&D positively affect the market value. On the other hand, Investments in low-tech firms negatively affect the value due to no or negative growth opportunities. The author also points out that the efficient market does not capture advertising and R&D in the firm’s stock price because these investments are expensed rather than capitalized and therefore reduce the profits making the financial statements to be misstated. It may be possible that R&D intensive firms may be underpriced because investors focus on accounting information failing to see the future benefits of the R&D investments. On the other hand, especially for those firms with negative earnings, overconfidence investors will overestimate the future benefits from R&D investments thus causing overvaluation. Maintaining R&D and advertising intensity provides the positive signal that management are overconfident in future prospects and the market tend to overlook those signals making it possible to realize abnormal returns. The author also explains the real option valuation model which he blames on the high valuation of internet stocks during the bubble...
References: Chan, L.K.C, Lakonishok, J., & Sougiannis, T., (2001). The Stock Market Valuation of Research and Development Expenditures. The Journal of Finance. 56(6), 2431-2456. doi 10.1111/0022-1082.00411.
Palepu, K. G., Healy, P.M., (2008). Business Analysis & Valuation. Mason, Oh: South- Western Cengage Learning.
Tokic, D., (2004). R&D Advertising and the Market Value of Internet Firms: Part 1. Journal of Internet Commerce. 3(2), 21-79
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