The Dot-com Crash in 2000.
Whose fault is it?
Introduction: The Dot-Com boom
In 1999, Internet companies’ stock prices began to grow very rapidly. Supposedly, the competitive advantage of these businesses was the elimination of heavy investment in capital. Dot-coms aimed to be competitive through value added information elements, such as consulting or electronic commerce. Many analysts called this industry, “the new economy” because of the competitive use of technology and knowledge, as opposed to “old economy” companies, which are capital and labor intensive. Nonetheless, almost none of these companies were showing profits during that period. Balance sheet and income statement figures were not very promising either. On the other, hand stock prices here extremely high. For example the stock of Scient, an Internet consultant company, had a peak price of $133.75, which represented a 1238% increase from its Initial Public Offering(IPO) in 2000. One year later, its stock decreased to $2.94 .
The Ethical Issue
After looking at those numbers one asks, how could an “effective” market allow unprofitable companies to reach those exorbitant prices in secondary markets? One may argue that supply and demand determine stock prices. However, if demand is given faulty information, investors are biased towards stock that they would not invest in otherwise. Although the United States has a very effective financial market, accurate financial and accounting information depends heavily on very few specialized firms such as Investment Banks and Analysts firms. These firms are capable of misleading the market, as it happened in the dot-com crash in 2000. Based on simple accounting and financial principles I propose that Investment Banks and analysts were not ethical during this bubbles because they did not value Internet companies as rigorously as they do with other start up companies.
During the dot-com bubble, financial intermediaries, analysts and investment banks did not provide accurate information to investors. These institutions normally receive commissions based on the performance of the stock they analyze. For example, Investment Bank Underwriters, receive a 7% commission on the capitalization during the IPO. As we know, the main providers of financial information in the market are those previously mentioned. Prestigious firms such as Morgan Stanley, Goldman and Sachs, Merry Lynch, Firs Union, etc participated in the analysis and valuation of these dot-coms. The dot-com crash in 2000 suggests that the information these companies provide has the power to mislead the market.
Due to the short period of time of the bubble and high valuation of the stock of Internet companies, there was a very high transfer of wealth in the market. Generally, those who had accurate and unbiased information did not loose money. For example Underwriting banks were getting high returns from IPO commissions; however, their participation in the investment ended at that point. Analysts were also getting commissions on performance. Some of them argue that even the most prestigious analysts supported the “new economy” companies. Consequently, If an analyst had argued against Internet companies at that time, he would have been considered unprepared.
It is hard to blame a certain group of people for this market failure. Most buy/sell recommendations are manly subjective because of future uncertainty of many variables that affect stock prices. However, during the dot-com bubble Investment banks and analysts did not followed basic accounting principles. For example, investment banks always require companies to have a strong profit record in order to be considered to go public. That did not happen in 2000 because most of the companies had negative profits. Moreover, analysts did not take into account basic valuation methods such as the Price to earnings Ratio, which had an “infinite” value for these companies. It is true that the potential for this industry seemed very solid; however, information holders must be more objective in order to prevent financial crashes.
Today, investors are very skeptical about Internet companies. The valuation of these companies is very low. In many cases, their stock price does not even reflect the market value of their assets. In 2000 the market allowed dot coms to grow over their real profit potential, which was a result of misleading information. The role of accurate financial information is essential for market efficiency. Investment Banks and analyst are entailed to be financially objective because of the power they may have over stock prices. Nonetheless, it is still hard to believe that this event happened in 2000, when regulation and transmission of information was supposedly efficient.
Sources:
Palpeu, Krishna The DOT com crash of 2000, Harvard Business Case Edgar Online, Yahoo Finance Quicken .com
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