Internet stocks may be priced for perfection

Posted: Friday, October 31, 2003

NEW YORK (AP) Here we go again.

Dot-com companies have seen their share prices jump to levels not reached since before the bubble burst, and shareholders are clamoring to get in on the action.

Nothing wrong with that. It's OK, even good, to be optimistic about a stock's prospects. Just don't get carried away, because this revived Internet mania isn't without risks.

For these super-high stock valuations to be justified, online companies will need to attain near-perfection in financial performance.

It has been a real comeback year for the Internet sector. The euphoria that took over Wall Street in the late 1990s has bubbled back in 2003 after the three-year bear market.

EBay's stock has nearly doubled, as has Yahoo's. Shares in Netflix, the online DVD rental service, have gone from just over $11 to $50 this year, while search engine Ask Jeeves' stock is up more than 600 percent. The Internet sector has been the best performer in the Standard & Poor's 500 stock index.

At first glance, this sure seems like great news. But analysts worry that many Internet shares are really priced ahead of reality, and the result of that may hurt investors down the road.

Consider the case of Amazon.com. Its stock collapsed several years ago when dot-coms fell out of favor with investors and there were worries that the online retailer wouldn't survive.

But its shares have made a stunning comeback tripling just this year alone as the company cut its losses and stepped up its sales growth through aggressive price-cutting and free shipping promotions.

This investor infatuation has caused valuation concerns to emerge. Amazon's stock now trades at nearly 63 times the value of next year's expected earnings for the company, nearly four times higher than the market average and even ahead many of its peers in the Internet sector.

That means Amazon will probably need to do more than just meet sales and earnings targets if the stock is to keep climbing. At current levels, it is priced to play at the top of its game.

So it shouldn't have been a surprise to see what happened when Amazon announced earnings last week.

Investors mostly brushed off news that Amazon had achieved a significant milestone by turning its first profit ever outside of the holiday-driven fourth quarter. Instead, they focused on the retailer's forecast that its anticipated sales growth for next year would be about half this year's rate.

Even though the company acknowledged that it was being conservative in its year-ahead projections, the idea of such a slowdown was enough to rattle Amazon investors.

The stock plunged 9 percent in one day, and now trades around $54, after hitting a 52-week high of more than $61 right before earnings were released.

And some analysts think that even more of a pullback is necessary. Goldman Sach's Anthony Noto, in a recent report, said the odds of Amazon producing the growth suggested by its current stock valuation were on the ''lower end of the spectrum of probability.'' He advised clients to take profits on the stock.

''We continue to be impressed with the breadth of Amazon's fundamental strength ... but think that the share price reflects long-term assumptions that we believe are too aggressive and provide little margin for error,'' said Noto, who has a price target on the stock ranging from the low $30s to about $50 depending how conservative or aggressive he is with his growth expectations.

Those concerns were echoed by Prudential Equity Group's Internet analyst, Mark Rowen, who lauds Amazon for being a ''viable, profitable business with bright prospects'' but worries that as Amazon matures, it's growth will slow.

His price target for the stock: $15 less than a third of its current price.

''We continue to believe that future growth rates ... will decelerate considerably, and will not support the lofty valuation,'' Rowan said.

Still, Rowen pointed out in his note that his views have their risks, too. Maybe Amazon's growth doesn't slow and it keeps growing its profit margins. Maybe Amazon continues to gain market share. Maybe online consumer spending skyrockets.

Or maybe it's just that investors keep pushing these Internet stocks higher because of good old irrational exuberance. They may not care whether the prices are justified, and if enough people think the stocks will go higher, they just may do that.

We've seen that happen before, and look what it got us.

Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck(at)ap.org



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