Dotcom Bubble

A stock market bubble that was caused by speculation in dotcom or internet-based businesses from 1995 to 2000

What is the Dotcom Bubble?

The dotcom bubble is a stock market bubble that was caused by speculation in dotcom or internet-based businesses from 1995 to 2000. The companies were largely those with a “.com” domain on their internet address.

 

Dotcom Bubble

 

The dotcom bubble’s origins can be traced to the launch of the World Wide Web in 1989 and the subsequent establishment of internet and tech-based start-up companies during the 1990s and rising momentum as the decade came to its end. The period marked the emergence of the widespread use and adoption of the internet from shopping online, communication, and a source of news.

 

Understanding the Dotcom Bubble

The dotcom bubble is also associated with the NASDAQ Composite index, which rose by 582% from 751.49 to 5,132.52 from January 1995 to March 2000. The NASDAQ fell by 75% March 2000 to October 2002, erasing most of the gains since the bubble started building.

Several online and technology entities declared bankruptcy and faced liquidation – namely Pets.co., Webvan, 360Networks, Boo.com, eToys, and others. However, other internet-based companies struggled but survived and are giants today – notably Microsoft, Amazon, eBay, Qualcomm, and Cisco, among others.

Share prices of internet companies were increasing much faster and higher than their peers in the real sector due mostly to speculation caused by the excitement and euphoria of the new internet age. As a result, it led to a market-wide over-valuation of internet firms relative to their intrinsic value.

The bursting of the bubble caused market panic through massive sell-offs of dotcom company stocks driving their values further down, and by 2002, investor losses were estimated at around $5 trillion.

 

Characteristics of the Dotcom Era

The frenzy of buying internet-based stocks was overwhelming, as many internet-based companies, so-called dotcoms, were starting up and because they were in a fairly high growth industry, they needed funding. Funding came primarily from venture capitalist firms. Lenders and individual investors also followed later.

Instead of focusing on the fundamental company analysis involving the study of company revenue generation potential and business plans, industry analysis, market trend analysis, and P/E ratio, many investors focused on the wrong metrics such as the growth of traffic to their website as propelled by the startup companies.

Most startups did not adopt viable business models, such as cash flow generation; hence, they were overvalued and highly speculative. It culminated in a bubble that grew rapidly for several years.

Outrageous valuations were placed on these companies and share prices continued to go up as demand was overwhelming. Therefore, the bursting of the bubble was inevitable and resulted in a market crash, which was more conspicuous on the NASDAQ Stock Exchange.

The dotcom bubble crash was a shock event that resulted in massive sell-offs of stocks, as demand waned and restrictions on venture financing increased the rate of the downturn. The crash also resulted in massive layoffs in the technology sector, as it was inevitable.

The dotcom bubble started collapsing in 1999, and the fall precipitated from March 2000 until 2002. Several tech companies that conducted an IPO during the era declared bankruptcy or were acquired by other companies, and others hung by a thread as their stocks plunged to levels so low it was never envisaged.

 

Causes of the Dotcom Crash

The cause of the dotcom bubble can be attributed to the following factors:

 

1. Overvaluation of dotcom companies

Most tech and internet companies that held IPOs during the dotcom era were highly overvalued due to increasing demand and a lack of solid valuation models. High multipliers were used on tech company valuations, resulting in unrealistic values that were too optimistic.

Analysts did not focus on the fundamental analysis of these businesses, and revenue generation capability was overlooked, as the focus was on website traffic metrics without value addition. Research carried out revealed an overvaluation of more than 40% of dotcom companies through the study of their P/E ratios.

 

2. Abundance of venture capital

Money pouring into the funding of tech and internet company start-ups by venture capitalist and other investors was one of the major causes of the dotcom bubble. In addition, cheap funds obtainable through very low interest rates made capital easily accessible. It coupled with fewer barriers to acquiring funding for internet companies led to massive investment in the sector, which expanded the bubble even further.

 

3. Media frenzy

Media companies encouraged people to invest in risky tech stocks by peddling overly optimistic expectations on future returns and the “get big fast” mantra. Business publications – such as The Wall Street Journal, Forbes, Bloomberg, and many investment analysis publications – spurred demand through their media outlets adding fuel to a burning fire and further inflating the bubble. Alan Greenspan’s speech on “irrational exuberance” in December 1996 also set off the momentum on technological growth and buoyancy.

 

How to Avoid Another Bubble

The measures below provide some insights on how to avoid another internet bubble:

 

1. Proper due diligence

Investment in new start-ups and similar tech companies should only be considered after carrying out proper due diligence, which involves a closer look at the company’s fundamental drivers of value such as cash flow generation and sound business models. The long-term potential of a stock should be properly analyzed, as a short-term focus will lead to the formation of another bubble.

 

2. Removing “investment of expectation”

Investors should desist from investments based on unrealized potential in entities that are yet to prove their cash flow generating ability and overall long-term sustainability. The expectations lead to the emergence of a bubble through speculation.

 

3. Avoiding companies with a high beta coefficient

Most tech stocks during the dotcom bubble posted high beta (greater than 1), meaning their downfall in times of recession would be much more than what the average market fall would be.

A high beta coefficient signals a high-risk stock in times of a market downturn. Since the opposite is true when there is a market boom, investors should be wary of a bubble formation.

 

More Resources

CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • 2010 Flash Crash
  • Startup Valuation Metrics
  • Types of Due Diligence
  • Voluntary Liquidation

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