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Net stocks: Critical mass vs. profits

Logic would seem to dictate that investors would twist and turn before deciding which earnings-less company to invest in. Well, paradoxically, dollars are flooding the Internet universe of public companies.

If questions were urls, www.whenaretheygoing tomakeanymoney?.com would put Yahoo's latest traffic number to shame--and that's no small feat! While Yahoo did not really start picking up steam until after August 8, 1995--around the time of Netscape's initial public offering--www.whenare theygoingtomakeanymoney?.com's traffic has never let up.

One would suspect that, given the number of times this question gets posed, investors would be very cautious about investing in Internet stocks. Logic would seem to dictate that investors would twist and turn before deciding which earnings-less company to invest in. Well, paradoxically, dollars are flooding the Internet universe of public companies.

Not only are investors flocking to companies without earnings, but, more interestingly, they are investing in companies that, from my perspective, may never have earnings.

Historically, growth investors and, more specifically, tech investors, have invested in companies that had earnings. While these companies may not have extremely high earnings at first, and rarely paid any dividends, it was nevertheless accepted by investors and entrepreneurs alike that growth companies would need to be profitable before bankers could be selected for an underwriting. As a result of the Internet, however, the investment landscape has changed significantly. Only very few publicly traded Internet companies have reached and sustained profitability, and this hasn't seemed to faze investors in the least.

When it comes to Internet stocks, investors seem to be rewarding revenue growth a great deal more than profitability, and have been doing so correctly for some time. Of course, when a company has achieved what seems to be critical mass, earnings are merely frosting on the cake, and hence are paid for as such. Otherwise, revenue growth is more greatly rewarded than earnings growth.

In my opinion, the ability to reach critical mass is a tremendous advantage for a company as it provides higher barriers to entry and increases switching costs. The notion of GBF ("getting big fast") is relevant to a number of Internet companies, but is it really imperative that they all strive for ubiquity? Is critical mass really more valuable than strong earnings?

It seems to me that, in many cases, ubiquity is necessary as Internet companies become less focused on technology and more focused on wrapping around and integrating technologies.

It should be clear, though, that when a company says it will reach profitability, profitability must be achieved. I would argue that there is a direct correlation between loss of goodwill by investors and profitability being moved out. Investors should accept postponed prosperity as long as prosperity can, in fact, be reached--as long as the company's business model is built in a way that maximizes profitability when the model swings.

Keep an eye out for companies that have promised to hit profitability in a certain quarter and then postpone their projections to a later quarter.

Danny Rimer writes regularly about the Internet in Marketwise.