Rational Pricing of Internet Companies

In this article, we apply real options theory and modern capital budgeting to the problem of valuing an Internet company. We formulate the model in continuous time, form a discrete time approximation, estimate the model parameters, solve the model by simulation, and then perform sensitivity analysis. Depending on the parameters chosen, we find that the value of an Internet stock may be rational given high enough growth rates in revenues. Even with a very real chance that a firm may go bankrupt, if the initial growth rates are sufficiently high, and if there is enough volatility in this growth rate over time, then valuations can be what would otherwise appear to be dramatically high. In addition, we find a large sensitivity of the valuation to initial conditions and exact specification of the parameters. This is also consistent with the observation that the returns of Internet stocks have been strikingly volatile. 3 RATIONAL PRICING OF INTERNET COMPANIES 1. INTRODUCTION It is diffic...