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What you need to remember about the Dotcom bubble

Some investors have a history of repeating mistakes and not learning from the past. This can be seen with dotcom companies, but what does it mean for you?

The tale of two dotcoms
Back during the dotcom era, there were countless companies that needed to file bankruptcy and only a select few that were able to thrive.

Investors know of Google (NASDAQ: GOOG) and Amazon.com, but there were far more Boo.com, theGlobe.com, or who could forget the likes of Startups.com. While there were many fundamental differences between those that succeeded versus those that failed, the one common theme was revenue.

Companies such as freeInternet.com had very little revenue but large market caps. In the case of Amazon and Google, both companies saw significant growth and were clear leaders very early in their business cycles.

Today, the same applies. We already know which companies are clear leaders in this new dotcom era, which include Facebook (NASDAQ: FB), LinkedIn, and even Twitter to some degree. As for the rest, all are rather small, with it being too early to know whether they are fads or will stand the test of time.

Nonetheless, the potential to earn sales through the web with relatively small costs has created large premiums, a lot of excitement, and a complete disregard for the past.

Acquisitions
While investors are more-than-willing to pay 20 times sales for dotcom stocks, well-established technology companies have also shown a willingness to make such acquisitions.

Reportedly, Facebook made a US$3 billion offer for Snapchat, but then Google made an even larger US$4 billion bid.

The presumed value in Snapchat is in its shared photos: Approximately 200 million photos were shared daily as of June, and that number increased to 350 million in September. It is believed that this growth combined with advertising potential makes the company valuable.

However, we are yet to know whether users will continue to use Snapchat once advertisements are implemented. Also, Snapchat’s largest user-base is teens, which are known for being fickle. To make matters worse, Snapchat has no revenue, hence no profits, making it more like a Broadcast than a Google.

History as a guide
Clearly, US$3 billion to $4 billion for either Facebook or Google is a drop in the bucket. However, these single multi-billion dollar acquisitions add up over time, especially if they fail.

For example, Cisco (NASDAQ: CSCO) has been one of the great technology companies for the better part of two decades. However, when the dotcom bubble burst, it lost more than 85% of its value. The reason had nothing to do with the possibility of bankruptcy, but rather large investments that never panned out. Essentially, Cisco threw money away, its fundamentals suffered, and the market reacted abruptly and harshly.

Therefore, investors must be sceptical of acquisitions such as Tumblr, Instagram, and Snapchat. If anything, the acquisition attempt shows an aggressive willingness on behalf of tech giants to gamble, and bet on future growth, infrastructure, and sustainability.

The multiple problem for acquisitive companies
Companies such as Google and Facebook are considered growth companies, and are awarded large valuation premiums because of their growth. Google trades at six times and Facebook 17.5 times sales, which is far more than the 3.5 times multiple within the technology sector. Companies like Cisco, trade at 2.3 times sales, thus showing the large disconnect between valuing such companies.

The problem with having higher multiples based on growth is that if that growth ever stalls or slows it is likely to produce a large pullback in the stock. This is one reason that such high-profile speculative acquisitions are dangerous. Obviously, betting large sums of cash on speculation can halt growth, if the investment turns out to be a dud.

The buyouts remove cash from the balance sheet, which could otherwise be reinvested into the business to obtain growth elsewhere. In the dot com era, we saw this process create a domino effect, and we could be well on our way to seeing a repeat of history.

Final thoughts
The bottom line is that every company is searching for the next YouTube, a company that seems expensive now, but that could be extremely lucrative in the future. Unfortunately, there are far more Broadcasts than YouTube’s.

As of now, investors are satisfied and accepting of the speculative nature of dotcom companies, even when such companies are acquired. However, if any or many such buyouts begin to show a lack of fundamental growth, then watch for significant stock losses in many of the sector’s elite.

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A version of this article, written by Brian Nichols, originally appeared on fool.com.

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