&DQG0HUF$SSOLHG(FRQRPLFVDQG)LQDQFH 'HSDUWPHQWRI(FRQRPLFV 0DVWHU7KHVLV ,QYHVWLJDWLRQ RIDQHZWHFKEXEEOH $XWKRUV 'DWH +HJH&KULVWRIIHUVHQ 'DYLG*XOEUDQGVHQ $XJXVW 6XSHUYLVRU 6FRSH (ULN+DOOHU3HGHUVHQ SDJHV LQFOXGLQJWDEOHVDQGILJXUHV Image is gathered from Fortune Magazine (2011) Illustrating the founder and CEO of Facebook, a company that is considered to be among the biggest celebrities in the technology sector. ³:HGRQ WJHWIRROHGDJDLn Don't get fooled again 1RQR´ The Who (1971) I | Page (;(&87,9(6800$5< Stock prices for technology companies reached astronomical levels in 1999/2000, resulting from market speculation. The high priced companies were characterized by low and even no earnings to speak of. This thesis investigates the listed companies represented in four technology heavy indices in the U.S. based on a variety of ratios with a goal to determine overvaluation. Compared to the overall stock market, these are priced at a higher level, though not as high as for the dot- com the period. The corresponding earnings may be explained by sounder business models for these companies in the current situation. Venture capitalists are eager to invest in technology due to the high growth and profitability opportunities. Venture capitalists` interests in technology are increasing, especially within the software sector and particularly for Internet related companies where social networking companies receive the highest investments. Based on IPOs being their most successful and profitable exit strategy, we find it plausible to assume that this increased interest will have a large impact on the public stock market. Due to the financial crisis, a lot of private equity companies failed to exit their investments, leaving the record high investment deals in 2005-2007 still queued to be disinvested. This pipeline shadow of IPOs is also likely to have an influence on the public market when the IPO window widens due to increased liquidity in the market. Due to the high valuation of companies soon to be listed, the thesis further investigates some of these companies within the Internet related company industry. LinkedIn went public recently, trading at a price earnings ratio of 1346 after the initial price surged from $45 to $94. 5, a 109 percent increase. This means that the transferred value of $388 million from LinkedIn´s existing shareholders to the new investors were made due to mispricing of the stock done by the company`s underwriters. The subsequent companies have either filed, or have said that they will II | Page file for an IPO within a short time frame; Groupon, Twitter, Zynga and Facebook. To be able to compare the companies under investigation, a price to sales ratio were computed, showing that all these companies had an over-valued market capitalization compared to the industry average. This may be a result of accepted overvaluation of these social networking companies due to a lack of benchmark companies, as this is a new type of industry. The valuations and venture capitalist investments in later stage of development, point towards a hot market for social networking and gaming companies within the sector of technology. The subsequent high demand for such companies when entering the public market, may lead to a bubble. The high demand may in turn be explained by media attention towards these companies, the celebrity stock effect, an under-pricing of the stock done by the underwriters, herd behavior and an increase of non-professional investors entering the market. III | Page $&.12:/('*0(17 This thesis has been done for the purpose to elaborate on a currently relevant topic in line with requirements from the cand.merc. Applied Economics and Finance program at Copenhagen Business School. The thesis has been written solely by the authors based on knowledge, and research done in a time frame of late December 2010 to August 2011. We want to give a special thank you to people who contributed with their professional knowledge who has been helpful in this process. First of all, our thanks goes to our supervisor Erik Haller Pedersen from the Danish National Bank, Erik Sonne from the CBS library and Tor Olav Gabrielsen and Morten Pettersen from Bergen Capital Management. The writing of this thesis has enabled us to get useful insight on highly relevant topics within the field of economics and finance, and it has been very interesting to apply theoretical aspects on to real life situations. IV | Page 7DEOHRI&RQWHQWV EXECUTIVE SUMMARY ......................................................................................................................... II ACKNOWLEDGMENT ............................................................................................................................. IV CHAPTER 1 - INTRODUCTION ................................................................................................................ 1 Problem Statement and Research Questions ............................................................................................. 2 Outline of the thesis .................................................................................................................................. 2 Scope and Delimitation ............................................................................................................................. 4 Methodology ............................................................................................................................................. 4 Methodology and Limitation Critics ..................................................................................................... 7 Literature Review based on relevant theory on bubble theory: ................................................................ 8 CHAPTER 2 - BACKGROUND ................................................................................................................ 11 The Stock Market .................................................................................................................................... 11 The Markets ........................................................................................................................................ 11 The Information Technology Market in General .................................................................................... 13 Solidity ................................................................................................................................................ 15 Stock Index Calculations ........................................................................................................................ 16 6WDQGDUG 3RRU¶V ................................................................................................................................... 17 6WDQGDUG 3RRU¶V&RPSRVLWH index ............................................................................................ 17 Global Industry Classification Standard (GICS®) ................................................................................... 18 American Stock Exchange ...................................................................................................................... 19 Inter@ctive Week Internet Index ........................................................................................................ 19 Nasdaq QNET ..................................................................................................................................... 20 Nasdaq Computer Index...................................................................................................................... 20 Short Conclusion ................................................................................................................................. 21 Nasdaq .................................................................................................................................................... 21 Creation of a bubble ................................................................................................................................ 22 Stealth Phase ....................................................................................................................................... 24 Awareness Phase ................................................................................................................................. 24 Mania Phase ........................................................................................................................................ 25 Blow off Phase .................................................................................................................................... 25 CHAPTER 3 - THEORY ............................................................................................................................ 26 Market Efficiency ................................................................................................................................... 26 V | Page Behavioral Finance ................................................................................................................................. 27 Herd Behavior ..................................................................................................................................... 29 Initial Public Offering ............................................................................................................................. 30 Motives for going public ....................................................................................................................