Business Analysis and Valuation

Assignment 1 - The Role of Capital Market Intermediaries in the Dot-Com Crash of 2000
Group Members:
1.
2.
3.
4.
5.

Prateek Jain 2011A2PS501P

Sahil Dumir 2011B3A1612P
Devesh Gupta 2011A4PS260P
Aniruddh Mishra - 2011B3C7585P
Ankit Rao Shivaprasad - 2011B3A1374P

Ans1.
The following entities perform the function of intermediation between individual investors and
entrepreneurs/managers:
1. Venture Capitalists: The function of Venture capitalists is to provide capital for companies in their
early stages of development and screen good business ideas and entrepreneurial teams from bad
ones. It employs business savvy people who worked closely with their portfolio companies to both
monitor and guide them to a point where they have turned a business idea into a well-managed
fully functional company that could stand on its own and nurture the companies until they reached
a point where they were ready to face the scrutiny of the public capital markets after an IPO.
Examples include Axiom Ventures, Seqoia Captial, Bain Capital Ventures.
2. Investment Bank Underwriters: Investment banks provide their expertise to companies to go public
or make subsequent public offerings and introduce them to investors. They provide advisory
financial services, help companies price their offerings and also underwrite the shares. Examples
include Goldman Sachs, Merrill Lynch and Morgan Stanley.
3. Sell-Side Analysts: Sell side analysts publish research on public companies. They provide their ideas
to buy side analysts, portfolio managers and money management companies by talking to the
managements of the companies, following trends in the industry and making buy or sell
recommendations on the stocks.
4. Buy-Side Analysts: A buy-side analyst performs industry research, talks to the companies'
management teams, provides earnings estimates, does valuation analysis and rates the stock prices
of the companies as sells or buys. Buy-side research is not published but a buy-side analyst has to
convince portfolio managers in the company to follow his recommendations.
5. Portfolio Managers: A portfolio manager either makes investment decisions using money other
people have placed under his control(investor side) or manages a firm's money, say a retail mutual
fund or an institutional account(investment side). He is responsible for buying or selling securities.

Portfolio managers make decisions about investment mix and policy, matching investments to
objectives, asset allocation for individuals and institutions, and balancing risk against performance.
6. Accounting Firms: The accounting auditors have the responsibility to plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free from material
misstatement. They have the responsibility to express an opinion on the company's financial
statements. They also assess the effectiveness of a company's internal control over financial
reporting the process designed and implemented by the company's management to address the
risk of material errors and misstatements in financial statements.

Ans.2
Different intermediaries have different ways of compensating for there performance. The way of
compensation for intermediaries identified above is as follows-:
1) Venture Capitalists: Their main form of compensation was a large share of profits (typically 20%) in
addition to relatively low fee based on the assets under management. Yes the compensation
arrangement is likely to lead to dysfunctional activities, as the fee is relatively low compared to the 20%
which they get if the company makes profit. As happened for internet companies, VC were being
influenced by euphoria of market and they knowingly invested and brought companies public with
questionable motives just to earn larger profits.
2) Investment bank underwriters: Investment banks were paid commission based on amount of money
that the company manages to raise in its offering, typically on the order of 7 percent. Yes, the
commission arrangement is definitely going to lead to dysfunctional incentives to maximise the profits,
as they would be tempted to help more companies, even those that are not ready, to go public.
3) Sell-side analysts: Sell-side analysts were partly compensated based on amount of trading fees and
investment banking revenue they helped the firm to generate through their research. Yes, the
compensation arrangement may lead to dysfunctional incentives as analysts may publish wrong results
and show opposite ratings, e.g. (publish buy share though results suggest selling) in order for company
to generate profits so that they can earn more.
4) Buy-side analysts and portfolio managers: The compensation of buy side analyst was often linked to
how well there stock recommendations did in market, while in case of portfolio managers compensation
was determined by performance of there funds relative to an appropriate benchmark return. These
compensation schemes aligned the incentive of buy-side analysts and portfolio managers with interest
of investors. As the interests of investors and buy side analysts and portfolio managers align together
thus the compensation arrangement here is less likely to lead to dysfunctional incentives.

5) Accounting Firms: Accountants and auditors charge fees for the work they perform. These fees do
not directly depend on what kind of opinion is issued and on how well the company being audited is
doing. Investors rely heavily on auditors opinion while making their investment decisions especially on
opinions of audit firms that have good reputation for long time.

Ans 3
The roles played by each of the intermediaries in the dot-com bubble is listed as follows:
1. Venture capitalists: They were highly influenced by the euphoria of the market and knowingly
investing in and bringing public companies with questionable business models, or that had not
yet proven themselves operationally. Many of the dot-coms went public with in record time of
receiving VC funding, companies averaged 5.4 years in age when they went public in 1999,
compared with 8 years in 1995. Public market had a tremendous impact on the way VCs
invested during the late 1990s. Because of high stock market valuations, VC firms invested in
companies during late 1990s that they would not have invested in ordinary circumstances.
2. Investment bank underwriters: Investment banks took underperforming companies public.
They bagged enormous fees, a total of more than $600 million directly related to IPOs involving
just the companies whose stocks came down to $1.
3. Sell side analysts: Instead of forecasting earnings per share, they started forecasting share
prices themselves. And those prices were almost always very optimistic. High-flying stocks that a
year before were going to be cheap at twice the price valued had halved or worse. Some
analysts were put out by recommendations all the way down. Analysts were highly influenced
by the possibility of banking deals when making stock recommendations. Analysts also got
significant fees from the trading revenue they generated and from the published rankings.
4. Buy side analysts and portfolio managers: Analysts at the firm began to recommend companies
simply because they knew that the stock prices would go up, even though they were clearly
overvalued. Portfolio managers felt that if they didnt buy the stocks, they would lag their
benchmarks and their competitors. They compare against the performance of their peers for
marketing purposes.

Ans 4.
As far as the role of intermediaries is concerned, the following steps could be taken to fix the problems:

 Venture Capitalists should do their best to ensure the companies they invest in have good
management teams and a sustainable business model that will stand the test of time.
Investment bankers are expected to use their expertise, and apart from simply helping
companies to go public, they should also advise companies about whether they are ready go to
public or not
Portfolio managers acting on behalf of investors must buy only those companies shares that
are fairly priced, and should sell them if they become overvalued, since buying or holding an
overvalued stock will inevitably result in loss.
Sell side analysts, whose clients include portfolio managers and hence investors, should
objectively monitor the performance of public companies and determine whether or not their
stocks are good or bad investments at any point in time.
Accountants must audit the financial statements of companies, ensuring that they comply with
established standards and represent true state of the firms. This give investors and analysts the
confidence to make decisions based on these financial documents.
The integrity of this process is critical in an economy because it gives investors the confidence
they need, to invest their money into the system.

Ans 5.
Summary and Lessons
The Bubble
This case talks about the various players and intermediaries who had a role to play in the famous
dot-com bubble crash of the year 2000. A combination of rapidly increasing stock prices, market
confidence that the companies would turn future profits, individual speculation in stocks, and widely
available venture capital created an environment in which many investors were willing to overlook
traditional metrics such as P/E ratio in favor of confidence in technological advancements.
Intermediaries
In any business the intermediaries play an important role. The availability of correct information is
important and very critical. Any wrong information can lead to wrong investments and tank the
confidence of investors. Without this confidence, they would not make any further investments and put
money back into the market.
Lessons and Reasons for the crash
1. Going Public too early: The companies released their IPOs at a very early stage. This led to a belief
that companies were doing very well and people started to invest in them.
2. Faults of Intermediaries: The financial intermediaries kept a blind eye towards the overvaluation of

newly emerged internet companies stocks, leading the investors to make huge investments in
the dot-com companies, who were unaware about the unsustainable business models.
3. Overlooking profitability: Companies were striving for large customer base that was needed to
cover the high fixed cost. So, profitability became a secondary concern and companies went public
without any positive earnings making them top operate at losses which gave rise to a period of
irrational exuberance and evolution of classic stock market bubble.
Aftermath
The dot-com bubble not only caused huge losses to investors but also used up valuable resources that
could have been more efficiently allocated within the economy. The people who worked at failed
internet companies could have spent their time and energy creating lasting value in other endeavours.
Many companies that needed to raise capital for investment found the capital markets shut to them,
leaving the market only with bad players.
Lessons learnt
1. Popularity does not equals profits i.e. many firms that are popular at a given point of time does not
mean they are worth investing in. Focus should be on the business fundaments that are being
followed by a particular company.
2. Never invest in a company based solely on the hopes of what might happen unless its backed by
real numbers.
3. A company without a sound business model should not be invested in.
4. When determining whether to invest in a company there are financial variables that must be
examined like dividends payout, sales forecasts, profit margin etc.