Rational Pricing of Internet Companies

We apply real-options theory and capital-budgeting techniques 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. We report that, depending on the parameters chosen, the value of an Internet stock may be rational if growth rates in revenues are high enough. Even with a real chance that a company may go bankrupt, if the initial growth rates are sufficiently high and if this growth rate contains enough volatility over time, then valuations can reach a level that would otherwise appear dramatically high. In addition, the valuation is highly sensitive to initial conditions and exact specification of the parameters, which is consistent with observations that the returns of Internet stocks have been strikingly volatile.