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Arithmetic in a Bubble

"Arguing in My Spare Time" No. 2.09

by Arnold Kling

July 8, 1999

May not be redistributed commercially without the author's permission.

My favorite Internet IPO went off this week.

The concept of is one to which I can relate instantly. Ever since I was a teenager, I have "produced" recordings by making tapes of albums, so that I could mix artists and listen to selected songs. From the tapes that sequenced Jefferson Airplane and Blind Faith to those that included Melissa Ethridge and REM, I have enjoyed making my own favorite blends.

The idea of musicmaker is to let you do that on the Internet. I have not used the service yet, because at the moment their catalog is not as good as mine. I mean, sure, they have licensed more records than I have. But I have more of the records that I want than they do. For example, they have none of the four artists listed in the previous paragraph.

But the concept is not what makes musicmaker my favorite IPO. What makes it my favorite IPO is the price/revenue ratio.

Last year, musicmaker had $75,000 in revenue. That is thousands, not millions. And that is revenue, not profits. They took in enough in sales to pay a secretary with benefits, and now they have gone public. Successfully.

After the IPO, the market capitalization of musicmaker was over $700 million. Dividing this by their revenue gives a price/revenue ratio of nearly 10,000.

Yahoo has a price of about $170 per share and sales of about $1.12 per share, for a price/revenue ratio of only 150.

I am told that investment bankers tend to value Internet companies before they go public at 10 times revenue. They are assuming that they can get more than that when they take the companies public.

If a company had a profit margin of 4 percent, then by definition its earnings would be 4 percent of revenues. If it were expected to grow at the same rate as the economy as a whole, it might have a price/earnings ratio of 25. In that case, its price/revenue ratio would be its price earnings ratio times its profit margin, or 1.

Based on the preceding paragraph, it would seem that 1.0 is a reasonable approximation of a "steady state" price/revenue ratio. By "steady state" I mean the conditions that will prevail once the Internet economy has matured to the point where it grows no faster than the economy as a whole.

Yahoo’s current market valuation is about $35 billion. If the steady-state price/revenue ratio is 1.0, then for Yahoo to achieve that ratio means that revenues would be $35 billion. If its revenues were to double every six months, then starting from the latest annual sales of $260 million and holding its stock price constant, it would take well over three years to reach that point.

Yahoo’s revenue per page view consistently has been 4/10 of one cent. They have benefited from an increasing interest in e-commerce on the part of advertisers. On the other hand, they have been hurt by "Nielsen’s Law" which says that click-through rates (the consumer response rate to the common form of Internet advertising, which in turn determines the value that sponsors place on such advertising) fall by 50 percent a year. (At the moment, I cannot locate a reference for the law. Jakob Nielsen’s web site is

If it takes Yahoo 250 page views to get $1 in revenues, then to reach $35 billion in revenues will require 8.75 trillion page views per year, or about 24 billion page views per day. If the world population is 6 billion, then on average everyone in the world, regardless of age, language, or access to the Internet, will have to view 4 pages on Yahoo per day.

Another statistical law found by Nielsen is that relative to Yahoo (which is the number one Web site), the page views of other web sites follow a zeta distribution. That is, the number two site gets half of Yahoo’s page views, the number three gets one third of Yahoo’s page views, etc. Using page views and site rankings for, I have found this approximation to be accurate.

Yahoo has a total market value of $35 billion. Assuming that the stock market values Yahoo correctly and that the value of web sites is proportional to page views, then the second most popular Web site would be worth $17.5 billion. To be worth $1 billion, a site would have to rank in the top 35. It should be difficult for any site that is not in the top 100 to go public.

However, this has not proven to be the case. For example,, which in terms of traffic probably is not even in the top 5000 web sites, has a market cap of over $900 million.