An unintended side effect of the internet is the generation of large amounts of hot air. The world, it is claimed is living through society's third great revolution, the internet revolution. Information is transforming

everything: innovation, knowledge, global connectedness and economic growth.

On the other side of the debate are the skeptics attacking the stellar stock market valuations of internet companies such as yahoo, amazon.com, Cisco systems and America Online. The valuations they claim do not make sense: the price/earnings ratios are either absurdly high or the companies do not have earnings at all.

What is conspicuously absent is balanced analysis of the implications of the internet. Most likely, neither side is right. The hyper merchants, unable to distinguish metaphor from mundane fact and dazzled by new types of transactions, outdo each other in predicting ever more implausible scenarios of transformation. The naysayer validates arguments with financial models, developed for mid-century industrial companies, not efficacious in a post industrial context. For the most part, they simply dismiss the high valuations of internet stocks as a type of asset price inflation.

THE VALUE OF THE INTERNET COMPANIES

The value of the internet stocks carries great significance for the world economy. Paul Volcker, a former chairman of the US Federal Reserve, has commented that the world economy is dependent on the US stock market, whose growth is dependent on about 50 internet stocks, many of which have never reported earnings. Put another way, about one third of economic growth in the US economy is producing about two thirds of global growth. With 10 companies constituting most of the market capitalization of the internet sector, it is not difficult to create a scenario in which the validity of a few internet company valuations could have a crucial effect on the worlds financial position.

Few argue that the character of economic activity is

undergoing fundamental change. In the 1980s, more than 40% of the economic activity in developed economies was transactions, essentially paperwork.

By converting this into data and reducing the cost, the cost base of developed economies can be expected to change. The internet revolution could do what stream engine transport did for the industrial revolution. Less clear, and made more opaque by the hyperbole, are the likely consequences.

THE WEIGHTLESS WORLD

Weightlessness is the dematerialization of production. Because weightless commodities have no respect for distance and geography, globalization and the spread of technologies such as the internet is the result.

Weightlessness has become commonplace. It is not too surprising to learn that a third of the increase in global output during the past half century has gone into health and education and a third into leisure, broadly defined to include the media.

This weightlessness is perplexing to financial analysis when they try to evaluate internet companies. Financial models were developed for a world of tangible wealth creation, the balance sheet has a heavy bias towards plant and equipment, land and inventory and intangibles tend to be weightless customer relationships.

An indication of this is that the market capitalization of the big internet stocks tends to follow a pattern in which the value of the shares is equal to revenue multiplied by rate of growth in revenue.

At first glance, this makes little financial sense, but it becomes more plausible when seen as a symptom of a shift in emphasis to customer transactions. Rather than the focus being on profit and by extension, revenue, physical costs and labour costs the emphasis is on ability to generate a high rate of customer transactions.

INTERNET STYLE COMPANIES

Internet style companies tend to create a greater range of potential customer relationships. This has mainly been understood in terms of their capacity to gain easier access to potential customers anywhere in the world. But the conventional customer chain from suppliers to business to customers is not where the internets greatest effect will be. A more novel type of customer relationship, business-to-business will be of much greater significance. Business-to-business activity is expected to produce five times the volume of transactions and is likely to draw companies into webs quite different from previous commercial structures.

Because of these changes the question that should be asked of internet and network style companies is what can be reasonably concluded about future customer activity rather than how sound is the current revenue stream and how much can the cost base be reduced. This approach requires a new risk analysis. Whereas in conventional industrial companies the risk tends to be linear, the risk in network style companies tends to be dynamic while their tangible fixed costs often are negligible.

ANALYSIS OF INTERNET RETAILER

Analysis of internet retailer amazon.com by management consultancy McKinsy & company confirms the emphasis on the rate of growth in transactions. On any conventional analysis of profit and return on capital, the Amazon share price makes little sense. But an assessment based on likely future customer behaviour yields a more plausible result. Rather than projecting profit to validate the capitalization of the stock, the approach is to examine the relationship between expected revenue and market capitalization.

The conventional approach of comparing price or earnings ratio of a company with that of other companies in the same sector does not work with internet stocks because many do not even have earnings. Rather, what has to be asked is what has to be believed to justify the valuation. The McKinsey method is to look at those horizons: the existing customer base which is relatively easy to value; the expansion of products and services and creation of a new customer base and long term growth expectations beyond 2005.

It is assumed that amazon.com is a fast growth company, comparable with Toshiba, Sony, so 35% of the companys valuation about US $18.5 billion is postponed to beyond 2005. For the remaining US$12 billion, two key elements are seen as crucial: the number of customers and the expenditure per customer. To justify this amazon.com would need to have 78 million customers with an average lifetime value of US$176 before 2005. This would require 36% growth in customers in the US market and a 50% growth rate elsewhere.

For this to occur, internet penetration in the US would need to rise to 70% of the population by 2005 and amazon.com penetration of the market would need to rise to 27% from its present level of 20%. In the big non-US markets, internet penetration would need to increase 33% annually with Amazon.coms market share rising from 7% to 20%. These are not impossible ambitions. Amazon.com increased its customer base 31.3% between 1997 and 1999. Television took 13 years to attract 50million users, the internet took only five.

The interesting is that if you did the same thing to Microsoft in the mid-1980s, you would have realized the stock was undervalued. Amazons services are more replicable, however.

YOU NEED TO TRACK TWO KEY DRIVERS

The two key drivers are customer numbers and spend online. Profit numbers are not the thing that counts in this business.

A factor in the internet boom is the greater availability of venture capital in the US than was the case in the 1970s and 1980s.

By increasing the emphasis on transactions there are seminal strategic implications. One is that the accumulation of tangible wealth, historically seen as a way of reducing risk, is no longer the best or only form of risk reduction. In internet style companies, net tangible assets are becoming less important as an indication of a company's value. The main protection is the plausibility of future customer participation.

SHAREHOLDERS

But how do shareholders defray their risk if a company is not accumulating funds or saleable tangible assets. The pattern of fast growing industrial era companys rapid market growth followed by the establishment of a strong balance sheet is unlikely to be replicated by internet companies, because their wealth creation is concentrated on intangibles.

The conclusion seems to be that there will be push to protect transactions to ensure market share. As long as the share market believes that internet stocks are high risk, high reward, the lack of risk protection is not a big problem. In a rising market and with a lack of demand growth in conventional industries, the larger pension funds are quire willing to tolerate risk.

But, in what is becoming a more volatile market, it is likely there will be a demand for greater investment protection and the focus will turn to protecting what internet companys offer: customer bases. New firms of insurance are likely to appear, similar to derivatives in the capital markets but designed to protect customer bases and databases. The fight for the customer has only just begun.

So far, these derivatives have appeared only on the upside. Some internet stock capitalization is based on what he calls real option value. Effectively with net stocks, these are derivatives embedded in the business rather than synthetic financial derivatives. That is why they are called real options.

REAL OPTION

Real option is a term to describe the opportunity to gain new markets, for example, Amazon.com moving into the music industry from the book industry.

Part if the problem is that the main assets of net companies are intangible and these have been a problem for accountants and auditors. A lot of the value lies in the brand name and network that some of these companies have, and accounting principles do not readily accommodate these.

The need for ways of protecting customer transactions is greater because the post industrial network economy is for the most part not generating a plethora of new products and new types of economic demand. It is mainly focused on reconfiguring delivery of old products in mature, industrial era markets. Amazon.com, for example is operating in a very old industry: book selling.

Several questions are likely to be posed as the internet use grows. To what extent will new ways of electronic delivery revive ailing conventional industry sectors How will industry sectors change as the boundaries blur And, perhaps most importantly what new industries will appear Unless the network economy can generate new industries or provide old ones with new markets, cannibalization of industries and employment without sufficient replacement activity is most likely.

Three things are certain:

There will be fierce competition to find and keep new customer transactions. For companies in older industries this will represent a crucial strategic shift. Rather than wealth being a function of asset accumulation, it will be mostly a function of the number and quality of customers. Because older companies have, by definition, the most durable relationships with customers, they are likely to benefit the most if they are able to adapt effectively to the internet and networked economy. Although historically they have focused on tangible wealth creation, companies in older industries often have the best intangibles: brand names, history of customer relationships and ability to use knowledge effectively.

Ways of protecting customer bases will emerge. The main imperative behind globalization is waning demand in the developed economics, largely because of slowing population growth. This is forcing the bigger companies abroad in search of customers. The aim will be to own customers rather than assets.

The new focus on transactions will change the way wealth is exchanged perhaps money itself. Global electronic commerce represents a seminal shift in the transmission of the means of exchange. Transactions occur more often and faster and they are no longer protected mainly by national authorities, but by risk minimization devices. In effect, the world is conducting a global experiment in self organizing systems of wealth creation.