To most people, the wild swings in the shares of small, newly public Internet companies look like irrational exuberance. Not to Arun Sundararajan. The New York University business professor thinks they actually contain thoughtful assessments of cyber-companies' strategies, which he claims to have decoded.

Moreover, he contends, Internet company executives are absorbing market information and acting on it, whether they realize it or not. This is a message that Internet companies considering a public offering might find alarming.

For the last six months, Sundararajan, an assistant professor at NYU's Stern School of Business, has studied what happened to the stock prices of 100 Internet companies that have gone public since August, 1995. First, he observes, Internet companies' prices rise more abruptly in the first week of trading than companies in other industries -- 36% compared with a 16% average rise -- something he attributes to the difficulty of pricing this little-understood sector accurately. (In the six months following their IPOs, about two-third of the companies that Sundararajan surveyed saw their stocks increase and one-third reported a decline.)

Then, Sundararajan tried to put their stock prices together with news that came out about the companies' strategies. Taking a counterintuitive tack, he concluded that as the stock price went up and down -- presumably from investors who vote with their wallets on what they heard about the companies' contracts, alliances, earnings, etc. -- some companies would change strategy in response. Moreover, he says, they may do it subconsciously, since few executives would admit to adjusting their business in response to wild stock gyrations.

In particular, Sundararajan contends, an Internet company that goes public with dreams of being a leader in the business might back off and adopt a niche strategy -- if its shares aren't well received by the market. "Once the firm goes public, it observes how high its price rises, and it gets an estimate about how good it thinks its prospects are," Sundararajan says. "They change or choose the best strategy, within a set of strategies, given the information they have received from the market through the IPO."

SILLINESS. Some small-business experts say the idea that companies adjust their business to their stock price fluctuations is like saying they consult a Ouija board. "The vicissitudes of the market have little direct effect on the actual business of the company itself," says Miles Spencer, founder of Money Hunt Properties, a multimedia enterprise in Norwalk, Conn., that's devoted to entrepreneurs. "Marking your company's strategy to the fluctuations in the stock price after an IPO is crazy."

Scott Smith, partner at Howard, Smith & Levin, a New York law firm that specializes in Internet IPOs, says the stock price isn't saying anything in particular. But, he concedes, if it goes up astronomically, and the company suddenly has a $3 billion market capitalization, the business will certainly get attention. "You can command more respect from the counterparties who are big software companies, big advertising companies, and others, and you get respect just because of your size," says Smith.

Still, Sundararajan insists that he has evidence -- though he admits it is only circumstantial. (The professor says he hasn't queried the companies about this because their responses would be biased.) He cites Yahoo, whose stock price rose 122% from an initial offering at $13 a share ($4.43 when adjusted for two stock splits) in its first week of trading in mid-April, 1996. The shares now trade around $217. Yahoo has gone on to an array of partnerships and service: with Visa for E-commerce and shopping services; with Granite Broadcasting Corp. for integrated Web and television news; and it provides Microsoft's MSN.com with directory services. Yahoo is considered the top Web portal with $53.6 million in revenue and a profit of $16.7 million in the third quarter. Media Metrix, a New York Web marketing company, reports that Yahoo had 30 million viewers last month.

By contrast, Infoseek's stock fell 2% from an initial offering of $12. Shares now sell for around $34. Revenues for the third quarter were $19.2 million, and it had a loss of $2.6 million. In October, Infoseek sold a 43% stake to Disney for $70 million in cash. The deal allowed Infoseek to acquire Starwave Corp., which produces ABCNews.com and ESPN.com. But, Infoseek has only 13.5 million viewers, according to Media Metrix.

Sundararajan also cites Lycos. But here his theory gets a bit shaky. Lycos' shares, which started at $16 when the company went public in mid-April, 1996, rose a mere 11% a week later. The shares now trade around $63. It formed partnerships with Bertelsman, the German publishing conglomerate, to build Web sites in Europe; and with AT&T, where subscribers to the long-distance company's Internet access service enter the Net via Lycos. Lycos had third-quarter revenue of $24.8 million and a loss of $2.6 million, but its viewership -- 28 million last month -- comes close to Yahoo's.

Yahoo Chief Financial Officer Gary Valenzuela, thinks Sundararajan's theory is backward. What's important, says Valenzuela, is how well a company delivers on its expectations. Those that live up to their promises well will ultimately be rewarded with a high stock price. Besides, he says, "There are a lot of market dynamics that can play into whether an IPO pops and whether the stock trades well in the aftermarket that could be somewhat independent of the company's long-term performance."

Harry Motro, chief executive officer for Infoseek, is blunter. He calls Sundararajan's theory "hogwash." Infoseek has not consigned itself to a niche category based on price signals from the market. "We have a great chance to go to the No. 1 position in this industry," says Motro. "With Disney behind us, we have a great opportunity to grow the brand."

A Lycos official also roundly dismissed the idea that his company is an also-ran.

No one really knows how Internet stocks as a class will fare in the future. Alhough with America Online Inc. acquiring Netscape Communications Corp. on Nov. 24, the next big Internet stock plays may be merger bets. But Sundararajan is convinced that he'll have plenty of opportunities to prove his point. "The recent slowing down of IPOs in the last few months is only a temporary glitch," Sundararajan says. One thing does seem certain: Executives and investors will continue to eagerly look for ways to predict the performance of those tantalizing Internet stocks as long as they give such a wild ride.

By Jeremy Quittner in New York
jeremy_quittner@businessweek.com

To: FINANCE