Welcome return from bubble age

The Nasdaq had been showing signs of recovery until it managed a fall of 4.1 per cent last week, and only a brave person would risk a sizeable investment in the high-tech sector. This stock market ended the week at 1785 points, still a long way off its 1999 peak.

The Nasdaq 100 Trust Series is a pooled investment designed to provide results that generally correspond to the price and yield performance of the actual index. Following a very positive 81.7 per cent return in 1999, the index has visited the deep south with negative returns of 36.7 per cent in 2000, 32.7 per cent in 2001 and 13.8 per cent this year.

Why is the market so volatile and why are people so keen to invest in sometimes nefarious projects? It only seems like yesterday when Halifax announced plans for its Internet banking strategy. Within two days of the announcement, its market capitalisation had increased by around Dh20 billion - and remember this was only an announcement.

Events such as this beg the question as to how companies are valued. How did companies with little revenue and titanic losses actually show a positive value? In theory, a business is worth the net present value of the stream of future income. This is calculated by applying an interest rate, the discount factor, to the income stream.

Put simply, if we were to take a discount rate of 10 per cent, Dh100 today would be worth Dh90.9 in one year, Dh82.6 at the end of year two, Dh75.1 at year three and so on. These discount rates are readily available from any finance textbook.

The discount rate will vary according to circumstances but it is based on the premise that most would prefer to receive Dh100 today rather than Dh100 after a year.

There are two reasons: The first is that if we receive Dh100 today we can make use of it straightaway rather than having to wait; the second is we can invest the money so as to ensure that it will be worth more than Dhs100 at the end of the year.

If say the U.S. Federal Reserve were to raise their base rate, it stands to reason that there would be a similar increase in the discount rate. That increase would in turn lead to a fall in the Nasdaq since discounted future earnings - using a higher discount rate - would not be as attractive.

The major problem facing the Gulf-based investor is that they often buy into the smaller quoted high-tech companies with little inside information and little control over their investment. If future revenues are not in line with expectations, the markets will inevitably fall and the investor is left high and dry with a not very liquid investment.

Finance students will be completely familiar with the efficient market hypothesis. To the rest of us, it indicates that any share price reflects all available information and that the market knows best and acts rationally.

There is a growing feeling that markets are definitely not efficient and are actually inefficient which helps to explain the numerous recent examples of volatility and illiquidity.

Many new issues have been over-valued mainly because of the fact that forecasts have been talked up to sometimes impossible levels. Subsequent cash-flow predictions have taken these forecasts into consideration with the end result that many companies have been over-optimistic.

When the time comes to show results, the company understandably falls below expectations. It may not be too long before investors show a little more common sense and revert to historic valuation yardsticks.

When rationality does return to the market then the roller may go out of the recent roller-coaster ride and investors may then start making money on real companies with real profits and real assets.

This would be a welcome return after the bursting of so many bubbles in the new e-age that has resulted in many Gulf-based investors suffering heavy financial losses.

Tim Howe is managing director of Al Ghaith & Co, public accountants, and a financial writer.