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The hottest IPOs on U.S. exchanges in 2010 came primarily from China, leaving American companies in the dust. But in February, the research firm Renaissance Capital saw a change for 2011.

New-stock issues from U.S. companies were up substantially, while international offerings, particularly Chinese, were down. U.S. investors "have balked at the poor quality, high [stock-option issuance] opaque revenue and expense recognition policies, insider issues and generally not-ready-for-prime time characteristics of some Chinese offerings," the Renaissance Capital analysts said.

Ah, late February - it seems an eternity ago. That's because the latest hot initial public offering is Qihoo 360 Technology Co. Ltd., which rose a mere 134 per cent on its first day of trading Wednesday. That, according to Renaissance Capital, ranks No. 3 among first-day IPO gains in the "post-bubble" era of the last 10 years.

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At Wednesday's close of $34 (U.S.) (it has since pulled back below $30), Qihoo was priced at a mere 68 times sales - sales, mind you - with a price-to-trailing earnings ratio of 462.

Qihoo makes China's second-most-popular Internet browser (after Microsoft's Internet Explorer) and Internet-security software for both computers and mobile phones. The former head of Yahoo's China operations is its founder and CEO. (Sure enough, a headline on a story about the IPO asked, "Do you Qihoo?") Through either its browser or its security product, it claims more than 300 million Chinese customers, more than 85 per cent of all the country's Internet users.

Its penetration and pedigree seem to have enabled it to be considered one of the better Chinese IPOs of the last several months. Indeed, Renaissance Capital referred to "accounting frauds and weak post-IPO financial results posted by several Chinese firms" as reasons why investors had soured on the country's offerings.

Let's say it's unfair to lump Qihoo in with these less-prominent companies that have already blown up. Instead, we'll consider it an established market leader, peer to companies like ("the Google of China"), ("the YouTube of China") and E-Commerce China DangDang ("the Amazon of China"). Let's accept the idea that it can maintain its status and take advantage of the robust growth of the Chinese economy and the nation's emerging middle class.

There's a problem with the scenario, however. Qihoo gives all of its products away for free, hoping to make money through advertising revenue instead.

A look at Qihoo's prospectus suggests that between December, 2009, and January, 2011, when it went from 231 million users to 339 million, it collected just under $54-million from them under its current business model. That works about to about 20 cents of annual revenue per user. The company's $8.5-million in net income works out to about 3 cents of annual profit per user.

Oh, but the growth possibilities! After all, the number of Chinese Internet users is projected to grow from about 450 million in 2010 to 667 million in 2013, according to research commissioned by Qihoo.

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Let's do some projections. We'll assume China's Internet penetration rate doubles from the current 30 per cent rate to 60, and we'll assume Qihoo maintains a relationship with 85 per cent of the country's Internet users. That would give Qihoo nearly 700 million customers.

Let's then give Qihoo credit for figuring out how to double revenue per user and, recognizing the economies of scale, let's say profit per user grows fivefold, to 15 cents.

That gives us a company with just over $100-million in net income. And, at a current market capitalization of just under $3.5-billion, a P/E of 35 - after, not before, the company has realized a great deal of its growth potential.

Things could work out better. Maybe the company will find a way gather even more money per user, or China's Internet adoption rate will ultimately reach the 80 per cent of nations like the U.S. or Japan.

But it's useful to remember the theory behind a price-earnings ratio - it represents the number of years it takes for the annual earnings of a company to cover the price you pay.

If a company's earnings are growing rapidly, it will ultimately take many fewer years than the P/E implies. When you are buying with a 400 P/E, however, you need an epic amount of growth - more, I think than the amazing story of China or Qihoo's business model can provide.

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About the Author
Business and investing reporter and columnist

A business journalist since 1994, David Milstead began writing for The Globe and Mail in 2009. During eight years at the Rocky Mountain News in Denver, Colo., he individually or jointly won nine national awards from SABEW, the Society of American Business Editors and Writers. He has also worked at the Wall Street Journal. More

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