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Is There A Tech Bubble? Probably Not…

2011 June 8
by Greg Satell

LinkedIn floats at nearly $10 billion?  Facebook valued at nearly $100 billion!  Is this a bubble or what?
 
Probably not.  While the numbers are eye-popping, they aren’t irrational (which doesn’t necessarily mean that the valuations will be proved right, just that you don’t need to be crazy or stupid to buy into them).
 
And that’s what’s important.  A bubble is a reflexive phenomenon, where sentiment runs away with itself.  Investors bid up assets only because they are rising, with the belief that they’ll always be able to sell to someone dumber than they are.  As we’ll see, that’s not what’s going on now and, in fact, all that money sloshing around is a very good thing.

What’s a Company Really Worth?

Before we move on to the specifics of the tech industry, let’s start by talking a bit about how to determine what a company (or any other asset for that matter) is worth.

Let’s say your brother-in-law wants you to invest $10,000 in his bagel  shop.  How would you value the investment?  Well, you would certainly expect the business to pay you more than a bank would.  If not, why take the risk?

So if a bank would be willing to pay you 5% interest guaranteed by the government, you would expect to make more than $500 per year with your brother-in-law.  Historically, stocks return around 10% annually, so you would to earn at least $1,000 per year (and probably more because you’re an insider).

Therefore, to determine how much of a share you are going to demand, you would examine his books (or business plan) and determine from that what your stake should be.  Theoretically, it’s a fairly straightforward process.

Here’s Where It Gets Complicated

There is, however, a substantive difference between your brother-in-law and a bank.  The bank, after all, promises to pay you a specific sum, your brother in law does not.  Rather, he agrees to give you a share of whatever earnings there will be in the future. Unfortunately, as the adage goes, the future is hard to predict.

Another thing that muddies the waters is that businesses are erratic.  There are up-years and down-years, but you expect them to grow over time.  Again, that’s different than a bank which pays you the same amount year after year.

Investors try to solve that problem by discounting future earnings (or cash flow).  To do this, they estimate the net present value of the money they expect the business to earn in the future.  So (and don’t worry about the math here), if you think the bagel shop will earn $100,000 per year over the next 5 years, it’s worth about $300,000 today.

There are some other factors to consider.  For instance, if already own a bagel shop, you could probably consolidate some costs and earn more money on the same revenues (what the hotshots like to call “synergy”) or if you think there’s a bagel craze coming on you might be willing to pay more. Finally, you might just really like bagels (I know I do!).

The Price Earnings Ratio

Of course, things like “discounted future earnings” and “net present value” take some work to calculate and confuse a lot of people.  That’s why you see the talking heads on CNBC yapping about price/earnings (P/E) ratios a lot.  What the hell is that?

Well, in reality it’s just a short way to calculate an implied interest rate (just like the bank pays you).  If a zero-growth company is trading at 20 times earnings, that implies an interest rate of around 5%. (In reality, we usually expect companies to grow, so it’s somewhat higher, but sometimes businesses decline, so it can be lower).

With central banks keeping interest rates so low, 5% actually isn’t that bad.  So what are today’s big tech companies trading at?  Google is at about 20, Apple at 16, Microsoft at 10.  In other words, those companies are valued so highly because they earn so much freakin’ money!  Implied growth expectations, if anything, are surprisingly low.

However, at some point market interest rates will rise, so that will put a damper on stock prices (the lower the price, the higher the implied interest rate).

A Start-Up Tech Bubble?  Maybe…

Okay, so the established tech companies are solid, but what about those companies that are just a few years old and are supposedly worth billions?  Here, the story isn’t as clear because, with start-ups, there tends to be scant data and high growth expectations.

However, Mark Andreessen makes a good case that there is not a bubble and his partner, Ben Horowitz makes one as well.  Henry Blodget, went into more depth in his presentation.  All three are worth a look.

For my part, I’m not so sure.  With interest rates so low and the stock market stalled, I have no doubts that every dentist in Palo Alto is taking part of his nest egg and putting it into some new start-up.  On the other hand, when I looked into Facebook’s valuation this past January, I was amazed at how solid the numbers looked.  More recent numbers are even stronger.

Anyway you slice it, there is something very real going on.  With 2 billion people online and cloud computing making computational resources dirt cheap, good ideas can scale super-fast and earn money very quickly.  That, perhaps, is the biggest difference between now and the dot-com boom.  We can actually evaluate the earnings this time.

The Opposite of Dutch (or Russian) Disease

Whether there is a bubble or not, one thing is clear:  There is a tremendous amount of resources going to one sector of the economy.  That’s partly because of true potential and partly because there’s so few other places for money to go.

Yet, it is also important to point out what these valuations do not represent.  They are not like the Dutch disease driven economies of Russia and other places where commodity driven booms crowd out human resources.  In fact, quite the opposite.  What’s being valued here is talent.

And that’s the irony of the last tech boom and bust.  It probably did more good than harm.  The juggernauts of Google, Apple, Facebook and Amazon that are printing money today are what rose from the ashes.  Even with our crappy housing market and global financial contagion, America’s power to innovate is still the envy of the world.

So whatever you might think of current valuations in tech, they represent investment in people and that’s never a bad thing.

– Greg

8 Responses leave one →
  1. June 8, 2011

    Nice post Greg. With regard to your last point, there are a few people that argue that bubbles are an essential part of figuring out how new innovations are going to work, including my colleague Jason Potts. He outlines some of his thinking in this talk – starting 15 minutes in:

    http://www.cis.org.au/media-information/videos/76-asset-price-bubbles-and-financial-markets

    He’s been arguing for a couple of years that bubbles lead to short-run overinvestment that lays down infrastructure that has substantial benefit over the long-run. He built the argument around the first tech bubble, but he looks at bubbles going back to the first recorded property bubble in Rome in 200 BC. It’s an interesting angle, I think.

    [Reply]

    Greg Reply:

    Tim,

    Thanks. I’ll watch the video. I definitely believe in it. However, it does depend on what’s being invested in. The housing bubble, for instance, certainly destroyed wealth (there is no real benefit to people paying $500K for a $300K house).

    Nevertheless, in emerging areas I think that the principle generally holds.

    – Greg

    [Reply]

    Tim Kastelle Reply:

    To me the housing bubble is the most ambiguous example. The first question that Jason gets in the Q&A section is about that exact issue. It’s only a 13 minute talk, by the way, with 30 minutes of questions at the end…

    [Reply]

    Greg Reply:

    Thanks Tim. I’ll watch it with pleasure!

    – Greg

    Greg Ivanov Reply:

    Tim, there is an interesting article on the legacy of cycles and bubbles and the conclusion there strikes me as quite pertinent: http://www.businessweek.com/magazine/content/11_17/b4225060960537.htm.

    Greg, it seems a bit strange to talk about the bubble (or lack thereof) without mentioning Groupon. Things there surely looks a lot more iffy (to say the least), and its stock performance will probably be quite a big indicator for the market stability. What are your thoughts?

    Greg

    [Reply]

    Greg Reply:

    Greg,
    Thanks for the Businessweek article. I just tweeted it.

    The reason why I didn’t mention Groupon is because I don’t know very much about it. I don’t live in the US so don’t use it or competing services and I haven’t checked into their numbers.

    In any case, I doubt it will be an indicator of much. It’s a hot stock that created a new category (and one which everybody else is jumping into). There’s high expectations and not much info to go on.

    – Greg

    [Reply]

    Greg Ivanov Reply:

    Greg,

    I think you’ve hit the nail exactly on the head: Groupon is a hot (probably too hot) new stock, numbers are vague, so is the mid to long term model sustainability. If one looks at the numbers and the trajectory (http://finance.fortune.cnn.com/2011/06/03/groupon-ipo-mind-the-ratios/) it starts looking like Groupon is simply cashing in while the going is good, and riding the wave created by healthier stocks. Groupon just feels too much like a over-valued sham (much more than anything else out there) so the potential for it being a confidence/bubble burster is probably adequate.

    Greg

    Greg Reply:

    Greg,

    Yeah, Groupon’s a tough one, like all start-ups are. They have real revenues, but implied growth expectations are enormous. It’s like trying to shoot the moon. If you’re a millimeter off, you’ll end up thousands of miles off target.

    – Greg

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