Digital Valuations: More Insanity or Too Low?

Déjà Vu All Over Again?

Some analysts of the technology market are starting to repeat this witty little comment by Yogi Berra. They think it might be an appropriate question to ask concerning the rapidly rising valuations of technology companies, particularly with the recent purchase of WhatsApp by Facebook.

It’s somewhat ironic to realise that many of the current digital entrepreneurs weren’t even out of middle school during the now infamous Dot-Com Bubble that burst in 2001. The irony is that many of the venture capitalists who made fortunes during that period and swore “Never Again” are now fueling this current round of valuations. For those with short memories, this was the era when a company could add millions or more to their market value simply by placing an “e-“ or “i-“ in front of their name with a .com on the back. The impetus for that round of speculative growth was the first public awareness of and commercialisation of the World Wide Web, or Internet. The period created an entire generation of entrepreneurs who disdained the need for profit and focused more on the “number of eyeballs.” That single metric encompassed a view of almost limitless potential of the new online world. Nothing captures the loss of reality during the boom like the purchase of Time-Warner by AOL, destined to be the worst business deal in history from a valuation perspective.

Round Two?

As everyone knows, Wall Street has a very short memory. Dot-com was a curse word by late 2001, and tens of billions of dollars of value were written off from portfolios containing Internet stocks. Even companies with operating revenues saw a loss of 90 to 95 percent of valuations, with Amazon dropping from $107 to $7 a share. However, only three years later Google went public in 2004 with a successful IPO, and overall prices of shares in companies surviving the crash slowly rose to highs greater than their peaks during the bubble. As a number of companies continued to test the IPO waters, LinkedIn went public in 2011, boasting a one-day increase in its $45 offer price of 109 percent. In 24 hours a company with only a $15.4 million profit was worth nearly $9 billion. However, as many were quick to point out, it did at least have a profit, no matter one so relatively small. To many, there were concerns among the celebration. Those were expressed by individuals who remembered the Netscape IPO of 1995 and how it seemed to be the bellwether of a frenzy leading to the crash.

Visionary or Fool Me Twice?

This progression of successful offerings set the stage, of course, for the later offerings of Groupon and FaceBook. The bumpy road of both Groupon and Facebook served to slow the fever, but only for a while. The slowly recovering economy and increasingly positive profit reports have fed the current run up in valuations, leading to the stunning purchase of WhatsApp by Facebook for $19 billion. While the announcement has spurred an avalanche of discussion on both sides of the question of the wisdom of this move, there are some real differences in this valuation and some of those during the Dot-Com Bubble. Instead of a mere concept, WhatsApp has over 450 million global users in a texting market that generated an estimated $120 billion for telecom companies in 2013. They also claim to be registering more than a million new users a day. But, others ask, $19 billion? It’s really hard for anyone to grasp the meaning of such numbers. It helps to provide a yardstick, however. An article in Forbes points out what this number represents. Facebook is paying $42 per existing user, and this for a company with only 55 employees. Certainly the management of and investors in companies such as American Airlines, Marriott International, Campbell Soup and others (like the venerable Coca-Cola Enterprises) are looking on with disbelief. These asset-dependent companies all have valuations less than the announced purchase price for WhatsApp. Others are asking similar questions. An incisive article on the financial analysis site ZeroHedge recalls when AOL purchased ICQ for over a total of $400 million to obtain its 12 million users. That deal, of course, proved to have essentially no value to the purchaser. The author also references a Wall Street Journal infographic showing 36 startups worth more than a billion dollars. Few have heard of these, such as Xiamoi ($10 billion), Spotify ($4 billion), and Palintir ($9 billion). Even this WSJ article points out, however, the difference in some of these companies and those insane valuations of Internet Bubble One. For example, Dropbox is one of the companies on the list with a valuation in excess of $10 billion. It has reported revenue of $200 million. While still an incredibly high multiple, it is at least on a real company.

Efficient Use of Capital

Adam Smith’s Wealth of Nations dealt with the issue of the efficient allocation of capital. The concept of the Invisible Hand gives a name to market forces ensuring companies with the right to capital will receive it. For generations, this meant to many providing the money to build GM’s factories and purchase American Airline’s airplanes. Today, however, Apple sells millions of phones and tablets and uses the billions in excess cash they generate to buy back its own stock, deeming that a better use than more factories. Likewise, Google spends $3.2 billion to purchase Nest, a bricks-and –mortar business on the periphery of technology. The large amounts of private equity flowing into these companies with extreme valuations are evidence of the many believers in the new digital economy. Wiser in many cases because of the first bust, these investors are at least making the effort to look at fundamentals in most of these companies.

A Return on Investment

There are two basic way to view the current valuations and trends. First, as in the Dot-Com Bubble One, many venture capitalists have already banked billions on profits in the current and near-term IPOs and acquisitions. When they make a paper play on equity investments and properly position themselves, the ultimate issue of success of a company is secondary. It is, in fact, this reality that fuels speculation. The only essential thing is to avoid being the last seller before a crash, not the last buyer. From the fundamental perspective, however, the ultimate test of any company is its ability to generate a consistent stream of growing profits. Bricks-and-mortar companies often require large amounts of capital and hard assets to generate that return. In contrast, if a company such WhatsApp does build a base of a billion or more active user with a couple hundred employees and a few million invested in servers, that’s a game changer. If profit is the ultimate name of the game, and it most certainly is, that means earnings must ultimately support the current valuations. After all, the price paid for a share of stock is supposed to represent the net discounted value of a future stream of earnings. Period, end of discussion. In other words, Facebook is expecting to generate enough earnings in the future to fully support its valuation of WhatsApp, or any other acquisition.

The Goose Keeps Laying

There is no better single metric to evaluate today relative to that reality than one stunning number from Apple’s latest quarterly report. Amongst all the media attention over a $19 billion purchase by Facebook, much of it from the value of paper stock, it’s easy to get bored over continued talk about Apple’s cash reserves. According to Bloomberg, Apple added another $12 billion to its coffers in the first quarter of fiscal 2014 alone. That puts it total cash on hand at just under $158 billion. Again, such numbers are meaningless without some comparative standard. Wal-Mart is by far the largest retailer in the world, with thousands of stores, millions of workers, and billions in inventory. All of that capital and hard work generated $17 billion in profits last year, less than 11 percent of Apple’s cash, and only $5 billion more than the cash it banked in one quarter. Apple represents the modern mix of capital and digital valuations. Certainly it is unique in its performance and position. However, there is one important consideration when it comes to capital. Apple simply never needed the proportional level of capital required by the traditional firms of Coke, AA, and GM. If it had, its story would be remarkably different. If there are simple takeaways from the current valuations, there are at least three:

  1. There’s nothing innately wrong or immoral about a WhatsApp being valued at at a greater level than American Airlines, if it’s not another AOL debacle. Only time will determine that reality. That’s why such moves are called visionary and risky.
  2. As Apple and Google show, among several others, the rules of return on capital have changed forever in the digital world. Facebook turned down a high offer for a buyout, and profited handsomely.
  3. The only way to determine if today’s valuations are in the ballpark is to watch for the earnings produced in the coming months. Even if there is another bust, some of today’s valuations, as in the case of Amazon’s rise, fall, and rise, may be too light.
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