In our minds, a recent Wall Street Journal Article entitled “Why This Tech Bubble Is Less Scary” by Christopher Mims is reason enough to believe that the tech bubble just might be as scary as 1999. Those of us old enough to remember Alan Greenspan’s infamous warning that the “markets are suffering from irrational exuberance” are hopefully wise enough to recognize the signs. Arguing that such exuberance doesn’t exist doesn’t make it go away.
We do valuation for a living. We study it, analyze it, report on it, teach it, and testify on it. All day. Every day. For years before the 1999 Dot Com Bubble Bust.
And it’s valuation that drives investment decisions. Decisions to buy. Decisions to hold. Decisions to sell.
Valuation, at its core, is simple. Value equals expected returns divided by the net of expected risk and expected growth in those returns. For example, if expected returns are $1,000 and risk (as measured by a required rate of return) is 15% and growth is expected to be 5%, then the value is $10,000 ( or [$1,000 ÷ (.15 – .05)], simplified to [$1,000 ÷ .10] ). The models we use are more complex to deal with more complex situations but the concept is exactly the same.
So when rational investors are looking for increased value, they are looking at some combination of increased returns, decreased risk, or increased growth.
Most, though, don’t look at valuation in these terms. Rather, the investor community talks about market multiples. A price/earnings multiple of 20 times, for example, is a good buy when the multiple is expected to grow to 25. What many don’t realize is that a market multiple is simply the inverse of a capitalization (or cap) rate. The cap rate is calculated by subtracting growth from risk. In the example above, the cap rate is 10% (or 15% less 5%). That converts to multiple of 10 times. In the market, illustratively, Apple (APLL), whose phenomenal profit margin of 22.5%, trades at about a 12.8 forward price/earnings multiple.
As business valuers, our job is to identify from various sources of empirical and non-empirical sources expected returns, risks, and growth in a particular company, investment, or asset. We use that evidence to derive a value estimate.
In this context, then, what was the irrational exuberance Mr. Greenspan spoke of? In 1999, it was the irrational expectation that growth would continue unabated. That irrational analysis led investors to assume that even if dot coms – the tech companies of that day – did not show any economic returns, now or in the foreseeable future, that the growth was so strong and so great, that once returns did materialize, the values would be so high that even high risk ventures seemed a bargain.
And almost like musical chairs, the greater fool theory kicked in and everyone ratcheted up their investments’ expectations. Then the music stopped. Growth, it turned out, would not continue unabated. Values plummeted, investors sold if they could, and people paid the price for their irrationality. But it wasn’t just tech that was impacted. The equity markets as a whole were impacted.
Fast forward to 2007/2008. Another stock market correction. This time driven by the banking and investment banking industries who again forgot basic valuation theory. This time, they – and the investor community – forgot to estimate risk. In fact, the complex securities created in the early 2000s were so complex, most weren’t even sure how to tag a risk premium to them. Add to that government guarantees provided by Freddie Mac, Fannie Mae and other entities, and the market again behaved irrationally – until it came to its senses, saw the risk, and corrected itself immediately – to the great angst of investors and taxpayers, the latter of which bailed out the banking industry. But it wasn’t just banking that was impacted. The equity markets as a whole were impacted.
So where does that leave us in 2015? Mr. Mims says that if we’re in a bubble, it’s nothing like 1999. We’re not so sure. In 1999, investors were pricing tech startups by a “click through” multiple – implying growth, not profits were important. Today, pre-public company deals are priced and transacted in terms of revenue multiples, which implies profits are not important. Grow the top line and grow the value.
For example, we recently valued a tech company that provided a SaaS-based CRM (customer relationship management) product. We looked a 6 publicly traded companies in that market space. Four out of the six have never shown profits. The largest, with a market cap of $46 billion (yes billion) has never shown a profit. Their valuation averaged 8 times revenues (not earnings), with two of the six at double digit multiples. The six average $1.2 billion in revenues and a market cap of almost $10 billion. None are forecasting any meaningful profits.
Compare that to Apple, with its way above market returns, it trades at 3.4 times revenue. And that’s a healthy multiple when compared to AT&T (T) at 1.4 times revenue or Ford (F) at 0.4 times revenue.
Going back to the price/earnings multiple, for these six companies, if we assumed a much better than actual normalized profit margin of 12 percent, that would translate to a price/earnings multiple of nearly 100 on average. That’s 800 percent more than Apples price/earnings mutliple.
Mims’ point that the bubble is not as big is accurate, but only as far as his explanation goes. Transaction pricing based on unsustainable multiples for these companies filter into the market as investors and their advisors value the future exit prices on irrational multiples that cannot be maintained or on profits that have never been proven are not nearly as large a portion of the market as they were in 1999.
However, a rising tide raises all ships. Including all the retirement money in the market today that wasn’t there in 1999. So just as we’ve seen twice in the last 15 years, it’s not just tech that will be impacted when the bubble bursts. Regardless of the size of the bubble,the equity markets as a whole will be impacted.