Inflated Tech Valuations Bloat The Entire Economy

Six year old Airbnb is now worth more than some 50 year old hotel chains --without owning a single bed, room, or building.

— Jeremiah Owyang (@jowyang) April 18, 2014

Hard to read around Owyang’s smiling Twitter pic, but the tweet sounds proud, boastful, even.  As if this is as good as it gets.  And why not?  After all, tech analysts are pleased when one of theirs hits it big.

And yet I’m troubled by the astronomical valuations in tech.  Tech isn’t separate from the rest of the economy.  Inflation in tech bleeds into, pumps up, infuses other sectors.

Goodness knows, there’s plenty of funny money out there.  With the Federal Reserve holding interest rates close to zero, the Treasury is able to drive an almost infinite number of dollars into the economy so as to inflate U.S. debt out of existence.  In reaction, there ought to be rises in price levels, since an ever larger pool of dollars is chasing roughly the same pile of goods and services.  But since money is merely an agreement among transacting parties, we’re all holding the values of common purchases fairly close to steady.  Amazing, really.  This stable state will last until trust evaporates.

But meanwhile, another sort of funny money is causing distortions at the high end.  And that is the over-inflated stock of tech companies.

For every deal — like eBay’s purchase of PayPal or YouTube’s acquisition by Google — that justifies a high valuation by eventually paying out, there are a dozen more that are just wildly out of line.

The poster boy for arbitrary and bloated valuations is Mark Zuckerberg.  His company, Facebook, has been on a veritable spree, buying 46 companies in the past decade.

Exhibit A: Facebook’s purchase of messaging platform WhatsApp for $19 billion early this year —$12 billion in stock, $4 billion in cash, and $3 billion more in restricted stock.  Newsweek describes all the things Facebook could have bought with that money other than a messaging platform.  Things like a passel of double-decker Airbus A380s, an aircraft carrier, or vaccinations for every child in the world.

Facebook’s two-year chart shows that, while there’s definitely value there (63% revenue growth in the December quarter on a base in the mid-single-digit billions), it’s been blown all out of proportion.  Facebook has a trailing price-earnings ratio of more than 100, no dividend, and earnings per share of a mere 61 cents.  Facebook’s valuation ($156 billion market capitalization) is all about belief in the future.  The market has for the most part bought into the narrative about Facebook’s being a platform for a vast array of other services over time.

But when Facebook takes its own inflated stock and buys other companies with it, the infusion pumps up the price of that company past a “reasonable” level and infects other companies in the sector and even adjacent sectors.

There’s no way Oculus VR is worth anything like the $2 billion that Facebook is offering for it.  The company has no revenue, no product on the market, and an unproven technology.  Does this mean that Microsoft and Sony can spin out their virtual reality headset groups as multi-billion-dollar companies?

To be clear, Facebook isn’t the only one.  Google has bought 147 companies over a 15-year period, often with stock.  And, of course, Apple and Microsoft have been big buyers over the years.  Apple, among the crowd, gets credit for showing some restraint, paying reasonable prices for assets that fit well with the company’s long-term strategy.  But Google’s purchase of Titan Aerospace is for what again?

Part of the problem with all this inflationary buying is that We The People aid and abet it.  People want Zuck to be a genius, not a fraud or silly person.  This type of thinking leads to the Silicon Valley ethos whereby these Masters of the Universe appear to be telling the rest of us, “It’s so clever that you can't possibly understand it.”

In reality, deals are done two ways: when the Master of the Universe cares and when he doesn’t.

When he doesn’t, bankers and lawyers run the show.  Valuations are derived from spreadsheets: some figure times earnings before interest, taxes, depreciation, and amortization (EBITDA), down to five significant figures.  Never mind that many of the assumptions are bogus.  The lawyers and bankers argue with the target, fudging the assumptions back and forth.  But these valuations are at least tacked to something in the mortal realm.

When the UMaster does care, the deal is just a made up number that he pulls out of his, er, pocket.  All caution is thrown to the wind, and the bankers and lawyers scramble to back-fit the spreadsheets and assumptions after the fact.  The back-fitting occurs because everyone needs to be covered.  Everyone except the big guy, that is.

(I say “he,” by the way, because this behavior is mostly male.  However, a tip of the hat to Marissa Meyer, CEO of Yahoo , who seems to have acquired an expensive taste in company shopping, too.  So, there's at least one Mistress of the Universe.)

The inflation factor seems to be about 100x.  Try this on for size: Oculus at $20 million.  Sound about right for a company with no revenue, etc.?  WhatsApp for $190 million?  That’s still a lot of coin for a messaging app.

With billionaires as thick as blackberries on the vine, this type of overvaluation can’t be good for the rest of the economy.  Only time will tell whether these fat birds come home to roost and we find ourselves buying chicken at $500 a pound.

Twitter: RogerKay