A few points about the “tech bubble” debate

Pretty much every day now a major blog or newspaper writes an article asking whether we are experiencing another tech bubble (e.g. see today’s NYTimes). I don’t know whether successful private companies like Groupon, Zynga, Facebook and Twitter are over or under priced since I don’t have access to their financials. Regarding public tech companies, it seems to me that incredibly innovative companies like Apple and Google trading at 19 and 22 P/Es respectively is pretty reasonable.

Rather than take a side on the bubble debate, I mainly just wanted to make a few points that I think should be kept in mind in this discussion.

1) A bubble is a decoupling of asset prices (valuations) from their underlying economic fundamentals (which is why the graph at the top of the NYTimes article today is meaningless). During the housing bubble of 2001-2007, smart economists noted that housing prices were significantly higher than their fundamental value (in housing, a common way to measure this is price-to-rent ratio, which is analogous to price-to-earnings in the stock market). During bubbles, investors stop valuing companies based on fundamentals and instead invest based on the expectation that prices will continue to rise and “greater fools” will buy the assets from them at a higher price. This process is unsustainable, which is why bubbles eventually pop. But when the economic fundamentals are strong, the last buyer can always hold onto the asset and collect a return through the asset’s cash flows, thereby preventing a pop.

2) The forces that drive the internet economy are strong and will probably only get stronger. I argue this regarding online advertising here so won’t repeat it. Since I wrote that post we’ve also seen a number of tech companies emerge that are generating significant revenues through non-advertising means – “freemium” (e.g Dropbox), paid mobile apps, virtual goods (e.g. Zynga), transaction fees (AirBnB), etc.

3) I think it’s a good thing that the speculation on large private tech companies is happening in secondary markets where the risks are being taken by institutions or wealthy individuals. This is in stark contrast to the dot-com bubble of the 90s where many of the people holding the bag when bubble popped were non-rich people who bought stocks through public markets. Obviously this could change if we have a bunch of tech IPOs.

http://20minus.com Thanasis Polychronakis

These are true facts Chris i totally agree with you. The weird thing is that there are no real numbers to back the “internet bubble” craze…

What is indeed “bubbly” is the start-ups’ valuations and this has only to do with the pure offer / demand principal of trade.

Which leads me to intuitively believe that the whole internet bubble story is generated and orchestrated by a few old-timer investors who try to scare out new comers in their market (of investing). Their in-experience may result in taking the “internet bubble” “phears” seriously and backing off from aggressive tactics, thus in the medium / long run driving valuations down…

just my $5 (used to be 2 cents)
http://www.aaronklein.com/ Aaron Klein

If there is a bubble, it appears to be only at the early stage. As good of an entrepreneur as Bill Nguyen is, it’s hard for me to fathom a $41MM 27-employee pre-launch startup.

I don’t see that kind of froth once you get past the front end. Groupon, for example, turned out to have revenues that could justify a $6 billion offer from Google. And many of the other fundamentals appear to be there as you eloquently stated.

So the real question is, if we do have an early stage bubble, will it just recede a bit as the bad bets don’t pay off, or will it truly pop and really thin the early stage crop?

I really hope it’s the former…

http://www.cdixon.org chris dixon

I would also say that even if you argue there is an early stage bubble (not saying I am) it is most likely concentrated amongst some top entrepreneurs/talent and in the b2c social media sector.

http://www.aaronklein.com/ Aaron Klein

That’s a very good point and I think you’re right.

The problem, of course, with defining that as a bubble is that ALL early stage financing is divorced from fundamentals, at least from a financial perspective and usually from a traction perspective too.

That’s certainly the case with Color, but that could turn out to be the best bet Sequoia has ever made.

That’s what leads me to believe (and hope) that we’ve just got a nice swell in the level of early stage activity that might nicely contract and re-expand over the next few years as the supply of new startups and the supply of investors shift.

http://twitter.com/rzsyd Reza S.

Facebook’s revenue was $1.2 to $2 billion in 2010. Let’s be optimistic and say Facebook earned 1 billion out of that revenue, then the private market valuation of $65 billion gives Facebook a P/E of 65. Those who say we are in a social media bubble do not believe that Facebook can outpace other tech companies like Google or Apple in earnings growth or at least not by a high margin. This is even more critical for a company like Groupon since it can increase revenue without increasing earnings. So, whether we are in a tech bubble or not only depends on your belief in the earnings growth of these companies over the next few years.

http://www.cdixon.org chris dixon

FB has a lot of revenue opportunities it hasn’t even started yet: off fb.com display advertising, payments etc. I expect revenue to grow linearly as they scale and in steps with new rev channels.

Anonymous

What kind of argument is that, seriously??!! You can basically say that about every web company out there…what matters are the FACTS, what they can really do to generate revenue NOW, and right now they’re generating revenue from shitty, clunky advertising system and zynga games. This is a 7 years old company after all. And so far their only ideas to generate revenue is to copy what groupon, foursquare and google did. If those are strong financial fundamentals that justify 50-80 billion valuation then I’m freaking Bill Gates.

http://www.cdixon.org chris dixon

It’s widely believed in tech circles that FB has a bunch of major initiatives lined up and has prioritized user growth over monetization for past few years. Perfectly rational to include knowledge like this in a stock valuation.

http://florianfeder.org Florian Feder

Thanks, Chris, agree with all your points with respect to a possible bubble in general. With respect to Facebook in particular, though, you are, in my view, missing one important fact: Facebook insiders and early investors want to sell!! Facebook is planning an IPO, which is nothing else but a sale of the company. The people who know most about the company will, at least to some extent, cash out. If they really believed that FB had “a bunch of major initiatives lined up”, then they wouldn’t sell.

Reminds me of Blackstone’s IPO. Perfect timing on the part of its founder, Steve Schwarzman. He sold his business at the absolute height of the private equity boom at the best possible valuation.

http://www.facebook.com/people/Natalie-Newton/100002033811621 Natalie Newton

It doesnt matter though does it, because at the end of the day, facebook are earning the money, no matter what they do, so they’re clearly doing something right. I would much rather be in their position than mine. You cant criticise a company for earning money. they havent been deceiving, they have sold a product that people want to buy.

http://www.facebook.com/eugenia.cosinschi Eugenia Cosinschi

That’s exactly how you defined the bubble: valuation based on expectations rather than fundamentals.

http://www.facebook.com/people/Ron-Williams/1094253462 Ron Williams

IF there happens to be a bubble building it is very likely a good ways off before a pop occurs. As Chris points out there are very strong fundamentals driving the early winners and most importantly the market of Internet users is now global (back in 1999-2000 it was mostly US users everyone was betting on). So a couple of things to consider: 1. IF its is a bubble, it will likely get as big or bigger than the 1999-2000 one before it pops so 2. we would be in the very early beginning of it with some people just trying to call it early (impossible to distinguish them from just Chicken Littles – even if a bubble pops in 5 years and they are ultimately proven “right”).

Keep in mind that markets have histories of ups and downs. A correction of the current valuations of Facebook, Twitter, Groupon, and the like would not likely be the bubble popping, but a time to buy in to these strong companies (well Groupon is a bit different as they have yet to moat their huge business built on first mover advantage). And regardless if we are in a bubble or not we can expect the quality of companies driving the market higher to decline in value – this is the nature of supply and demand driven markets of all kinds – there are only so many good customers with only so much spending capacity.
http://www.kidmercuryblog.com kidmercury

totally a bubble. all you have to do is look at money supply figures, which are at all time highs. then track where this money is coming from…..it’s obvious. the global economy is in the midst of a massive restructuring. the US will not recover until debt problems are drastically reduced.

it is also important to note that a bubble borne out of monetary inflation (expansion of the money supply) is basically a transfer of wealth. cost of living rises with valuations, thus representing a transfer of wealth from everyone to the bubble shareholders/flippers. only way to solve the problem, assuming anyone actually wants to, is by fixing monetary policy.

http://www.cdixon.org chris dixon

Not sure I get your low interest rates -> investors like VCs having more money argument….

http://www.kidmercuryblog.com kidmercury

all money is loaned into existence, and thus money supply is largely a function of the price of debt. the cheaper debt is, the more money will be created. all money trickles from banks down. we can see this clearly in the current bubble, with goldman money (which includes milner) and jp morgan being big drivers and direct participants. low interest rates also make VC a more appealing asset class relative to debt/cash, thus enabling larger VC funds.

http://www.cdixon.org chris dixon

definitely agree some of the money here comes directly (TARP) or indirectly
(lack of regulation etc) from government bailouts.

also agree low interest rates are making these “alternative” asset classes
more attractive.

I have trouble with the 3rd argument. I know for example where Founder
Collective $ came from – mostly years of toil of entrepreneurs. I suppose
it all originated at a bank somewhere, but it seems like you can’t blame the
kids of the sins of their fathers.

http://www.kidmercuryblog.com kidmercury

indeed, can’t really blame the children for the sins of the father,
but there is the question of how the problem is going to get solved.
there is also the issue that while some of the flippers will make
money, the valuation process is distorted as a result of all this hot
money and capital becomes increasingly inefficient in its deployment.
if the market were setting interest rates, or if a hybrid approach
that showed greater respect for the market was utilized, we would see
greater constraints on money supply and something more akin to a
deflationary spiral. this would enable debt levels to fall, prices to
fall, bad assets to be liquidated and fall to their appropriate
prices, and then we could work our way back to a bull market after
clearing the system out. now we just have all this crap in there and a
bubble borne out of forced money supply expansion. the end result is
significant profits for some of the flippers (who end up timing it
properly), higher valuations across the board in the dot com sector,
higher cost of living for everyone, and in the end, more debt and more
malinvestments that need to be liquidated. anyway, i think we’ll see a
global currency crisis within 2 years. and perhaps therein lies the
opportunity to free ourselves from the endless cycle of
bubbles/busts…..

http://twitter.com/JRalphHamilton Jamie Hamilton

We might have overvalued companies, but we don’t currently have a bubble. There’s a big difference.

At the peak of the last tech bubble there was a double decoupling. Professional investors who knew companies were garbage invested anyway, because they were making big profits flipping. Then less professional investors piled into short positions, and were mercilessly squeezed in early 2000. As they were forced to cover, the stocks shot ever higher, and the Nasdaq peaked over 5000. As of now, we don’t have the kind of flipping and covering that makes for truly crazy prices.

Most of the people holding stocks now believe in what they’ve bought. They might be wrong, in which case the stock is overvalued. But they aren’t buying out of cynicism or desperation — and that’s what you need to blow a bubble.

http://www.cdixon.org chris dixon

great comment, thanks.
http://www.spotsift.com Peter Chang

I mostly agree with what you said but one thought that came to mind when I read, “Most of the people holding stocks now believe in what they’ve bought.” was Yuri Milner’s blanket $150k investments in all YC companies. I doubt he believes in all those investments (maybe belief enough to put in that amount and not afraid to lose it).

Of course, it’s probably small change in the scheme of things for him but the general concept of loose buying is something I wanted to point out.

http://twitter.com/JRalphHamilton Jamie Hamilton

Yuri Milner believes in Paul Graham — any LP knows it’s more efficient to believe wholesale rather than retail. The YCombinator thesis might be wrong, but it’s absolutely not cynical. If you believe it, than $150K per newco is a reasonable bet, because one big hit will pay back the entire investment with interest.

It will also give Milner entree for late-mezzanine investment, which might be his real goal.

http://www.spotsift.com Peter Chang

I understand that when you look at the difference in the details it makes sense. I also understand some of the possible motivations for Milner to do what he did.

But buying by proxy is also not the same thing as believing in companies you invest.

I wasn’t claiming it to be cynicism but relating it to your point about decoupling. In my view, there was a decoupling during the last bubble where people were buying just to buy or buying what looked sexy instead of buying on fundamentals or buying what they understood. It’s to this type of decoupling that I point out Milner’s blanket investments.

In a way, you could say that PG has almost become Milner’s money manager for a small fund. It’s not a bad bet.

Obviously, if he makes one hit then he’ll make his return on investment. But isn’t that sort of logic true for your typical personal investor particularly during a bubble? All it takes is that one stock in their portfolio to double and it pays off all the other bets. Again, this illustrates the danger in this sort of thinking.

http://twitter.com/JRalphHamilton Jamie Hamilton

Got to disagree with you here. Other than an index fund, the best possible way to invest is via a proxy with a well-reasoned thesis, a track record, time for diligence and company support, etc. No individual can develop the expertise to manage a diverse portfolio in their spare time.

I don’t think you can compare this to retail investors buying random stocks based only on buzz and a chart line going up.

http://www.spotsift.com Peter Chang

You use the term “proxy” quite loosely. Maybe if you’re talking about an investment fund or a venture capital firm as a “proxy”, then I would agree. But that’s not the same as a blanket investment in companies that come out of an incubator program.

Just to clarify, I wasn’t comparing _that_ (funds or firms) to buying random stocks based on buzz and charts. I was comparing Milner’s investment to this.

I guess you just fail to see the analogy (for the record, obviously he’s not a typical consumer investor but you seem adamant in ignoring the possibility that he bought on “buzz and charts.”)

http://www.johnstanderfer.com John Standerfer

Ben Horowitz’s blog (http://bhorowitz.com/), has a good post on this as well where he points out how aggressive the valuations of public companies were doing the .com bubble. Many were trading at higher multiples of revenue than they are currently on profits.

I think the real debate today is not on overall valuations, but on the specific sector of social media. How will social media be monetized and how profitable will it be are questions no one knows the answers to. Since this is still a nascent industry it means there is a very wide range of investor expectations since there is very little previous data or experience to base estimates on. This wide range is why very smart people are lining up on both sides of the “are we in a bubble or not” debate.
http://technbiz.blogspot.com paramendra

Some real wealth is being created. But there is some accompanying froth. Can’t avoid that part.

http://www.cdixon.org chris dixon

Agree, some real, some froth.

http://www.spotsift.com Peter Chang

Bubble or not, I think the thing to watch out for is where the money is coming from. That’s how things become a bubble.

In the last tech bubble, it was everyone and their dog buying tech stock with their retirement money. With the housing bubble, it was massive parts of society who don’t have the financial footing to own a home (at least not what they were paying for it). There’s this crowding effect with every perceived gold rush that pushes up valuations at an abnormally high rate (I use the word “abnormally” pretty loosely since there is no normal, just economic but hopefully you get the drift).

I’m not qualified to speak about all the firms who’ve been investing in the sexy tech companies in the past few years, but from this article it sounds like it’s a number of large name investment banks and mutual funds. I don’t know the size of their investment relative to prior history but the this scares me.

As quick as these huge players come in, they can leave and create a lot of volatility (and uncertainty). There’s also the issue that this has been playing in the private markets and not the public ones but a few of these companies are going public soon.

I fear that the combination of these factors are/will lead to some tech bubble. No bubble is the same so it won’t be 2001 again but I think there’s a real possibility of some kind of limited fall-out in the next 3-5 years.
http://twitter.com/expertio Expert.io

To me, it feels like everyone who is looking for fund hope that they could be included in the bubble.
And to those who are watching everyone else getting funded, they wish the bubble could burst asap.

By the way, we are the ones looking for fund! http://expert.io – Marketplace for your expertise.
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http://tradewithdave.com Dave Harrison

Chris:

You nearly got it right. You said, “I think it’s a good thing that the speculation on large private tech companies is happening in secondary markets where the risks are being taken by institutions or wealthy individuals.” Unfortunately, due to the reality of “too big to fail”, these institutions and wealthy individuals that are risk-on in your scenario are the same institutions and individuals that were bailed out and continue in a perpetual open market operation of fraudulent wealth transfer. The risk rests on the shoulders of anyone who still believes in the dollar as the world’s reserve currency and the full faith and credit of the U.S. government, namely the American taxpayer.

If you want to know why there is a bubble in tech, you need to admit the phantom value created by false imprisonment of individual profile information and its monetization through the means of behavioral economics based on a “choice architecture” of scarcity and duopoly is eroding. Profile portability is rising in the consciousness of users and when the inevitable jail break ensues (either through reform or sheer revolt), the prisoners will be taking the value of their slave wages with them. Think health information portability or mobile phone number portability as two examples of what’s coming to the future fo social tech.

For more on the topic click here: http://tradewithdave.com/?p=5846

Dave Harrison
http://www.tradewithdave.com

http://www.cdixon.org chris dixon

re banks: i supported the initial bailouts when it seemed the entire
financial system was collapsing and we were on the verge of massive “bank
runs” throughout the economy. I was, however, extremely disappointed to see
that after the crises was averted the government allowed these banks to keep
their same structure, remaining “too big to fail,” and pretty much go on as
they were before the crisis. So yes, you are right, a decent amount of the
(mostly later stage) speculative capital in tech markets come from ill
gotten gains. Espeically the stuff being traded through secondary markets.
FWIW, most top VCs get their money from university endowments and state
pension funds, a more benign source of capital imo.

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http://mattlanger.com langer

Regarding your third point here, and even though I’m in complete agreement with you regarding all this misdirected “bubble” hype, I’ve had exactly the opposite concern when it comes to the hypothetical pop, namely that all this activity going on in secondary markets which is driving valuations upwards could produce a situation where a sky-high IPO self-regulates and comes back to earth a little bit, albeit at a point where those elite investors who had early access (via Goldman’s vehicle, as an example) are able to get out and make a handsome profit while the average investor is left once again holding the bag.

http://www.cdixon.org chris dixon

I agree and worry about that too- if we see these companies all go public and P/Es are way too high.

Anonymous

Chris, what I think a lot of the debate is missing is that although the technology opportunity in web 2.0 companies is huge the valuations of the indivdiual companies can be argued to be full. In other words, if we all agree that social networking will be worth over $50 B, we all won’t necessarily agree that Facebook will dominate it ten years from now on. It may double or triple over ten years but given the amount of change inherent in the web and the tail risk that most web companies won’t be around in 10 years or 20 in the same form as today the debate on valuation is interesting. Who knows, I think it is hard to call it a bubble, maybe reasonable speculations… – Adrian Meli
http://hapnin.com/users/2 theschnaz

Do you invest in public companies and if so do you have some type of framework you can share?

I’ve been using stocks2own.com for technical indicators for trades. I also like the 90 day moving average for $SPY.

I would love to hear more about this!
http://jaxn.org Jackson Miller

As a founder of a recently-funded startup, I appreciate your separation of the valuations in private markets vs the value being creating by leveraging new technologies.

The fundamentals of entrepreneurship haven’t changed – creating new efficiencies makes money.
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Anonymous

I just met with an entrepreneur whose developing a SAAS product in the health care space. He said that he met with a group of silicon valley VCs who were creating a small fund to invest in the health care space. All of the VCs’ experience had been in consumer tech, they had NO experience whatsoever in health care.

Have you seen this anywhere else? It just seems to spell bubble to me in that we have people with no relevant experience putting cash into deals they may not fully understand, despite being very smart.
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http://twitter.com/spcohn Steven Cohn

looking at PE ratio is not the right metric. i know chris mentioned pe ratios in his post, but a pe ratio is only half the story. the better metric is PEG (or PE to Growth) ratio. the point is that a company growing 100% y/y should be trading at a 2x multiple to one growing 50% y/y. that is rational if valuation is simply a discount of future cash flows.

as for fb. they are just beginning their business model. in a few years, they will be one of the largest banks on the planet. just watch.
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http://www.connectme360.com Anonymous

I’m reminded of the crash in retail real estate stocks wayyyyy before the Internet reared its head (and I interned at a supercomputer startup back when it was still called ARPAnet). The prevailing logic was that people would continue to need goods and that more sophisticated approaches to shopping would result in greater yields. After they tanked, Monday morning quarterbacks opined that speculative bubbles were minimized when the investment was being made by professional investors instead of public markets.

I do see a huge as-yet-unrealized opportunity in the space some people call “curation”. The growing addressability of documents (Internet), people (Facebook/Twitter), physical objects (RFID, the “Internet of Things”) and even intangibles like sentiment and intent are powerful enabling forces. But just because the value has yet to be harvested does not mean it is invulnerable to an external event.

The conceit of anyone living in a bubble is that we have access to perfect market information and consequently we rationalize all of our decisions are sound. I do not believe the marketplace adequately recognizes the structure of information vending companies, specifically the winner-take-all nature and the nearly monopolistic returns that can be realized by the winners. But I also don’t think the market appreciates the rapid reversals of fortune that can take place. Today’s supply chains are optimized for a given set of circumstances, yet are vulnerable to black swan events, as recent events in Japan have shown. One black swan event means someone somewhere is going to have a bad day, but what happens when two or three happen at once?

The last time we put all of our eggs in one basket was in a little place called Alexandria. The mission of the Library of Alexandria was to “(collect) all the world’s knowledge”, and one of its last known acts before it burned reminds me of the little juke Google tried to do recently with out-of-print books.
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BuyGiftsItems

I had exactly the opposite problem when it comes to pop hypothetically, that all this activity happens in secondary markets

a deal a day
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Chris Dixon

A few points about the “tech bubble” debate