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.
- 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.
- 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.
- 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.