Growing pains: dot-com bubble 2.0?

Back to '99

When I began my career, many of the old rules on valuation - like the ones we've discussed in this week's lead feature - had been temporarily abandoned. Market capitalisations were now decided by clicks and eyeballs, not the cold hard business of generating cash. Companies that had never made a profit were coming to market and raising billions, in the belief that the internet would rent asunder the old economy and these technology upstarts would take over the world.

Hindsight has demonstrated, of course, that there was some truth to this. The internet has had a profound effect on the way the world works, deeply ingrained in our lives whether we're shopping, driving or reading a book. And companies such as Amazon (US: AMZN), eBay (US: EBAY) and Google (US: GOOG) are among the most valuable on the planet as a result. In fact, if you had invested in the IPOs of these three companies you would have made a small fortune as the table (below) shows.

What a $1,000 investment at initial public offering would now be worth

Wall Street washout

Yet for every Amazon or Google, there were dozens of other technology and internet companies that fell by the wayside. But pre-1999 there was little recognition that this could ever be the case - a stock market mania had set in that sucked in billions from people who had never invested before, and who subsequently bid up even the most speculative new economy enterprise to huge valuations.

There were, of course, those that saw it coming, and refused to believe that the fundamentals of valuation had changed. One of these was Aswath Damodaran, whose 1999 paper 'The Dark Side of Valuation: Firms with no Earnings, no History and no Comparables' became essential reading for young analysts like myself attempting to get to grips with what instinctively felt like a crazy situation.

Professor Damodaran was concerned at "the inability of traditional valuation models to explain the stratospheric stock prices of technology companies" and "the willingness of analysts to abandon traditional valuation metrics and go over to the 'dark side' of valuation, where prices were justified using a mixture of new metrics and storytelling". While he believed that young companies, or those with negative earnings, could be valued, it wasn't straightforward - as a result, he argued, Wall Street, utterly blinded by greed, had become lazy in the way it approached setting realistic prices for these new enterprises. The phrase 'new paradigm' was regularly trotted out to explain the inexplicable. And when greed meets such mass-delusion, disaster usually follows.

Is Twitter a bubble?

So, has the market lost its mind again? 2012-13 has certainly been a big year for IPOs, including several in the social media space - and, according to analysis from Jay Ritter at the University of Florida, nearly two-thirds lost money in the year leading up to the IPO, "the highest percentage since 2000". With Professor Damodaran's concerns in mind, it's worth turning back to Twitter to see if history is in any way repeating itself, and whether investors are deluding themselves as to the extent of its potential. Max Wolff, chief economist and strategist at ZT Wealth, certainly thinks so, describing the IPO as "an emotional event, not a fundamental event".

But there are many who don't agree, and who suggest that those harking back to the dot-com boom to build a bear case against Twitter are missing the point. "Businesses like Twitter and Facebook can demonstrate their numbers of users and their popularity and this is fundamentally different to the stock market assumptions during the technology bubble of the '90s where successful adoption by the public was a given which failed to materialise," says Guy Stephen at wealth manager Rowan Dartington Signature. "Twitter, like Facebook, is the future of social communication."

Twitter is unquestionably a unique phenomenon, hence the huge interest in its flotation. It boasts 230m users, a figure that has doubled in the past year, and their engagement with the social media service is high - so while it has fewer users than Google's foray into social media with Google+ its users spend nearly 40 times longer using the service each day. It will generate sales of about $630m on that this year, derived exclusively from advertising services first introduced in 2011, four years after Twitter was founded. Those revenues are expected to double over the next two years, as its user base and suite of advertising products grows - this includes expansion of its data licensing, which accounts for two-thirds of its valuation and which to many stands out as the most unique element of its proposition. What's more, following its wildly oversubscribed IPO, it now has $1.8bn to invest in growing these revenue streams.

Even more importantly, sales are anticipated to grow at a much faster rate than its cost base, much of which remain relatively fixed. Indeed, Twitter's gross margin is expected to move much closer to the 75-90 per cent achieved by peers, so that by 2015 it is expected to be turning a profit.

The story, as one media outlet put it, is "seductively simple". But that in itself is one of the lures of the dark side that Professor Damodaran warns of, because it encourages investors to adopt a less rigorous valuation approach rather than take on the hugely challenging task of really valuing a company like Twitter. And one suspects the retail investors piling into the IPO at $45, which marked the cheapest first day entry point for many, have not taken the time to get to the bottom of an extremely challenging valuation.

In fact, without any meaningful cash flows - and only a few comparable companies to benchmark it against - deriving a valuation for Twitter is less science than art (although arguably there is a little art in all valuation). But even the few comparables we have suggest profitless Twitter is somewhat expensive; the 2014 price to-sales ratio is almost double those of LinkedIn (US: LNKD) and Facebook (US: FB), while revenue per user is considerably lower. Bulls would point, perhaps, to the faster sales growth rate, and suggest that it is still early days when it comes to monetising its fast-growing user base, and especially its international user base which now accounts for nearly four-fifths of the total but generates less than a quarter of sales.

Noise overload

Even if we accept that Twitter's business model is more robust that those of the dot-com bubble era, and it does indeed have such strong growth prospects ahead of it, that does not mean that a valuation reached through such diligent analysis would be correct. As Professor Damodaran puts it: "The noise in these valuations is such that no matter how much information is brought into the process and how carefully a valuation is done, the value obtained is an estimate. Thus, investors in these stocks will be spectacularly wrong sometimes, and it is unfair to judge them on individual valuations. They will also be spectacularly right in other cases, and all that we can hope for is that with time as an ally, the successes outweigh the failures."

What he means is that by the very fact that the variables that determine such valuations are somewhat subjective, it is only possible to infer an extremely wide valuation range for a company like Twitter - and that means that there is a high risk that investors will be paying too high a price for such a stock. In other words, the margin of error is extremely wide and prices can run far ahead of realistic valuations.

Amazing Amazon

In his first paper on the so-called dark side of valuation, which has been refined and reprinted several times since, Professor Damodaran looked at the valuation of Amazon.com, which was trading at a price of $84 a share.

Professor Damodaran's analysis showed that such a price could only be justified if Amazon achieved a 60 per cent compound revenue growth over the decade, and delivered a sustainable operating profit margin at the end of the forecasting period of 8 per cent, below the then retail sector average. Although it achieved the first, Amazon still remains far from delivering that level of profitability - in its last full year its operating margin stood at 1 per cent, well below the 20 per cent-plus reported by the likes of Google and eBay - and yet today the shares trade not at $84 but at over $350 each.

Is this a case of those investors who kept faith in Amazon’s model being proved spectacularly right? Or is Amazon now simply overvalued (as the analysis in the table below would suggest)? Again we must look to the valuation "noise" Professor Damodaran highlights for explanations of the extreme swings in sentiment. The case of Amazon also perfectly highlights that the unknowable future direction companies and industries take can significantly affect the way the market values them. Were Amazon still just an online retailer, would its shares be worth $350 each today? That it has branched out to become a technology supplier, too, changes the investment case considerably, as it reaches deeper into the supply chain to increase its dominance. "No matter how careful you are in getting your inputs and how well structured your model is, your estimate of value will change both as new information comes out about the company, the business and the economy," points out Professor Damodaran.

In the case of Twitter's valuation, it's almost assumed it will deliver a similar degree of industry-twisting innovation. That's a dangerous assumption, just as assuming every biotech - another sector that's seen sky-high IPO valuations this year - will deliver a blockbuster treatment. Sure, some of them will strike proverbial gold, and the rewards could be massive - but the risks you need to take to earn such potential rewards are massive, too, because many won't.

That's not to say you shouldn't take those risks at all - a speculative investment adds a little dose of fun to any portfolio. But it should be an addition to a well-diversified portfolio otherwise built around solid asset allocation principles, and with realistic investment objectives firmly in mind. The glamour of the new and unknown should not take precedence over the tried and tested.

Tech giants compared