Editor’s note: This article was first published in June 2011 on 16 June. LinkedIn’s share price of 75 dollars, Facebook’s growth towards 700 million users and the valuations of Groupon and Twitter, then not yet listed, are figures from that moment.
Before analysing whether today’s dot-coms are in a bubble like the one at the end of the 1990s, let’s start with the definition of a speculative bubble.
A bubble occurs when the prices of certain assets rise irrationally, driven by expectations of explosive demand. A bubble bursts when returns have reached a point where the asset can’t appreciate any further. The question is whether we are living through another tech bubble.
Most opinions are black or white. Big investors don’t trust these companies because they believe their prices are “inflated”, and they have a point. To take one example, LinkedIn trades at 75 dollars a share even though, for now, its business model hasn’t proven sustainable over time. If we compare it with Apple or Microsoft, two technology companies with physical products, distribution chains and a proven, profitable business model, we could say that if LinkedIn is worth 75 dollars a share, Apple and Microsoft should be trading at around 725 dollars a share, and that isn’t the case.
On the other hand, Enrique Dans argues that this new tech era isn’t at risk of a bubble like the one at the end of the 1990s. In his view, the dot-coms of the 90s were valued on a purely speculative basis, and some even went public before making any profit. So in some cases the speculative investment was built on these companies’ debt, and in others on a future promise of profitability that never materialised.
It’s true that companies like Google and Facebook have a profit model based on advertising revenue, with the assurance that their revenue grows month after month along with the number of people using their services. Groupon, meanwhile, has an advertising intermediation model, and Twitter, despite its high market valuation, probably hasn’t yet achieved profits in line with its value.
I don’t think either view is wrong, but we can’t expect the answer to be black or white: when it comes to investing in technology companies, we should use the whole scale of greys.
The question is not whether there is a tech bubble, but when it will burst and which companies it will hit. Some of these companies are diversifying into other products, while others are putting all their capital into a single focus: the internet. Google isn’t betting everything on a single business model, so in a few years we may see it involved in other kinds of technology businesses and in renewable energy, two sectors it is currently investing in.
Are they a profitable investment?
As of 16 June 2011, I would say that any investor who holds these companies for the long term will lose money. On the other hand, the moment a company goes public is an ideal time to invest and hold for the short term.
Nobody can predict how these companies will grow, although common sense says Groupon or LinkedIn are more likely to fall than Apple and Microsoft, which are constantly innovating. We can’t know whether we are facing a speculative bubble when we are speculating in markets whose behaviour we can’t foresee.
The problem with these companies is that they depend not only on their service but also on fashions (which can be fleeting) and on any competition that may emerge. In fact, we are already seeing growth slow at some of them, as is the case with Facebook. Zuckerberg’s company was growing at a breakneck, unstoppable pace towards 700 million users, and today, even though connections are increasing in emerging countries, Facebook has seen its growth slow considerably. On top of that, 35 million accounts have been closed in the United States.
The biggest problem with investing in these companies
The obvious problem is the huge rise these companies achieve on the stock market in their first few hours or days. Their value climbs so much that they quickly hit a ceiling, after which the only way for the share price is down. Traders know this and turn tech IPOs into billions in profits in a single morning, but few investors dare to keep their money in for the long term.
So, going back to the definition of a bubble, we would say it isn’t one, since not all of these companies will close for lack of profitability. But their growth has a ceiling that is usually reached very quickly, so it is a bubble for the long-term investor and very profitable for the short-term investor at the time of the IPO. Contradictory, isn’t it?
Further reading
- Warren Buffett’s investment portfolio
- Social networks may be overvalued, but that doesn’t mean they can’t be profitable investments
Featured image: Raphaël Quinet, CC BY-SA 2.0, via Flickr.
