Young, articulate, computer science majors from Silicon Valley have once again captured the imagination of countless aspiring entrepreneurs. Their companies are receiving sky-high valuations despite showing minimal, even non-existent, profitability. The phenomenon has left analysts asking one question: “Why?” In reality, it comes down to the brilliant technological innovation supporting their platforms that drives investors to factor in enormous growth potential and justify, at least in their minds, the high prices we see in the headlines.
Consider Dropbox. Many of us know it as an easy-to-use, file sharing service. Its valuation? A cool $10 billion. Despite its 200 million user base, its revenue model cannot sustain a monthly user fee as proponents claim (Would you pay $10 per month for the basic service level?). There are plenty of substitutes, such as Google Drive, Box, or SkyDrive. Other money-losing tech companies have received high valuations as well. For example, Snapchat, best known for its time-sensitive photos, is valued at $4 billion even though it has earned zero dollars. Although Twitter continues to lose money, it is valued at $35 billion. Large pools of available capital are partially to blame for the high valuations.
Understanding the Multiples
Private equity and venture capital firms have an estimated $1 trillion in “dry powder,” or idle capital. After raising capital from institutional investors such as Canada Pension Plan, portfolio managers must find suitable investments and allocate capital to earn management and performance fees. Due to the growing number of PE and VC firms, there is increased competition for solid investments. As a result, private equity and venture capital firms are competing for the valuable investments at higher valuations. Due to the potential of high growth, and thus significant returns, portfolio managers are increasingly investing in consumer technology platforms. For example, BlackRock, the world’s largest fund manager, has invested roughly $250 million in Dropbox.
Multiples, often used to determine company valuations, may provide some hint to the high prices. Enterprise value to sales (“EV/Sales”), a financial measure comparing the cost to acquire a business to its sales, is a commonly used metric. Recently, technology companies have been acquired at 8-12 times EV/Sales. For example, Google paid $3.2 billion, or 10 times EV/Sales, to acquire Nest, a smart thermostat maker. However, Google’s stock trades at a modest 5.4 times EV/Sales. Or consider Twitter, which trades at an astonishing 59 times EV/Sales. Have sophisticated investors become oblivious to high valuations, or are they just insane?
The answer lies in future expectations. Instead of valuing companies based on present sales, investors value companies based on revenue growth and future return on invested capital (ROIC). Like most valuations, technology businesses are based on forward looking assessments. However, tech companies are seen to have limitless growth potential, encouraging investors to pay a significant premium to own them today. As a result, companies in their start-up stage, such as Dropbox, receive high valuations that seem unjustified based on present sales.
So how do you pick the good apples from the rotten ones? Investing in the Tech sector, as with any sort of investing, requires skill, experience, and a lot of luck. Some companies grow into their valuations. Facebook, for example, received strong criticism for its $100 billion dollar IPO valuation in the face of weak revenues. However, the social media giant’s revenue has since doubled in the last three years, and its stock price has appreciated 40 percent since it began trading. But not all businesses grow into their valuations. Friendster, another social media network, failed miserably and had to revamp their business model after pressure from impatient investors. Therefore, technology investing is risky, as market reaction and growth potential can be hard to quantify with any reasonable certainty.
Undoubtedly, tech valuations have soared, primarily due to large pools of unallocated capital and high growth expectations. Moreover, short-term investor horizons have led to an increase in momentum investing. It is reasonable to expect increases in valuations as long as tech companies, such as Facebook, materialize their high expectations and build investor confidence. However, as rapidly growing tech start-ups seek public listing, there is an increased chance of a high-profile failure, which would decimate investor confidence and burst the potential bubble. The lesson, then, is to perhaps take these valuations with a grain of salt. There is no better example than technology valuations to demonstrate Warren Buffet’s investment principle: “Price is What You Pay, Value is What You Get!”