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What’s wrong with the tech valuations?

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LinkedIn stock as of July 7, 2012

For nearly a decade and a half, internet companies have been accorded nosebleed valuations by the stock markets. Despite shaky business fundamentals, internet companies have often gotten a premium in the markets.

Magister Advisors, an M&A advisory firm in a press release emailed earlier today noted that all these new companies are getting what it calls “faith multiples.”

Loose translation: public markets are valuing some of the new internet companies too generously, especially when compared to more established companies.

For example, next generation players such as LinkedIn (s lnkd) and Facebook (s fb) have price/earnings (PE) ratios many times higher than industry stalwarts Apple (s aapl) and Microsoft (s msft). LinkedIn has a PE ratio of 711 and Facebook has a PE ratio of more than 70. Apple has a PE ratio of 14.5 and Microsoft has a PE ratio of 11.

To put the overrating in context, if Apple, a business with enormous brand value and a world-class track record of execution, received the same valuation as a business like Facebook or LinkedIn, it would be valued at many trillions of dollars.

Victor Basta, managing director of Magister Advisors was pretty harsh in his assessment of the situation. This is how he summed it up:

“Unproven future value is worth more than achievement. LinkedIn and Facebook are incredibly important next-generation internet businesses, but it is absurd to believe they are worth several times, or even several hundred times more than companies that already dominate their sectors.

Soon companies like Facebook will reach their own level of ‘saturation’ and this should already be priced in. We may be connected to every cousin or sales executive on the planet, but short of hiring someone or showing them a picture of our mother’s 80th birthday, we quickly run out of enough commercial meat to justify these premiums.

The technology industry has always over-valued the next big thing, and some of this ‘irrational exuberance’ is perhaps understandable. But where is the value for decades of performance? It is only in the technology industry that a bird in the bush is worth far more than a bird in the hand.”

Groupon Stock Chart
Groupon stock, July 9th, 2012

All good points. However, we should also not forget that at some point in their life, even Apple, Microsoft and Google were valued at jaw-dropping valuations, especially in the early years of their life. Since then they have grown into more mature and stable companies.

Facebook, could perhaps be the same kind of company. And in case of others who don’t quite match up to the hype, well the stock markets do have a darwin way of dealing with them. Groupon is a perfect example.

5 Responses to “What’s wrong with the tech valuations?”

  1. It does however seem that the lifecycles of tech companies are growing shorter. Does anyone really feel that the apex of Facebook is 20-30 years away from its IPO, rather than closer to 5? Of all the major tech companies founded from the mid-1990s onwards (plenty of which had their time in the spotlight at one point or another), only Amazon and Google have managed to display any sort of long-term staying power.

  2. It is more like they have a manic/depressive view of young tech companies. Make earnings like LinkedIn and they are wildly optimistic. If a company misses earnings, they will be severely punished. That said, it isn’t any different with other companies. The difference is more established companies have more predictable revenue on a quarterly basis.