It has been another seven months since my last post and life moves on with excitement (our Giants won the World Series!), political drama (the Republicans wrestled back control of the House), the absurd (Judgment Day on May 21, 2011 came and went without notice) and the silly (a new, live action Smurfs movie). In the valuation world the silly came in the form of astounding valuations. The Huffington Post sold for $315 million, LinkedIn went public at $45.00 a share and now trades at a market capitalization of $7.1 billion or 24.0x trailing twelve month revenue and 185.0x trailing twelve month EBITDA and Groupon, which was founded in 2008 is looking for a valuation double that of LinkedIn at $15.0 billion. Not a bad three year ride. Are we headed for another technology bubble? Does the future of our economy ride in the clouds of social networking, iPads and groundbreaking technology?
The short answer is absolutely. Our economy is so focused on smartphones (talking with our thumbs, updating our Facebook pages and tweeting the details of our last meal) that we can’t get enough technology in our lives. Does this mean that there is a valuation bubble in our future? It depends on how you like your coffee. Let me explain…
It is my feeling that a market bubble occurs when fundamentals are replaced by froth. By “froth” I mean the alternative definition of “being unsubstantial, worthless, or light and airy.” The froth of a bull market hides the lack of fundamental value. As a result, the investor makes a bet that the valuation of a company will either catch up to its value today (i.e. over time LinkedIn should be worth $7.0 billion but at that point, will it be trading for $14.0 billion?), sell for more than they paid for it (i.e. the Greater Fool Theory) or provide them with a capital loss to offset other gains.
So what is this about coffee? I see fundamental valuation as a cup of black coffee, no sugar, no milk. In the words of Bill Belichick “it is what it is”; just coffee. A value based on fundamentals has the support of its underlying assets, its earnings capacity and its comparison to the market in which it competes. A frothy market is a cappuccino; one third espresso, one third milk and one third foam. The one-third espresso is fundamental but in concentrated form needs the milk to be mellow it out. The foam is the “light and airy” component that sets the stage and helps tell the story of what is below. But once the foam dissipates, your left with just a half cup of milky coffee.
Market froth expands valuation in a similar way. Over time, once it dissipates, the $45 IPO will trade on its fundamentals which may not support that $45 price tag. The IPO graveyard from the .com bubble is filled with deflated cappuccinos like pets.com, etoys.com and mp3.com. Some of their exits were able to capture some fundamental value for its investors while others just faded away. So when the “foam” settles five years from now which one of these current IPO hot shots will exceed its IPO value? Will they be a:
1. “Google” – IPO valuation was over $24.0 billion in August 2004; current market capitalization is $163.7 billion,
2. “PortalPlayer” – $376 million IPO valuation in November 2004; bought by NVIDIA for $362 million two years later, or
3. “Arbinet” – $423 million IPO valuation in December 2004; merged with Primus Telecom in an all stock transaction valued at $28 million.
Time will tell how much foam is in their coffee….?