“The Bubble Question” is the title of a recent Fred Wilson blog and the frequently asked question: “Are we in an stock market and/or technology company valuation bubble?”
Fred Wilson is a managing partner at Union Square Ventures, prolific venture capital blogger, and (from what I’ve gathered reading his blog for years) a pretty smart guy. Given his position, he gets asked the aforementioned question quite often and laid out his current conclusive response via blog. The gist of his explanation for the bubble is:
“valuations are at extreme levels because you cannot get a decent return on your money doing anything else…. really just one factor (cheap money/low rates)… is the root cause of the valuation environment we are in. And the answer to when/if it will end comes down to when/if the global economy starts growing more rapidly and sucking up the excess liquidity and policy makers start tightening up the easy money regime. I have no idea when and if that will happen. But until it does, I believe we will continue to see eye popping EBITDA multiples for high growth tech companies…. It’s been a good time to be in the VC and startup business and I think it will continue to be as long as the global economy is weak and rates are low.”
After having read Fred’s blog and my recent analysis of Castlight Health, my good friend and old Heyzap coworker Micah Facebook asked me for my thoughts on the tech bubble discussion. With his permission, I’ve posted the transcript from our April 24th conversation which contains my simplified explanation of the outrageous tech company valuations we are currently seeing and other thoughts on the internet industry.
Note: After the transcript I’ve included some further references related to points in the discussion. I also realize some comments in the conversations are over-simplified, but my friends/readership fall all along the spectrum of economics knowledge, so I usually opt for over-simplifying and clarifying details for those who ask. Any comments, critiques, or elaborations are welcome at loganfrederick@gmail.com.
Part One: Shortly Before Leaving Work, Micah Asks Me a Question
4/24, 5:10pm – Micah Fivecoate: So, does Fred’s post explain Castlight?
4/24, 5:10pm – Logan Frederick: I haven’t read through his post yet
But Just from the comments
It is a big part of it
I will respond tonight
After I read his article
4/24, 5:10pm – Micah Fivecoate: I don’t understand yet how it’s tech-specific
4/24, 5:10pm – Logan Frederick: Basically the simplified chain is
Fed lowers interest rates -> Means it’s really cheap to borrow money -> So everyone starts borrowing money -> That money is expected to be put to work to earn a return -> But given the economy now, a lot of industries and assets do not look that appealing -> Tech/internet sector looked pretty strong coming out of financial crisis with increased usage and actual revenues/profits from the giants -> Investors with cheap cash view that as the best place to get a return -> All the money goes into tech
4/24, 5:13pm – Micah Fivecoate: Ah, okay
4/24, 5:13pm – Logan Frederick: Even more basic, it’s just two factors: Tech companies look like the biggest growth opportunity compared to all other asset class, and the Federal Reserve policy makes it very easy for investors to get money to invest in tech
4/24, 5:13pm – Micah Fivecoate: So, it’s a combo of free money + tech looking good
4/24, 5:13pm – Logan Frederick: Yeah
That’s really it
If/when Fed rates rise
It will surely hurt tech company valuations
Even as some commenters said it would be a signal the economy is stronger or inflation is higher
But regardless, less money would be available for investment
So some companies might do better with higher interest rates, but overall valuations will be lower in real terms
4/24, 5:15pm – Micah Fivecoate: Wonder what would do better with higher interest rates
I guess any co with lots of cash
or that facilitates loans
4/24, 5:16pm – Logan Frederick: Well assuming rates go higher because of a strong economy, you could reasonably expect that the large tech companies would be doing well
4/24, 5:16pm – Micah Fivecoate: Oh
4/24, 5:16pm – Logan Frederick: The fed interest rate moves
Are more a trailing indicator
“Oh, economy is strong? Then we raise rates”
But your point was right as well to a degree, a company with a lot of cash can weather a rate increase better because it does not need to borrow
4/24, 5:18pm – Micah Fivecoate: So, is the effect to slow change when things are strong, and accelerate change when the economy is weak?
4/24, 5:18pm – Logan Frederick: Yep
That’s the basis of Monetary Policy
4/24, 5:18pm – Micah Fivecoate: cool
4/24, 5:19pm – Logan Frederick: You can continue down the rabbit hole of Monetary Policy theory, but all the research and debates are about what is the best mechanism for maintaining/finding the right equilibrium of economic strength or growth in relation to interest rates
The libertarian/anti-Fed Reserve crowd’s argument boils down to: The Fed does more to deviate us from the right equilibrium than help
In the pre-modern Federal Reserve era (pre-1917 if I have the year right)
Individual banks set their interest rates
I could go on and on, but I am packing up at work
Will respond more after reading Fred’s blog
4/24, 5:22pm – Micah Fivecoate: Cool, I’ll read up a bit on monetary policy in the meantime
4/24, 5:22pm – Logan Frederick: lol Good deal, see ya in an hour
4/24, 5:22pm – Micah Fivecoate: later
Part Two: An hour later with a glass of wine and dinner at Logan Bar and Grill
4/24, 6:16pm – Logan Frederick: I did not realize that this blog post
Was the same one posted a month ago
4/24, 6:17pm – Micah Fivecoate: Oh
4/24, 6:17pm – Logan Frederick: I didn’t fully read it then either
Halfway through, don’t see anything I disagree with and is pretty simple finance
I like Fred
It’s pretty simple finance but his readership is tech folk
So it’s good to post this kind of analysis
So Finished his post
Agree with it all, but it’s only half the story
Which is disappointing
4/24, 6:20pm – Micah Fivecoate: Yeah, it wasn’t clear from his post why the money would be going in to tech
4/24, 6:21pm – Logan Frederick: Well that’s not what I meant by half the story
4/24, 6:21pm – Micah Fivecoate: oh
4/24, 6:21pm – Logan Frederick
But that’s also true
But I filled in that part for you
That you can draw, from his post
4/24, 6:21pm – Micah Fivecoate: yeah
4/24, 6:21pm – Logan Frederick:
If you judge things by growth rate
Tech offers the best right now
And always, really
I don’t like “tech” as a sector term
I prefer “software” or “internet”
4/24, 6:22pm – Micah Fivecoate: oh, makes sense
“tech” isn’t necessarily the same sort of low-marginal cost business
4/24, 6:23pm – Logan Frederick: Well I just mean it as tech is too vague a term
In a recent copy of Intelligent Investor, editor Jason Zweig overlays one of the tech stocks of the 80s (IBM I think) on top of General Motors in the 1920s and it’s the exact same. Because General Motors was the “tech” of that era
4/24, 6:23pm – Micah Fivecoate: hah, yeah
4/24, 6:23pm – Logan Frederick: But that’s semantics
4/24, 6:24pm – Micah Fivecoate: barnes and noble isn’t doing too well with their printing press tech
4/24, 6:24pm – Logan Frederick: Your point is valid too, in that different “tech” companies have different business models
Barnes and Noble has a lot of issues and I should look again at shorting them maybe
It’s scary now that they keep decreasing in market cap, someone will take them over before they go bankrupt (possibly)
Hard to short in that situation
4/24, 6:25pm – Micah Fivecoate: Oh, yeah
4/24, 6:25pm – Logan Frederick: I can guarantee some PE firm has run numbers on them
If it’s a takeover candidate or not
4/24, 6:26pm – Micah Fivecoate: Yea, it’s pretty high-profile
4/24, 6:26pm – Logan Frederick: High profile, really the only monopoly in the space left, even if it is a shitty industry of bookstores
But that’s the job of a PE guy, run the numbers of what their debts are, do they own their real estate locations? What’s the value there?
How many costs can be cut?
If we can get them for $100 or $200 million, can we reconfigure them to spit out enough free cash flow to cover whatever debt they have/we add AND give us a private equity level return?
4/24, 6:35pm – Logan Frederick: I should turn this into a blog post
And write a blog post in response to Fred’s
I did not elaborate on what I meant as “the other half of the story”, which is what happens when interest rates rise again to the levels he suggests in the post
4/24, 6:36pm – Micah Fivecoate: Oh, yeah
4/24, 6:36pm – Logan Frederick: And that’s the sound of the bubble popping
The high valuations will end either when the Fed decides to raise interest rates (by their indications 2016 I think?) or when companies with high valuations fully realize that they can not earn returns on their investments
Whichever comes first
4/24, 6:37pm -Micah Fivecoate: the giant sucking sound of all the money leaving SV
4/24, 6:37pm – Logan Frederick: At least some of it, yes
I’m still a big believer in tech and think software still has a lot of room to run
4/24, 6:38pm – Micah Fivecoate: Oh, are they planning to raise rates in 2016?
looks like
maybe going to 2%ish in 2016?
4/24, 6:42pm – Logan Frederick: But I think people forget that software is meant to improve things and that largely means taking process which cost $100 using humans to cost $10 using machines, but that generally speaking means a lot of software companies don’t need to be as big as companies of old
Paul Graham says as much in one of his essays
The goal should be maximizing profit per employee. Can you have a billion dollar company with only 10 people?
Software shouldn’t require a business to need to be valued at $100 billion
You can replace General Motors with new high tech cars…at a lower valuation
I’m kind of shooting ideas from the hip, but you could vet them out and qualify them where need be, but the general point stands I think
4/24, 6:43pm – Micah Fivecoate: What principle does the rev/employee metric maximize?
4/24, 6:44pm – Logan Frederick: Well from the PG essay he was just talking about software leveraging human talent, that was his point there
I’m sort of adding on that you could make the link that PG’s point implies valuations don’t need to be as big to have as significant an impact/be as disruptive
A five person, $10 million company could hypothetically replace a 10,000, $10 billion company
Craigslist versus the newspapers as an example
4/24, 6:45pm – Micah Fivecoate: Yeah, i guess it’s how you define disruptive
4/24, 6:45pm – Logan Frederick: So then why, taking it a step further, are investors and tech entrepreneurs *seeking* valuations larger than the company is intrinsically worth
4/24, 6:45pm – Micah Fivecoate: Oh, and the profits of the $10B company just dissipate into the market at large
4/24, 6:45pm – Logan Frederick: Intrinsically judged by how much money they actually make over a future time span
Exactly
4/24, 6:46pm – Micah Fivecoate
Shouldn’t the smaller company be able to keep profits as high?
like, costs could go down
maybe the profits would fall because the competition could implement the same software, and there wouldn’t be as much room for differentiation
or just it’s harder to justify to customers such a large profit margin
or is valuation tied in some way to gross revenue rather than net
4/24, 6:49pm – Logan Frederick: If a new software startup has costs of revenue (cost of providing the service) much lower than an old non-software company in the industry, the company won’t keep their price point at the same as old company because their customer’s substitution costs wouldn’t be affected. Their disruption will lower the costs to customers, and then depending on the industry, competition could drive those lower over time
Yeah, I typed that as you typed, but basically you as a new disruptive company would have higher profit margins, but lower prices than your old incumbent
4/24, 6:50pm – Micah Fivecoate: yeah
So you can initially keep the same profit, but lower price due to lower costs
but then other people start competing with you with software
and that’s what takes the valuation down
4/24, 6:52pm – Logan Frederick: Well valuation goes down even before your second step of competition
4/24, 6:52pm – Micah Fivecoate: because they know it’s coming?
4/24, 6:52pm – Logan Frederick: Well no, I take my last statement back
This would be an empirical question, but I would guess most software that very directly replaces an old manual task
Does not have gross profits greater than the old manual business
That’s hard to test empirically I think because most software replaces a cost of an old manual task
So you’d have to say, what were people spending on process A that was replaced with software product B
And cost of B is probably less than A
So in terms of valuation
It’s odd to word it this way
But what was the “valuation” of the dollars spent on A versus the valuation of company B
But I would guess if you did that kind of test
B is significantly lower
And that’s my point of valuation being naturally lower
4/24, 6:55pm – Micah Fivecoate: Weird
It seems like if one company can provide the same service at a lower cost
they should have a higher valuation
Might be running in to some sort of efficient-market fallacy
4/24, 6:56pm – Logan Frederick: I always view valuation in terms of return on investment
If the cost and price are lower
You can have a high ROI and still come up with a valuation number lower than the old incumbent
And then like you said earlier
If the ROI is *that* good
Then competition comes in and keeps everything in check like prices, cost, valuation
4/24, 6:58pm – Micah Fivecoate: Yeah
I guess, I’m thinking if the incumbent charges $100 for a product that costs them $90 to produce
and the disruptor charges $90 for $10 cost
then disruptor should have a higher valuation
4/24, 6:59pm – Logan Frederick: That is true
4/24, 6:59pm – Micah Fivecoate: but it probably just rarely works out so well
and then competition
4/24, 7:00pm – Logan Frederick: And that’s where it’s a case by case basis and where I think the tech industry screws up
I agree with your statement
Maybe half of software companies are like that
And another half, the bad ones, think they are doing that but are really only charging $20 at a $10 cost or charging $90 at an $80 cost, and so shouldn’t have a higher valuation
But because they are “tech” they and others think they should have the same multiples
4/24, 7:01pm – Micah Fivecoate: Hah, yeah
4/24, 7:01pm – Logan Frederick: And that’s part of why you get bubbles
Businesses thinking they can achieve a level of profitability and margins that similar-ish companies have
But really the business is not the same
And they don’t achieve it
And I guess my larger point would be
There is nothing wrong with *not* having the best margins
You just have to accept your okay margins and profits and accept that your valuation will be okay
But in a bubbly environment, every company thinks they will have the best margins, profits, and a valuation that their real margins and profits do not justify
4/24, 7:04pm – Micah Fivecoate:
Makes sense
So, is that purely because there’s too much money that wants in on this market
4/24, 7:06pm – Logan Frederick:
Yeah, so companies raising money can get away with it
If there wasn’t as much money available, investors would be more picky
4/24, 7:07pm – Micah Fivecoate: Doesn’t seem like the risk tolerance would shift with the amount of $ available
maybe it does though
4/24, 7:08pm – Logan Frederick: I could be wrong, but I think it does, although long-term it has been trending toward high valuations and more entrepreneur control, specifically in the computer software and hardware industries. Over decades that may continue.
But I say the risk tolerance does shift
Because VCs, the main drivers of these valuations, have investors themselves
And in weaker economic climates
There is a real possibility of VC investors, the big funds, saying they won’t do as much VC investing
And if VCs are worried about bad returns
They will get more choosey when it comes to investing
4/24, 7:09pm – Micah Fivecoate: Oh, interesting
4/24, 7:09pm – Logan Frederick: I can think of some counterarguments on both the high and low end though
On the high end, you could argue that VCs will still pay whatever it takes to get into the clear winners, the “next Google”
And on the low end, the dollar amounts are so low it doesn’t hurt them to continue this
And that leads into what people have been saying about Series A and B crunches
Companies in the middle of these two places who haven’t proved their worth to VCs that they can earn big returns but need more money than seed rounds can provide
I dunno how valid the Series A or B crunch is based on a few articles I’ve read, but that logic I just laid out would explain why it exists
VCs are just increasingly worried about investments in those stages
4/24, 7:11pm – Micah Fivecoate: Yeah
4/24, 7:11pm – Logan Frederick: Series D is safe
Seed is safe
By VC math
4/24, 7:11pm – Micah Fivecoate: right
4/24, 7:12pm – Logan Frederick: Any other thoughts/questions for me?
That I can come up with half-assed, on the spot answers for
Notes:
-
Regarding my comment about wanting to maximize revenue per employee from Paul Graham, I tried finding the exact PG comment I had in mind. My memory of it may have been off. His essay “How to Start a Startup” has the closest passage to what I was thinking that I could find quickly:
“If hiring unnecessary people is expensive and slows you down, why do nearly all companies do it? I think the main reason is that people like the idea of having a lot of people working for them. This weakness often extends right up to the CEO. If you ever end up running a company, you’ll find the most common question people ask is how many employees you have. This is their way of weighing you. It’s not just random people who ask this; even reporters do. And they’re going to be a lot more impressed if the answer is a thousand than if it’s ten.
This is ridiculous, really. If two companies have the same revenues, it’s the one with fewer employees that’s more impressive.”
- My comments at the end about Seed funding and late stage funding being safe for venture capitalists is based on discussion in the past six months on what the media called the “Series A” and “B” crunches. There was debate on whether there was a trend in venture capital of increasing investments in really young or really old companies, but a lack of investment for companies in the middle. Google “Series A Crunch” or “Series B Crunch” for more details.
Logan Frederick 