Are technology firms madly overvalued?
Posted by hkarner - 25. Februar 2017
Source: The Economist: Schumpeter
Three financial sanity tests for whether there is a bubble
IS THE technology industry in La La Land? There are alarming signs. House prices in San Francisco have risen by 66% more than in New York over the past five years. Even at the height of the dotcom bubble in 2001, the gap was lower, at 58%. Shares of technology firms trade on their highest ratio to sales since the turn of the century. Four of the world’s most valuable firms are tech companies: Apple, Alphabet, Microsoft and Amazon. Snap, a tiddler with $400m of sales and $700m of cash losses in 2016, is expected to list shares on March 1st that will give it a valuation of over $20bn.
For companies and investors in any industry, it is hard to work out if you are living in a bubble. To help, Schumpeter has created three sanity tests for global tech firms. These examine their cashflow, whether investors differentiate between companies, and whether forecasts of their future earnings suffer from a fallacy of composition. The exercise suggests that tech valuations are frothy, but not bubbling.
The first test is cashflow, and the industry passes it with flying colours. In 2001 about half of all listed tech firms were unable to convert their sales into hard dollars. Times have changed. In the past 12 months the biggest 150 technology companies generated a mighty $350bn of cashflow after capital expenditures—higher than the total cashflow over the same period of all the non-financial companies listed in Japan, for instance.
In a bubble, investors bid up the value of assets regardless of their quality. The prices of good and bad tulips soared alike in 17th-century Holland, and in 2008 subprime debt was almost as valuable as Treasury bonds. So the second test is whether buyers are differentiating clearly between tech firms, of which there are three broad types. Some, such as Samsung and Apple, are mature and profitable. At other firms, including Alibaba, Tencent, Facebook and Alphabet, sales are growing at an annual rate of over 20%, with high margins. Then there are “blue-sky” firms that are unprofitable but have explosive sales growth. Uber and Snap are examples.
One way to gauge whether investors are sensibly valuing each category differently is to calculate companies’ duration, or how much of their current market worth is expected to be realised soon and how much relies on pots of gold being found far into the future (see chart). Schumpeter has crunched the numbers for the world’s ten biggest tech firms and for three rising stars, splitting their market value into three parts: value which has already been realised in the form of net cash held, the present value of expected earnings in the next four years, and the value attributable to what happens after 2020. Samsung and Apple are not growing much but are low-risk: over 40% of their value can be explained by cash and near-term profits. The raciest firms, such as Tesla, are expected to generate over 90% of their value after 2020. These firms could well crash and burn. The good news is that investors are placing their most eye-watering valuations on a fringe of smallish companies that are growing very fast indeed.
The third test is whether there is a fallacy of composition. In a bubble the bullish claims of individual companies aren’t plausible once you add them all up. In the dotcom era the market-share targets of internet-service providers added up to well over 100%. In the subprime crisis every bank claimed that it had offloaded its risks onto other banks. The technology industry is less vulnerable to criticism on this front. The aggregate profits of the top five tech firms are expected to rise from 6% of American corporate earnings last year, to 10% by 2025: bold, but not implausible. Managers are not anticipating the same profit stream twice. For example, Facebook is not expected to become a force in search, while Google is not expected to conquer social media.
Although the lunatics have not taken over the asylum, there are, however, pockets of excess. Even though their valuations are now starting to deflate, there are still too many privately held technology firms with stretched valuations of $1bn-10bn. Worldwide, such companies have a total worth of $350bn. When it comes to facing up to failure, too, the industry’s record is bad. Twitter’s sales may shrink by 14% this quarter compared with a year earlier, and it is losing money. Past company failures in the tech business suggest that once decline sets in, it takes only two years or so for a firm to lose a quarter or more of its sales. Yet Twitter is sticking to its line that rapid growth will soon return.
Another worry is Amazon. It is one of the most optimistically valued firms, with 92% of its current worth justified by profits after 2020. Outside investors have a lot at stake because it is huge, with a market value of $410bn. About a third of this value is justified by its profitable cloud-computing arm, AWS. But the rest of the firm, which straddles e-commerce, television and films, as well as logistics, barely makes money despite generating large sales. Nor is it growing particularly fast for its industry. To justify its valuation you need to believe that it becomes a sort of giant utility for e-commerce which by 2025 cranks out profits of around $55bn a year, or probably more than any other firm in America.
The final worry is that technology firms are flouting the laws of corporate finance, which hold that there is a relationship between a company’s market value, its profits and the sums it has invested. New entrants should be attracted by the fact that companies are winning huge valuations from tiny investments, in turn dragging profits and valuations back down. As a group, the biggest ten technology firms have $8 of market value for every dollar they have sunk in net fixed physical and intangible assets. For Snap the figure is $36, and for Tencent it is $53. If new competitors do not, or cannot, emerge, then competition authorities are likely to intervene more than they do now. It sounds odd, but the main valuation risk for many of the world’s tech giants is that they rake in too much money.