THE BLOG

The New High Tech Bubble

07/20/2011 08:16 am 08:16:57 | Updated Sep 19, 2011

Facebook has been valued recently at $80 billion while Google has a current public market value of $195 billion and Apple has a market capitalization of $350 billion.

Will any of these companies still be around in forty years?

Analysts attempting to arrive at a fair value for these and other hi-tech firms typically estimate the firm's earnings power and then apply a P/E multiple to arrive at the company's market value. This is not that different from how most firms are valued in the marketplace, but with tech firms a much higher P/E is applied reflecting the greater growth prospects of the firms.

But, high tech firms also face a much higher risk of obsolescence for their products than more traditional firms. When we say that a firm like Facebook might be worth 25 times its potential earnings in 2015, we are saying that Facebook is not only going to grow rapidly beyond 2015 to justify this aggressive P/E multiple but will also be around for a very long time. Similarly, Google's current P/E of 20 or Apple's P/E of 16 both assume the firms will be hugely profitable for a long time to come.

Recall that firms only have value to their shareholders because they eventually pay cash dividends to those shareholders (or make share repurchases). It is the present value of these dividends that approximates the current market value of a firm. If a tech firm is growing at 20% per year and an investor requires a 20% return in order to take the risk of holding its common stock, then the present value can be calculated by taking the current dividend amount and multiplying by the number of years you think the company will be in business. No discounting is necessary because in this case the discount rate exactly equals the growth rate of the company.

So, to value a high tech firm you only need to guess how many years the company will be around and growing and its products relevant to arrive at an appropriate multiple. If you assume that dividend payouts will be half of the company's after tax earnings going forward, then the market is in effect saying that if you double the P/E you arrive at an estimate of how long in years the company can perform at this earnings potential and growth. So the market is saying that Google will still be around and growing at 20% per year forty years from now and that Apple will still be jumpin' in 32 years.

These estimates may not sound crazy for more traditional firms, but the very nature of high tech firms is that they are in industries that are changing each day at an exponential rate. We all applaud the success of Amazon.com and Cisco, but how many of us remember Commodore computers or Visicalc or Atari games or pets.com or webvan. In an industry that measures the number of hits by the second and tracks results by the minute, a year seems like a lifetime and a decade seems like eternity.

Google's obsolescence risk is obvious, someone just needs to come up with a better search engine algorithm. Their huge ad revenue is based on the fact that everyone uses their search algorithm and if a better one is found, Google is gone, most likely in much less than forty years. If you think it might happen in the next ten years, then it looks like Google might be overvalued by some 75%.

Apple has had an incredible run of success with its Mac, the iPod, iTunes, the iPhone and the iPad. But even after taking over the graphics business, the music business, the cell phone business and the publishing business, they only have $50 billion of cash on their balance sheet. Since they haven't paid a dividend recently this has to be the value that these advances have brought to Apple to date. As to the future, I am sure Apple hopes it has figured out the formula for how to design and create user friendly products in any arena, but I am not so sure. For example, in the toy business it is unheard of for a toy manufacturer to have the hit toy for Christmas and then follow it up with another hit in future years. Similarly, I think it is a mistake to believe that Apple will continue to have hit products in the future equal to its most recent successes, especially given that Steve Jobs' future with the company is so uncertain. So again, the question is how long will iPhones and iPads be big sellers in a world of tech consumers that are always demanding the next new and cool thing. 32 years sounds awfully optimistic.

This brings us to Facebook and its valuation. In a July 14th Wall Street Journal article, Geoff Yang, a very successful venture capitalist at Redpoint Ventures provided an analysis that said that Facebook might be worth $140 billion in 2015. (He was not alone. In the same article, Lou Kerner, a managing director at Wedbush Securities said he thought Facebook would be worth $234 billion by 2015). Yang assumes that Facebook will have revenues of $19 billion by 2015 and after-tax earnings in that year of $5.6 billion. He then applies a 25 P/E multiple to these earnings to arrive at a valuation of $140 billion.

But his 25 multiple assumes a life expectancy of Facebook of some 54 years if I am right. How can this be when the company is already being threatened by new competitors like Google+ and the firm hasn't even gone public yet. Remember Friendster and MySpace? Facebook's founder, Mark Zuckerberg, famously said that what people like about Facebook is how cool it is. How can he possibly expect Facebook to be cool fifty years from now? Are there any techies out there that think their grandparents' rotary phones or eight track tape players are still cool?

Using Geoff Yang's estimates of Facebook's earnings in 2015 means that Facebook could afford to pay a $2.8 billion dividend in that year and have it grow at its risk adjusted discount rate of 20% in the future. If you assume it is more likely that Facebook will be obsolete in 20 years rather than 50, then the present value of this growing dividend stream in 2015 will be $45 billion. Discounting back four years at 20% per year you arrive at a firm value for Facebook of approximately $22 billion today. This is a far cry from the $100 billion plus valuations that Facebook is thinking about going public at. And remember, the $100 billion IPO price is what big institutions and insiders pay. As a small individual investor you will most likely be buying in through the secondary market weeks after the offering at valuations of $150 to $200 billion just as the insiders are unloading their overvalued shares.

A similar type analysis can be applied to Groupon, LinkedIn and the other hot internet stocks out there today. The key is estimating how long of lives these firms have before they are made obsolete by the next big thing. Remember how big a deal monster.com was to corporate recruiting just five years ago and how we thought its dominant market position would last for decades, and now Linkedin has created an even more powerful networking site for recruiters. And amazon, the gorilla on the block is already after Groupon. While we can all applaud the next big thing in the tech world, we have to start assigning values to firms in this space that fully recognizes that innovation is both a blessing to growth but also carries the curse of more rapid obsolescence.

John R. Talbott is a best selling author and consultant. His new book is mandatory reading for anyone interested in learning the real reasons for this crisis and how to protect yourself going forward. You can read more about John and the new book at www.stopthelying.com or at amazon.com. Information for media contacts is available at www.stopthelying.com.