The Tech Boom Then & Now
Who famously said that, “profits are for wimps!” You could easily be
mistaken for believing that this must have been uttered by some avid socialist.
Wrong! A clue; cast your minds back to the early millennium tech boom.
Indeed, this was the prevailing view and said many times by the then budding
new economy entrepreneurs. The owners of these new businesses argued that
in this modern world of technological development the traditional methods of
evaluating businesses were completely outdated and that profits were for wimps.
But shouldn’t the object of a business remain the same, namely to make a
profit, irrespective of whether the entity was a builder of railroads in the
18th century or a provider of technology in the new millennium.
Back then, the boys with MBA's and shiny shoes from the Ivy League
business schools somehow bamboozled investors with impressive business plans.
They put forward compelling arguments about forsaking company profits in the
foreseeable future for instead the greater good of focusing their goal on
increasing market share.
It was a rather devious plot, if investors seemed weary about the viability
of the business, they would be patted on the back and told not to worry; after
all who cares about foreseeable profits in short term, when the goal of the
business is world domination. Be patient; forsake rewards in the near future
for huge rewards in the long term. The business strategy seemed credible,
moreover it tapped into one of the most powerful human emotions of all; greed.
Investors scrambled over themselves in desperation to buy anything that had an
internet sounding name. Many of them didn’t even understand the business
activities, let alone conduct some preliminary research into the financial
credibility of the company’s share they were buying.
But who cares, just buy and hold, then sell next month and bank the
profits. It seemed like a no brainer with everyone jumping on the bandwagon.
As the saying goes the rest is history. The technology bubble ended
like so many previous bubbles before it; with a burst, a sharp correction in
technology share prices followed by a recession. Like in all investments,
it’s all about timing, knowing when to buy and when to sell. Only a lucky few
people were fortunate enough to get out at the right time. The result being
that a few people made a lot of money, but even more people lost even more
money.
Fortunately, there were a few voices of reason during the internet mania,
as it was dubbed back then. The author of “Irrational Exuberance”; Robert
Shiller, an economist at Yale University argued in early 2000 that there were
many similarities with the technology bubble back then and with Britain’s
railway mania in the 1840’s. Would be railway millionaires raised large amounts
of capital on the stock market to finance railway construction. Most railway
companies never made a profit due to the fact that over investment resulted in
overcapacity, which resulted in many going belly up.
So, now in 2014 is the technology sector in a period of “irrational
exuberance?” I would argue definitely! Moreover, the correction
coming is going to be bigger this time around. Regretfully, investors have not
learned from the previous correction. Put simply the objectives of a
business is to make profits. Getting back to fundamentals is desperately needed
and the traditional methods of evaluating a business are more so valid today in
the technological sector.
Let’s revisit some old fashioned ways of evaluating the viability of the
tech sector. For example, the Price-Earnings ratio (PE) is a useful tool
in the investor’s box for assessing whether the current market price for a
stock is trading at a fair value.
The PE ratio is relatively a simply ratio to calculate; divide the current
market price of the share divided by its annual earnings (EPS). As a rule
of thumb, when the PE ratio is high it would indicate that investors are
optimistic about the future earnings of a company compared with a lower PE
ratio.
Face book’s current PE ratio is 71, which means that the stock is trading
at 71 times its earnings per share. To give you some perspectives, the average
Dow Jones industrial company trades at only 13 times EPS. Investors normally
feel comfortable with a PE of 20. So Facebook’s PE ratio is sending up a
big red flag. Investors are overoptimistic about the future earning potential
of the company; the current share price is overvalued.
Let’s examine another useful figure, market capitalization. This is
the total market value in monetary terms of all of a company’s outstanding
shares. Market capitalization is calculated by multiplying a company's shares
outstanding by the current market price of one share. Face Book’s has a current
market capitalization 142.99 billion USD. Again putting this into
perspective the British engineering aerospace company Rolls Royce has a current
market cap of 32.26 USD billion. The US automobile company, Ford has a current
market capitalization of 63.62 billion USD.
Now ask yourself this question, is Facebook really worth more than four
times Rolls Royce and more than twice Ford.
Facebook may have a billion users, but this glorified bulletin board is
finding it challenging to turn users into a revenue stream. Indeed, some users
are turning away from Facebook in the belief that their privacy is being
violated. Also the preposterous amount of money that Facebook paid for
Whatsapp, the mobile messaging service, 19 billion USD, defies business logic.
How many users have switched to rival free messaging services when Whatsapp
tried to charge its customers, who now have free alternatives, such as
Line and Tango, just to name a few?
What we are seeing is more than irrational exuberance this time, indeed it
seems more like investor insanity! Perhaps it is fitting that Mr.
Zuckerberg now has a wax model in Madame Tussauds because when his
investors eventually hold a candle to re-examine his business model they may
find their wealth vanishing, just like the melted wax of Mr.
Zuckerbeg’s model in Madame Tussauds.
Darren Winters
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