Why we’re in a bubble
So, then, it shouldn’t be that hard to see if we’re in a bubble, right? If our three criteria our met, we’re in one. Bob’s your uncle.
First, I’d posit that this is not a “dot com” bubble. I believe the bubble we’re in is a social/mobile bubble. I say this for a number of reasons: social/mobile companies have higher valuations than many of the other tech companies out there, and they garner considerably more press. It’s easy for us to think of the entire dot com sector, thanks to the previous dot com bubble, but in fact we have several sub-markets now. When Chris Dixon says “Instagram aside, there is SUBSTANTIAL revenue and even profits being generated by a much larger # of companies than ever before,” he is generally mixing all tech companies together. There are indeed several tech companies producing substantial revenue. But what percentage of social/mobile companies are?
Let’s look at those three pillars of the definition:
Trade is at high volumes
Social mobile companies are proliferating. Many are getting invested in. TONS of them. We all know this. We see new deals every day on Techcrunch, VentureBeat, Betabeat, etc. Perusing the Branch discussion, everyone agrees there’s some “froth” at the early stages for “certain” types of companies (i.e., social/mobile).
But all this is, of course, subjective. So let’s look at Blodget’s empirical data. Despite some blurring at the beginning, in his Anti-Bubble presentation, Blodget points out VC investment in tech is increasing, now, even in a down economy.
Prices are “considerably at variance to intrinsic values.”
So let’s turn our attention to pricing. There are two parts of this equation: (1) considerably at variance and (2) intrinsic values. Let’s go one by one.
(1) The very existence of a plethora of heated discussions on bubbles should be enough evidence that investors profoundly disagree. The tepid IPO market vs. the number of companies aiming to IPO, along with their substantial number of backers wishing for the same thing, should indicate two parties who substantially disagree on value, considerably.
(2) “Intrinsic value,” of course, is a bit more complicated. This has always been the sticking point for any educated bubble conversation. The tech sector has produced myriad companies that operated for years without revenue that eventually went blockbuster: Google, Amazon, Facebook, etc. Revenue, then, is only part of the equation. The trick is to figure out what else matters.
Intrinsic Value is defined by economists as the current and projected future value, marked to the present, of an asset. It is the “actual” value vs. the “market” value (and, thus, Facebook’s $1B purchase of Instagram is moot. That is a market value). This also means that if revenues are currently at zero, but future revenues are projected to be high, the current valuation is positive. So, then, despite zero present revenues, a company can have intrinsic value.
Opinions vary, however, on how to calculate this intrinsic value, since it relies solely on unknown future revenue. Is it the next instagram? Or a failure? It could be either. Mark Andreessen suggests factoring in the likelihood of the big win, thus adding a percentage multiplier into your calculations.
So let’s do that.
It is my position that many, if not all, of these companies are projected to earn their revenue from advertising. There are exceptions, like Zynga, but by and large, most of these companies are expected to make their money off of advertising. I have written extensively in the past about the finite size of the global ad market, and how we can only support 9 more google-sized companies.
There are about 3,500 startups funded every year. Delve into the stats at that link and you’ll see 1,000 of them are new startups in internet or media. The online ad market in the US is about $40B. The math there is $40 million potential for each new startup (you could complicate this by saying 5,000 startups over, say, five years, and $200 billion over the same span, but the math is the same.) And this ignores the previous contenders. What, really, is the statistical chance that any new startup will capture a substantial portion of that market? Given the massive barriers to entry via the need for building a substantial user base, and the large, incumbent players who already capture that ad revenue (Google is not going to go away), statistically, the answer has to be that It is approaching zero.
That should be the end of the argument from a mathematical perspective. The “rational” future “actual” value is the potential future value multiplied by its likelihood. I contend that the potential is far lower than stated, and the likelihood is far lower than stated as well. It’s not a $40 billion times 10%, it’s $40 million times .01%.
So there we have it. Mathematically, prices are out of whack with intrinsic values. And there is considerable disagreement, i.e. “considerable variance.”
There really shouldn’t be any thing else to the argument. However, I concede that all of this, while based in data, statistics and fact, is still based on my opinions of likelihood. There is still some guesswork.
Let’s look at the counter arguments.