There’s been a lot of discussion lately about whether or not we’re in a yet another tech bubble. It’s a complicated question because what exactly is a bubble? Clearly we all agree it involves “irrational exuberance” but to what degree?
Mark Cuban says it’s not a bubble, it’s a pyramid scheme. I think his logic is flawed. It assumes that later investors are paying back the former, which is quite atypical. Most of the action these days is coming from seed and angel investors, who rarely get paid anything before an IPO or acquisition. If anything, convincing later investors to follow on only increases an early angel’s variance, as it raises the figure needed for an acquisition. The public markets, I think, aren’t going to be as easily fooled as last time around and I don’t think anyone’s counting on them being the suckers at the bottom of a pyramid.
Currently there isn’t much bubble-like activity in the public markets. In the first go around I was asked questions like “I just bought 1,000 shares of Cisco, what do they do?”. Back then anything even remotely computer-related had a stratospheric P/E ratio. Most publicly traded tech stocks are trading at reasonable levels now. Even Apple is at 20, compared to an S&P 500 average of 24. There are a couple exceptions (most notably Netflix) but on the whole tech stocks are not out of line with what we’re seeing in other industries.
There are a few big differences this time around. For one there are real revenues and even profits. Groupon will likely top $1 billion this year, and their margins are probably pretty high. Facebook’s may have topped $1 billion last year already. Zynga is pulling in somewhere in the 9 digits. Last time the problem wasn’t that people were giving a company a $50 billion valuation despite it only having $1 billion in revenue, it was that they were giving a multibillion dollar valuation to a company that might not even have a feasible business model. When it comes to P/E ratios, there’s a huge difference between fifty and infinity. Fifty means the company has a proven revenue stream and a high chance of increasing profits through improving operations or scale. Infinity means they might be trying to sell something nobody wants.
I have no doubt that startup valuations are overly high. It’s just to good of a fundraising climate for founders. Even though Y Combinator alone is pumping out 80+ startups a year, the relatively low capital needs have too many investors chasing after two few startups. Even if you assume there are another 80 startups worth funding in the valley every year (and we’re at the point where I’m not sure that’s a safe assumption anymore, at least at the angel level) that’s still not that many opportunities to do an early deal with a team of founders.
So what’s going to happen in the long term? Well, I expect investors are going to see a lot of middling returns. This time around companies, with a few exceptions, aren’t going to crash and burn like last. Even Twitter will probably find a way to make decent revenue. The amount of money that can be made selling ads alone is now substantial thanks to targeting. During the original bubble products like AdSense and virtual goods and freemium services weren’t yet widely understood, and if they had been I think we would have at least seen fewer wipeouts. People know a lot more about making money on the net now than they did a decade ago and that will help a lot when the inevitable correction comes.