- We as investors constantly alter our standards for finding good investments in new tech.
- Twitter, Workday, Tableau and FireEye are examples of such compromises.
- Facebook is an example of new tech that can be purchased according to old tech rules, making it superior.
Due to high-profile IPOs like Twitter (NYSE: TWTR), Tableau (NASDAQ: DATA), FireEye (NASDAQ: FEYE) and Workday (NYSE: WDAY), and acquisitions like WhatsApp, investors have found a new way to value new technology, and that's by sales. Essentially, these companies don't have net income and are spending aggressively in order to maintain the explosive growth that Wall Street expects. Hence, the late 1990s "get big fast" motto has returned, and price/sales ratios have become the new standard of investing in the future. However, this new system in tech may create hidden value, as high margins from the likes of Facebook (NASDAQ: FB) might go unnoticed.
The new standard
There is one notable difference between now and the dot-com bubble of the late-90s: Today's new-tech are real companies with significant revenue. The problem is that many are just too expensive, and have inflated valuations that they may never be able to fully support, which could eventually create a bubble burst.
Still, we obviously haven't learned our lesson from history, and today's investor values new tech on three key areas: Revenue, growth and in some cases eye balls. The last is the newest, and has been brought into light following Facebook's $19 billion acquisition of WhatsApp. Essentially, Facebook bought a company with $20 million in last year's revenue, a price/sales ratio of nearly 1,000. Therefore, to more logically explain the acquisition, many analysts have noted its 465 million monthly active users, as $40 per user looks slightly better to the naked eye.
This can also be seen in Twitter's last earnings report as its 116% revenue growth would normally satisfy Wall Street. However, investors were much more worried about the fact that timeline views fell 7% quarter-over-quarter. Still, despite Twitter failing the eyeball test, and now trading more than 30% off its all-time high, shares still trade at a whopping 43 times sales, which is clearly not cheap.
Other new-tech companies like Tableau, FireEye and Workday are not subject to the eyeball test to the same degree and are more connected to sales and top-line growth, although subscribers are closely watched as a way to gauge future growth. Workday sells software-as-a-service and trades at 36 times sales, FireEye trades at nearly 60 times sales, and lastly, Tableau trades at 22 times sales. Each of these companies are growing in excess of 80% annually, but the problem is that each company will need many more years of such growth in order to support these excessive valuations due to the absence of profits.
Don't you remember?
Unfortunately, we have grown so accustomed to seeing these multiples - in most cases these price/sales multiples are higher than P/E ratios for old and big tech - that it doesn't even look abnormal anymore. Even Facebook falls into this category with a price/sales ratio of 21.7. However, there is one major difference between Facebook and everyone else, and that is margins.
Each of Facebook's noted peers in new tech are spending rapidly, and most are highly unprofitable, as you can see below:
12-Month Operating Margin
As you can see, these companies are far from consistent profits, thus the conversation of comparing any to earnings is irrelevant and useless. This brings up an interesting point: We were forced to compare WhatsApp to users because its revenue was so meaningless, and we've been forced to judge these companies on sales because net income is non-existent. Furthermore, with each step we as investors take back, we become more illogical, and ultimately, more accessible to a bubble.
Finally, the exception, and that is Facebook. Here's a company that grew revenue by 55% last year and saw its income from operations grow five-fold in 2013 over the prior year to $2.8 billion. Hence, Facebook is a highly profitable company whose costs are increasing at a slower clip than revenue growth, and has operating margins of 37.1% last year. Overall, this means you can value Facebook like old tech despite its 21.7 times sales ratio, and at 38 times next year's earnings, with 50% plus growth, Facebook is not expensive.
As investors of the moment, we are all guilty of accepting and even defending the valuation methods of Wall Street, and then using them to make investments. While this may lead to temporary gains, it will eventually leave you hurt with losses, as it's this logic that ultimately create bubbles and bursts.
With that said, I too have been guilty of such behavior. Back on February 17 I wrote a detailed article assessing Facebook's current business, including peak revenue potential and future revenue streams. My conclusion was that Facebook could not fundamentally support its $170 billion market capitalization, or that it would be very difficult and would take many years. Hence, my conclusion added that Facebook was destined to enter a correction or to trade with many years of no returns.
However, I didn't fully take into consideration one thing, and that is profitability, and the income that this company is earning relative to its peers. In that case, Facebook's price/sales ratio relative to Microsoft and Google is irrelevant. And as long as it's growing at its impressive rate, and maintaining its high margins, Facebook is without question the best choice for investors who want to be a part of new tech, but wish to invest in an old fashioned and safe way.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.