IPO mania is setting in with the likes of LinkedIn (NYSE:LNKD), Groupon (NASDAQ:GRPN), Renren (NYSE:RENN), Pandora (NYSE:P), and potentially Facebook and Twitter. However, the soaring valuations, risky secondary-market trading, and infectious over-enthusiasm in the technology startup space could be warning of an overheated and potentially dangerous market.
There is no doubt that companies like Facebook, LinkedIn, Groupon, and Twitter have revolutionized the way we interact with others and how businesses interact with us. These companies show tremendous user and subscriber growth, promising future opportunities, and huge profit potential. It even seems as if the world would no longer function properly without them. But with unproven money-generating capabilities to justify such exorbitant valuations, and what appears to be an over-reliance on the belief that these companies will one day validate investors’ expectations, investing in many of these companies may be highly unwise and risky. Moreover, such extreme euphoria regarding the future of these companies could be pointing to a renewed technology bubble that will be met with failed expectations and big financial losses.
I am not saying that a Tech Bubble 2.0 is necessarily here, but the rapid growth in enthusiasm over these up-and-coming technology companies and the willingness to pay high premiums to own shares in their stock should at least be a concern. Particularly when many of these companies have yet to prove their profitability and while expectations are sky-high and possibly unrealistic (See: Betting Against Facebook).
With valuations of these highly popular companies reaching $10, $20, or even $100 billion in the case of Facebook, investors need to be aware of the pricing basis which determines the amount they must pay to own shares in these companies. It would be one thing if these companies were earning enough money to justify their valuations. But when LinkedIn is being valued at $10 billion, Groupon at near $30 billion, and Facebook at $100 billion- and their revenues don’t even come close to established companies with similar market caps- such frothy valuations are not so appealing.
For example, at its current valuation, LinkedIn is bigger than Sirius (NASDAQ:SIRI): $10 billion vs. $7.5 billion; Groupon is bigger than one of the top cloud-computing companies, Salesforce (NYSE:CRM): $30 billion vs. $18 billion; and Facebook is even bigger than Amazon (NASDAQ:AMZN)! That's $100 billion+ vs. $85 billion. It would be fair to say that the new companies could possibly one day earn these lofty valuations, but to be valued at such extreme levels when their revenues don’t even compare is risky, to say the least.
So how extreme are the valuations? We can compare them based on two fundamental valuation metrics – Revenues and Price-to-Earnings (P/E) Ratios. In terms of revenues, LinkedIn earned a measly $243 million in 2010 compared to $2.88 billion for Sirius; Groupon saw $600 million in 2010 compared to Salesforce’s near $2 billion; and Facebook earned a tiny $2 billion compared to $37 billion for Amazon. These are not just small differences – these are massive discrepancies that the new companies must justify.
Furthermore, these companies aren’t even profitable yet! LinkedIn had profits of only $15 million last year while its valuation is at $10 billion; Groupon even saw a loss of $413 million: (Click to enlarge)
Or take Pandora (P), which is expected to IPO this week: (Click to enlarge)
As the hottest company in years, Facebook is still not matching Google’s (NASDAQ:GOOG) early success: (Click to enlarge)
These lofty valuation wouldn’t be so much of an issue if the companies were producing proportional revenues to justify their market caps. And surely much of the money that has been invested in Facebook, Groupon, LinkedIn, and others is being invested because of the potential future profits that these companies may produce. Time will tell, but the probabilities are low.
P/E ratios are the second concern. The P/E ratio, or price-to-earnings ratio, is a measure of how much investors are willing to pay today for a company’s earnings tomorrow. If a company is expected to grow rapidly, and therefore “prove itself” by earning the required revenues, investors will pay higher multiples for the company’s stock; a company with a bright future would therefore be proportionally more expensive than a failing company. But while investors generally benefit from paying more for growth companies, there are big risks involved in overpaying. A 20 or 30 P/E ratio is historically reasonable for a growth company, and a 50 or 60 P/E ratio may sometimes prove profitable. However, massive and dangerous investment bubbles have formed and collapsed when P/E ratios reached extremely lofty levels. For example, the dot-com bubble days saw the P/E ratios of many overly-hyped companies reach over 100, only to send those companies’ stock prices crashing down once reality set in.
So if P/E ratios of over 50 are even dangerous, and ratios near 100 were seen at the height of the dot-com bubble, how high are the P/E ratios for these companies? Facebook’s P/E is over 100, Groupon’s can’t even be determined because it’s still losing money, and LinkedIn’s P/E is over 1000! These aren’t just concerns, these are warning signs of overspeculation and hype. Keep in mind, even Netflix (NASDAQ:NFLX) which many consider to be overvalued is still only a 75 P/E, and Apple (NASDAQ:AAPL) has a P/E of under 16!
Investors are once again ignoring P/E ratios, assuming these companies have entered a revolutionary market niche and will be able to justify their stock prices as they continue to grow rapidly. And a big reason why investors are paying huge premiums to own shares in these companies is because valuating these companies is even more difficult before they go public or before they show a few years of financials.
Risky Secondary-Market Trading
With many private companies have avoided going public through an IPO in the past few years due to poor market conditions and the desire to avoid disclosing their financials to the SEC, secondary market trading of company shares has been gaining a lot of popularity. In other words, instead of buying and selling stock on a public exchange, private shareholders have been selling their stake to outsiders such as Goldman Sachs (NYSE:GS), T. Rowe Price (NASDAQ:TROW), Morgan Stanley (NYSE:MS), and others without going through the traditional methods of exchange. Secondary markets for private shares, such as SecondMarket, have been growing, and have offered investors a way to buy shares in companies before they go public.
Secondary markets have tremendously inflated prices and risk, however. With little clarity as to how much these companies are really worth, along with the extra excitement and overpricing that the 'hard to acquire' status of those private shares have produced, the valuations of these companies have been able to reach what appear to be highly unreasonable levels.
Most of the Price Appreciation Already Over
After investors bought and sold shares on the private secondary markets and brought about massive price increases in these companies, there is probably little upside left. In a traditional market, a stock that is released through an IPO could gain momentum as institutions and investors pile in; but since secondary trading has been taking place for years now, many of the big players are already invested, and the late-comers (average investors) may be the suckers who lose money as the big players pull out.
Just take LinkedIn (LNKD) as the example: (Click to enlarge)
LinkedIn’s valuation soared on its way to IPO, and reached a price of over $120/share on its first day. But since much of the trading was done on the private markets, the IPO was an opportunity for those already invested to bail and sell it to the latecomers. The price has dropped from over $120 to near $70 in less than 20 days. The same has happened to Renren (RENN) which is down from a high of $23 to just above $8 in less than a month. And the same could happen to the other companies that eventually go public – Pandora (P), Zynga, Living Social, Twitter, and even Facebook.
Overstated User Growth?
Facebook supposedly has nearly 700 million users, Twitter has over 100 million, and Groupon has over 80 million. But how many of these users are actually active? And do these users really stand as any value to the companies other than just another person to add to the list?
A large user base is a tremendous advantage to these companies since they can reach a much wider audience and attract advertisers, businesses, and investors. But if the user base is made of inactive or non-profitable users, their value is limited.
Twitter is also showing an overstated user base. This company is my favorite within this space, since it is the least overvalued. However, it still shows a tremendously inflated user number; with only half of its users following two or more people: (Click to enlarge)
After growing tremendously for years, Facebook is beginning to show weakness. It has lost over 7 million users in the U.S. and Canada in May. Though growth in Mexico, Brazil, and India has made up for the losses, the threat of peaking popularity and stagnant growth are a huge potential problem for Facebook and others. If the growth that most investors have expected cannot be sustained, these companies are setting themselves up for huge disappointment.
After a few years of massive excitement regarding the future of social media, group buying, and the bright future for internet startups, signs of a bubble are continuously emerging. We've got it all:
Rapid increases in valuations
Extreme P/E ratios that are reminiscent of the dot-come bubble
Revenues that do not even come close to justifying company valuations
Risky and ambiguous secondary-market trading
Overstated user bases
Extreme expectations that may never be met
These are all signs of mass speculation, euphoria and huge potential risks that have emerged. They should stand as a warning to investors looking to get in at a time that may be too late.
Disclosure: I am short NFLX.