It seems like almost every day now I see someone who believes we are in the midst of tech bubble (a world in which companies are valued far above their true worth). The most common arguments people mention are 1) startup valuations are massive and dissociated from underlying value 2) public technology companies are overpriced, and 3) MBA-types are moving to Silicon Valley to get a piece of the gold rush. In this post I will address each of these points and argue that we are not in a bubble.
Startup valuations are too high
Argument: Nosebleed startup valuations are the most commonly cited indication that we are in a bubble. Airbnb and Dropbox are valued at $10 billion each. Snapchat and Pinterest are valued at $4 billion each and they don’t even have revenue. Facebook bought Oculus for $2 billion before consumers could even get their hands on the product. Whatsapp is just a joke.
Most people have become comfortable with the idea that even though young startups are likely to fail, seemingly high valuation can be reasonable if there’s a sufficiently likelihood of success. Early stage venture investing follows a power law, and the billion dollar outcomes can justify valuations for a whole set of startups. This is why two founders with an idea and a prototype can raise money at a $5 million valuation; early stage startups are treated as part of a basket.
For mature companies like Microsoft, valuation is best understood on an individual company basis, as a discounted stream of future cash flows. Huge companies trade at a reasonable multiple of their earnings because dramatic growth is typically out of the question.
I believe the mental error here is categorization. When people criticize multi-billion dollar valuations, they are bucketing them alongside mature public companies, when really they should still be considered as a basket that will follow a power law of outcomes. The right question is not “is Snapchat worth $4 billion?”, but rather, “is there a 10% chance Snapchat is worth $40 billion?” [1].
We live in a world with over 1.5 billion smartphones and more sophisticated technology than ever before, which means startup potential is greater than ever. When you combine this with an understanding of these companies as part of an overall basket, multi-billion dollar startup valuations seem reasonable.
Public markets are overpriced
Argument: Tech high-flyers like LinkedIn and Netflix are trading at hundreds of times their earnings. We are seeing the most new tech IPOs since the tech bubble in 1999, and many of them are for companies that are quickly burning cash. The NASDAQ is closing in on its all-time highs from 1999 bubble, and the small-cap tech stocks are at some of their highest P/E ratios ever.
There is some truth here; tech stocks are expensive right now by any measure. However, that doesn’t mean they’re overpriced.
While it’s true that younger smaller tech companies are richly priced, the mature tech companies like Microsoft, Google, Apple, Cisco, Yahoo, etc. are trading at very reasonable levels. Also, younger, struggling companies like Groupon, Zynga, and King have stock prices that reflect their situations.
Investors are evaluating each company on an individual basis and valuing businesses that at least make sense and have workable business models. This is very different than the last bubble when companies erroneous business models got great valuations as long as they were “tech”, and mature companies valuations were rising with the rest of the tide.
What we really have in the public tech markets is highly priced young companies and moderately priced mature companies. If you believe that some of the young companies are poised to disrupt the incumbents, or if you take a basket view to young tech companies, then public market valuations aren’t so scary.
Outsiders are migrating to startups
Argument: Five years ago, consultants were competing to get into business school, MBAs were funneling back out to Wall Street, and bankers were quitting to work at PE funds. Now, everyone is just joining a startup.
With this argument, the premise is true; more people are starting and joining startups than ever before, and they’re coming from a much more diverse set of backgrounds.
What’s not necessarily true is the conclusion, that this migration of talent is a bad thing that indicates a tech bubble.
The largest new source of tech workers is the veterans of banks, consulting firms, and business schools. This demographic is widely assumed to be “in it for the money”, and so skeptics believe they will be unable to build the revolutionary companies that drive innovation forward and create massive value.
I have a more optimistic view [2]; I think the majority of this crowd was unsure what they wanted to do, but knew they wanted to work hard and feel important. It seems plausible then that they could discover the startup world a little late and fall in love with it just like anyone else.
Instead of viewing this influx of workers as a sign of a bubble, it should be viewed as the logical extension of an increasing attractive industry in a country with fluid labor allocation.
Conclusion
A bubble is one of those things that can only be identified in hindsight, not because we don’t have enough information right now to know, but because it has not yet been determined. If companies collapse and lose their ability to grow and earn money, then we will have been in a bubble. If enough startups succeed in the ways we hope and expect, then we will not have been in a bubble.
I believe the latter is more likely to be true, that tech is poised to continue on a trajectory of massive growth. The market for startups today is different than it has ever been. Over a billion people have a computer in their pocket at all times, and billions more have access to the internet. Software can be deployed from the cloud and run on a massive scale instantly. Industries that never used technology before are welcoming software into their businesses with open arms. Large amounts of capital are available to startups at every stage, and there is a bigger pool of talent wanting to work in startups than ever before.
Yes, capital is plentiful and cheap, expectations are high, and new tech workers are flooding in from every corner of New York. This may scream, “bubble!” to you, but remember that technology is not zero-sum game. All of this could very well signal the influx of capital and labor that is necessary to create a virtuous cycle that can grow an industry at a massive scale.
[1] In fact, the bar is even lower. The real question should be is the integral of graph of probability vs. outcome worth more than $4 billion.
[2] As a side note, although on some level I understand the reaction to be skeptical of MBAs entering startups, I think it’s an unsubstantiated bias and drives an unwelcoming culture that we should not encourage.