Twitter went public today, and I couldn't help but feel alarmed.
After seeing the 75% valuation pop from $14 billion to $25 billion, my initial condolences went to Twitter. A surge on IPO day is good of course, but 15-20% is more than enough; 75% simply means the company was mis-priced and that Twitter left over a billion in cash on the table.Once my sympathies for Twitter subsided, I began to reflect on a much bigger problem that has been bubbling up in the tech community for the past couple of years, and is being tragically reflected and reinforced by this very public valuation.
The link between valuation and underlying value is quickly fading
Startup valuations are, to put it euphemistically, frothy.
Valuations are becoming entirely dissociated from intrinsic value, and investors are focusing entirely on reward with almost no regard for risk.
Snapchat and Pinterest are worth around $4 billion dollars each. Evernote and Airbnb are each worth over $2 billion. Path is worth $500 million. By comparison, Peabody Energy, the largest coal company in the world which owns almost 10 billion tons of coal, is worth about $5 billion.
I understand speculation and risk; it's been my job for the past two years. I know that these companies are still at an early enough stage that investors buy a basket of them hoping that one or two hit it out of the park. Is there a 10% chance Snapchat is worth $40 billion? Maybe, but that's not a bet I would take.
"Forget valuation multiples, how does the product make you *feel*?"
What worries me most about the valuations of companies like Twitter, Snapchat, and Path isn't the nose-bleed revenue multiples (nevermind positive earnings), but the emotional way the valuations are justified.
Today, the Twitterverse is lighting up with investors chattering excitedly about Twitter's reach, impact, connectivity, meaningfulness. "People who think the company is overvalued," they scoff, "just don't get the power of Twitter."
Twitter is an awesome company and I love the product too, but we need to try to remember that Twitter stock is a financial asset, and financial assets are worth the present value of the discounted future stream of cash flows. Full stop. (Alternatively, financial assets are worth what the next fool in line behind will be willing to pay a year later, but surely no self-respecting investor thinks that way.)
Valuations trickle down from the top
I'm worried about the entire startup ecosystem because startup valuations propagate down from the top of the market. This valuation (along with the recent surge in Facebook stock) will send a rising tide of valuations rippling down through the ecosystem until "my friend and I have a pitch deck and an idea for a web app" is worth $10 million.
Our tacit understanding is that while early stage investing is a crazy game, public investors do serious diligence and put the company through rigorous financial analysis, so their valuations must be grounded in reality. "So if Twitter is worth $25 billion and its size is X," thinks the VC to himself smugly, "this other startup must be worth $250 million because its size is 0.01X."
Big promises, frothy markets
Because human nature dictates that people have no patience and jealousy problems, the problem fuels itself. Investors see other investors getting rich off of pipe-dreams-turned-billion-dollar-exits, and they want a piece of the action. The only way to get the big returns is to have a piece of the big companies, so the dozen consumer companies that could plausibly go public in the next 12 months receive incredible attention. Emotions run high, valuations run high. Froth begets froth.
Maybe Twitter really is fairly valued at $25 billion, and maybe the same is true for Snapchat at $4 billion or Path at $500 million. I'd be shocked, but maybe.
The real problem here is that we increasingly live in a world where technology companies are valued on emotional whims and promises of unbelievable future growth. I wasn't paying attention back then, but I feel a hint of what I imagine was running rampant in 1999; excitable, short-sighted investors betting billions of dollars on large audiences with promises of inconceivable growth and eyeball monetization.
I'm not calling the top or saying we're in a bubble, but I think we would all do well to step back and think about what valuations actually mean and where they come from. This quote from Warren Buffett always seems to do the trick.
“You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what it’s worth at current gold prices, you could buy — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils (XOM), plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?” -Warren Buffett