THE PENNY seems to be slowly dropping. Investors have taken fright at how they have driven up the value of the tech sector. A range of big name tech firms have suffered sharp falls in share prices. Twitter is down over 40 per cent over the last three months. Facebook has fallen by 11 per cent over the same period.
But before we start congratulating ourselves that the follies of the last tech bubble are being avoided, a cold look at the facts is needed. Despite the recent correction, many tech companies remain remarkably over-valued by any rational analysis. More importantly, given the size of the sector and the money involved, this unsustainable boom now poses a much bigger risk to the health of the global economy than a decade ago.
It is hard, of course, to draw comparisons over valuations. As one commentator put it, tech – and particularly internet – stocks are not judged by the “financial laws of gravity that determine the value of fuddy-duddy corporations like General Electric”. They are, John Cassidy wrote in his New Yorker blog, viewed as “invaluable options on the limitless future of online commerce which, one day soon, will pay off in limitless profits.”
Only this suspension of economic reality can explain how Twitter, which had then yet to make a profit, was valued at $31bn (£18.3bn) when floated in November. Or why Facebook paid $19bn for WhatsApp, a messaging service which is still searching for a way to extract revenue from its subscribers.
And the boom is not limited to the US. In London, the sale of shares in takeaway food website Just Eat last month gave the business a value of £1.5bn. That is a staggering 100 times earnings before interest, taxes, depreciation and amortisation (EBITDA).
Tech companies, of course, argue that such old-fashioned metrics simply don’t apply to their businesses. But even when using measures which take into account expected growth, such as price to sales, valuations are extraordinarily high. The last tech bubble, for example, saw many tech stocks bid up over ten times sales before the inevitable crash came. The ratio is now often 20 times, or even 33 times in Twitter’s case at its initial public offering.
We saw what happened in the early 2000s when the music stopped. Pets.com, which raised $82m when floated in 2000, went bust nine months later. eToys, whose shares floated at $20 in 1999 and then almost quadrupled in price, filed for bankruptcy in 2001. Investors lost huge sums of money. Startups went out of business in their droves, and $1 trillion was wiped off the sector in a day.
Those who argue that history need not repeat itself point to the fact that e-commerce is no longer a new development but an established fact of life. Technology continues to transform every aspect of our world, with no prospect of the revolution slowing.
Investors, too, claim they are more professional and experienced. The companies involved are also global in their consumer base and outlook rather than restricted largely to the US. They are apparently more sophisticated and mature. Unlike in the late nineties, when many of the tech firms coming to market were barely months old, Twitter was set up in 2007, Just Eat in 2001.
The same wishful thinking has, however, been used to justify every feeding frenzy since tulip mania in seventeenth century Holland. There is nothing contradictory in believing that technology will continue to change the world, yet also doubting that those companies – and investors – now at the forefront of the revolution will reap the financial benefits. Many of the darlings of the first technology boom are now history.
What’s more worrying is the impact that another crash could have on the global economy. It won’t just be investors in tech stocks and internet entrepreneurs who will lose out.
Over the last decade, the scale of the money invested in the technology sector and the number of countries at risk has grown enormously. Google, for example, is now valued at about $350bn, higher than Malaysia’s GDP. Facebook’s market cap is equivalent to the size of Vietnam’s economy.
Another collapse in the value of the tech sector will hurt established successful businesses like them, as well as those based more on a wing and a prayer. It will send shock waves across the global economy, damaging confidence and reversing recovery.
What will be the trigger? It is the intervention of central banks that has helped stoke up the tech boom as investors hunt for better returns. As central banks begin to unwind monetary stimulus, the risk is that the present retreat from the sector will become a stampede. It poses plenty of dangers for all of us.
Guy Hands is chairman of Terra Firma Capital Partners.