Technical Analysis

Is a bubble forming online?

Raghu Kumar | Updated on March 02, 2014 Published on March 02, 2014

A bubble is an interesting phenomenon. The fascinating part of it is that it can occur, if and only if, majority of the public do not see the bubble coming. The dot-com bubble of 1997-2000 and the housing bubble of 2008 are two classic examples. Before the bubbles were formed, most “experts” agreed about the rising prices for dot-com companies in 1997-2000 and for real estate in 2008; it was only after the bubbles burst that the same “experts” reversed their stance and began rationally explaining how and why the bubbles burst.

Buffett’s checklist

Warren Buffett is widely considered one of the best value investors of all time. Buffett is also very conservative when it comes to deciding which companies to invest in. Regarding technology companies, it wasn’t until 2010 that he made his first investment, and even then, he only invested in those that followed three rules:

The stock must trade at a cheap P/E (price-earnings) multiple;

The stock must pay a dividend;

The company must have sustainable product offerings for the future

Coming to the present, Facebook recently acquired the messaging service WhatsApp for close to $19 billion. WhatsApp has around 400 million users worldwide and an interesting revenue model: it charges a one-time fee of $0.99/iPhone user and $0.99/year on all other platforms (with the first year being free).

WhatsApp reported revenues of just $20 million in 2013; therefore, Facebook essentially valued WhatsApp at a price-earnings multiple of 1,000 ($1,000 per dollar of revenue generated). This is almost unheard of in Wall Street. You can be sure that Buffett would never go for such an over-valued deal.

WhatsApp has no plans of advertising or changing its revenue model. Although its expenses are low and streamlined, there seems to be no clear way to objectively validate the $20-billion price for the messaging company.

One could argue that although WhatsApp, in itself, does not warrant a valuation of $19 billion, it was a good deal for Facebook as it did not have much to lose, ensuring at the same time that its competitors (Google and Microsoft) did not acquire it. However, this deal sets a wrong precedent for the valuation of other technology firms.

Bidding wars

If a messaging service like WhatsApp can be valued at such a high price, it is only a matter of time before another technology company with a questionable revenue model is bought at such a huge price. Bidding wars will begin over technology companies with huge user base, murky revenue models and uncertainty over product sustainability. While most of us would probably bet on Apple and Microsoft being as popular 15 years from now, can we be as confident on a messaging service like WhatsApp?

Then again, Facebook is a technology company in itself. It doesn’t pay dividends; has a questionable revenue model, and has the third largest P-E ratio at 105 compared to several S&P 500 companies. Apple, Microsoft and Berkshire Hathaway all have much lower P/E ratios.

In short, technology companies are being valued purely based on their future potential and not the present. It may be just a matter of time before the market does a reality check.

The writer is Co-founder, RKSV

Published on March 02, 2014
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