The term “bubble” has been constantly and loosely used to describe the current tech industry. Most commonly, it has been used to describe any short-term price actions. But what does it really mean when we say there is a bubble? Can we even identify a bubble as it occurs? What caused its initial formation? And what catalyst will be the needle to “pop” it? Or will it ever pop and if so, is it always a bad thing? These questions are recurring with each bubble that’s formed throughout history and mostly answered in retrospect. Coming out of the most recent real estate bubble and financial crisis, individuals are overly cautious of bubble signs and are quick to conclude that a bubble exists. As such, volatility is high and valuations become unstable, but these may not indicate a “bubble” exists.
In the current environment, we observe high valuations for startups surrounded by an uncertainty about not just their profitability but also their top-line growth, new valuation metrics to evaluate fundamental value, investors that include institutions and the public, looser monetary regulations regarding funding, ease of access to capital and large follow-on investments. Wow, with that said it sounds like I should just end this post and conclude BUBBLE!! But….Back up. First, what is a bubble before we decide we are in one, and are we in danger if we are in one?
Spoiler: My definition of a bubble supports my belief that bubbles cannot be labeled in the present.
I define a bubble as a speculative process, in which high valuations of an asset or market continue to be undeserved in the long run by evaluation of its business performance, independent of economic factors. As such, in a bubble the overvaluation is purely attributed to individuals and institutions collectively driving up asset values with their expectations of achieving a profit from future price increases and the long-term growth potential of the asset, without fully understanding the invested asset and despite concerns about increasingly significant deviation from the intrinsic value of the asset.
Snapchat’s $3.2 billion valuation and $50 million investment by hedge fund Coatue Management in its Series C, BlackRock’s recent $10 billion investment in Dropbox, and increasing equity crowdfunding platforms, suggest that we are indeed experiencing inflated valuations from an influx of capital into the industry. I believe at the heart of this phenomenon is a financing effect, in which low interest rates, modern yield pigs and a depressed fixed income market are boosting institutional funds and encouraging riskier investments. Individual appetites are also riskier as a result. Additionally, with revisions to the JOBS Act, such that startups are now able to advertise their fundraising process and sell equity to qualified investors from the general public, early-stage investing is becoming more public, allowing more investors to take on a higher level of risk with investments in startups. But to conclude this financing effect has led to a bubble creation, we will need to understand investment rationales. Unfortunately, that’s not possible to do for an entire industry; however, we can gain some insight on the rationale by evaluating the businesses themselves.
Everybody’s favorite example: Snapchat
Snapchat had no revenue and was only 2-years old when it was valued at approximately $3 billion. Investors attribute the high valuation to its large user base of ~4.6 million and app usage, building in expectations that Snapchat will be able to monetize on this user base. Sounds familiar? Ah yes, what I like to call the “Facebook mentality”. But unlike Snapchat, Facebook was already generating revenue in its first year (2004). According to its S-1, Facebook made $382,000 in 2004, $9 million in 2005, $48 million in 2006 and $153 million in 2007, with no net loss. Based on the table below, 2-years old Facebook was valued at approximately $900 million, based on an offer by Yahoo that was turned down. With Snapchat, it appears that despite uncertainty of its revenue generating abilities and a recent hack that exposed the personal contact information of its users, the company along with many others is optimistic of a higher valuation than that of its $3 billion bid from Facebook. Although this example strongly supports the argument that a bubble is forming in the young tech space, according to our definition, this is not yet a bubble until we can conclude that Snapchat is unable to generate the expected revenue to support its valuation, and speculation was the main driver of value, not the business or market environment, and that many other companies in the industry are achieving valuations in this way. So you’re still not allowed to say bubble yet!
Looking at other players in the tech industry, we see that Snapchat and similar companies are more like outliers rather than lead indicators of the space.
Another favorite example: 3D Printing
Last year, there were a number of acquisitions and IPO’s in the 3D printing space that excited valuations and brought the technology mainstream. ExOne went public in February, closing at $26.52 a share compared to its opening price at $18. Stratasys acquired MakerBot for $403 million. Voxeljet went public with its stock priced at $13 but closed at $28.83. These days, it’s almost impossible to not hear people discuss the potential of 3D printing (especially if you’re friends with me!). But with such fast growth and share prices of listed companies skyrocketing, investors immediately assumed a bubble was in the making and fled, sending prices plummeting and bringing down valuations. Such was the case last week with 3D Systems Corp slashing its profit estimate in fear of bubble signs, sending its shares down as much as 28 percent as well as other 3D printer makers. Although these trends may follow certain theories such as Jean-Paul Rodrigue’s, in which a take-off is followed by a first sell-off from investor uncertainty about continued growth, these price volatilities do not serve as indicators for a bubble, rather they reveal cautious investors.
Looking back at the beginning of the .com bubble, the internet was a revolution with unclear boundaries for its growth and money flooded the idea from all angles. Focus quickly became on returns from quick exit strategies rather than the sustainability of the business. And there was great uncertainty about the profitability of many of the companies and the market capacity. However, when we look at the 3D printing industry, we see that there are clear paths for its growth and ability to achieve profitability. The technology’s adoption spreads across almost all industries, from aerospace to biotechnology to fashion, and has already shown signs of profitability. I believe 3D printing will significantly alter manufacturing, enhance business processes and create new business opportunities. These fundamental drivers will allow for the sustainability of 3D printing.
The aggressive funding into the industry should not be confused as excessive investment. I believe capital injection into 3D printing is helping companies in the space invest more into the technology to allow it to scale, achieve profitability and grow the market; 3D printing is a capital-intensive industry. Finally, compared to the first quarter of 2000 when ~159 internet IPOs were completed, there were only 4 publicly listed 3D printing companies at the end of 2013, with 2 IPOs occurring in 2013. I believe the limited number of public 3D printing companies is also a driver for price increase as individuals seek opportunities to invest in 3D printing but are limited to the 4. I believe the current high valuations will be justified by subsequent performance of the industry in the next few years and extreme price volatility is a short-term phenomenon as the industry is still in its youth, and therefore, I do not believe a bubble is forming in the 3D printing industry.
Evaluating the larger tech industry, I break it down into 2 parts. The first part consists of the Snapchats of the world and the second consists of companies that have proven revenue-generating businesses (i.e. Dropbox, One Kings Lane, Etsy, Twitter, Amazon) but may be currently overvalued because of their growth potential in an identified new market. The first are what I believe are “fads” and naturally the result of an ever-changing technology industry that is fueled by curiosity, innovation and excitement; they do not provide a lasting utility. Many of these “fads” will disappear after a first sell-off or a change in the economic environment (i.e. interest rates rise). The second part comprises of companies that have the potential to disrupt the current landscape and introduce efficiency or utility to individuals.
And now, to finally get to the point, I don’t think we are necessarily in a tech bubble, but are seeing a lot of attention around some fads; however, we need to be cautious and observe what is being funded, understand why it is being funded and question if funding would have occurred given a different economic environment.
So, nope, still can’t say bubble!
But go ahead and call this a bubble…