Bubble Warning on Facebook, Groupon
The mysterious ways of financial valuation manifest daily. One mystery: Facebook, the social network business, and Groupon, the buying network company, both generate annual revenues of about $1 billion. Yet reported private stock trading indicates that traders are pricing Facebook at about 50 times that while pricing Groupon at about 5 times that.
Perhaps this is attributable to analytical factors, such as observed user growth rates, potential market and revenue sources, perceived capacity to convert the revenue into earnings, competitive threats—or negotiating skill in trading of privately-held shares. But given the wildly varying pricing traders give enterprises like this in recent years, it could be a sign of a bubble.
Financial bubbles recur as a natural, inherent product of human behavior in capitalist economies—from the recent real estate bubble, to the dot-com bubble a decade earlier, and stretching back to the tronics bubble of the 70s and back to Amsterdam tulip bulbs centuries ago. (I wrote a trade book about this after last decade’s bubble burst.) By definition, a critical mass cannot recognize the bubble as it is in inflating, though invariably some pessimists detect something.
Internet and other tech companies are notoriously difficult to value, especially in early years before earnings, and the best value clues are calculated as a multiple of recent revenue. With standard value measures and recognized business types, reliable rules of thumb apply, putting limits on a fair price to pay expressed in ratios of price to basics like earnings or tangible assets.
But with businesses in unchartered territory, the tendency is to measure price in relation to annual revenue—and there is essentially no standard yardstick. Of late, the range has extended from 6x revenue to nearly 400x revenue.
At the extremes in recent years: Microsoft bid 6x revenue for Yahoo, which declined the offer as insulting; eBay bought Skype for 370x revenue, which it later acknowledged as a massive overpayment that it had to write down. More moderately but not much more succesffully, News Corp bought MySpace for 12x revenue, also later written down. More wildly, Google bought YouTube at 113x revenue and Microsoft’s initial small investment in Facebook was bought at 100x revenue—neither yet seen to be profitable. This month, Google bid 6x revenue for Groupon, which declined the offer as too low.
At todays’s ratios (Facebook 50x revenue, Gropuon 5x revenue), Facebook looks overpriced and Groupon on sale. On the other hand, laying down cash for shares in either is akin to gambling in Atlantic City or Las Vegas. You can make a bundle or lose all you commit, with odds favoring losing. But if you work for an institution, playing with other people’s money, you can hedge your bets—brag if returns turn out big and simply not speak about the deal otherwise. That may explain some of the wild valuations, driven by institutional buyers, the “smart money.”