The Web 2.0 Madness

After hitting a bottom in 2009 the S&P 500 index experienced a triple-digit appreciation; this year alone it has increased by 25%. The Federal Reserve has been pumping money into the economy, and with this help (which has been pushing investors out of the bond market in the direction of the stock market) we are currently experiencing a very healthy bullish trend.

A problem with a prolonged market rise, however, is that it tends to increase margin debt and attract more and more investors. All of these factors end up pressing prices higher and higher. No one wants to get out while stocks are still rising, so a vicious cycle forms. One may want to believe that this time will be different, but stocks cannot rise forever without any limit. A continued rise in stock prices is rarely followed by a proportional rise in earnings, so valuations get out of sync with prices during such periods. When this is happening, it is time to be careful.

One of the biggest problems of the tech bubble of the late 1990s was related to the huge P/E ratios that companies were carrying. In some cases this ratio could not even be computed because many of the high flyers don’t even have historical profits. Analysts invented alternative metrics, like value per user, to justify P/E ratios of 100x, 200x, or even infinite P/E ratios.

It all ended badly:  stock prices crashed and caught up with the traditional value earnings. Ultimately, the ability of a company to generate profits in a consistent way is what drives value, not the number of unprofitable users they have.

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But it seems that memory fades for many investors, considering that the average P/E rose again in 2007 to as high as 70x, only to crash later to 15x with the onset of the financial crisis. Now in 2013 P/E is around 25x, substantially above the long-term mean of 16.5x, indicating we may be heading toward a bubble again.

Dotcom companies such as Linkedin, Facebook, and Netflix,  have very high P/E ratios, yet demand is very unstable for this type of business. Netscape, Yahoo, Hi5, and Digg,  were once the best in their specific category, but in the blink of an eye new trends stole their users to other companies.

A great example of the irrationality rising around these companies is last week’s three-billion dollar offer from Facebook to SnapChat. Facebook is willing to pay $3 billion for a company that shows zero profits on its income statement – just because it develops a beautiful app that is supposedly used by 10 to 30 million users. More irrational is the fact that the owners haven’t accepted the offer, probably delaying the deal because they expect the value to rise to the hundred billion dollar level. But, in this business, the same who love SnapChat today will probably find it useless tomorrow. This will most likely take place before the company has an opportunity to let earnings catch up with price. If that happens, it will be the price that will catch up with earnings, which, if you recall, happens at the zero level at this point.

Remember that when there are no earnings you’re exchanging money for fresh air and expecting this fresh air to turn into something more valuable in the future. The higher your expectations, the higher the risk you will be deceived. Be careful out there.

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