Tuesday, March 22, 2011
A Social Media Internet Bubble? Can Irrational Exuberance Recognize Itself?
Posted by Find Insurance Online at 11:50 AMOn March 17, 2011, USA Today observed, “Tech and Internet stocks turned into bad words after the dot-com bust in 2000. But the get-rich-quick feelings toward tech are back. . . . Given the near-hysteria about promising but largely unproven companies, investment [practitioners] warn that things could start getting out of hand.” So why doesn’t the government step in and stop it from going so far and then crashing? This is easier said than done. Beyond the difficulties in having regulators intercede to stop transactions that may be necessary to avert a party from bankruptcy, the sheer ambiguity in ascertaining whether a bubble does in fact exist can have a paralyzing effect. "It's a boom, not a bubble, when you hear the sound of dynamite profits," according to Bing Gordon, a partner at a venture-capital firm and a board member of social-gaming company Zynga, which was valued at $9 billion in March of 2011.
However, a big boom can explode in a giant bust; Gordon’s distinction doesn’t carry much water. Neither does that of Geoff Yang, a founding partner of Redpoint Ventures. "There is effervescence, but no bubble." Effervescence can manifest, however, as an attribute of the sort of irrational exuberance that characterizes bubbles. That the market mechanism not only does not temper, but may even magnify the volatility from, this all-too-human psychology, whether in pushing a “boom” or “bubble,” is the real problem. Government regulation will not be able to effectively pull up this root until its nature is uncovered. In the meantime, we are left with the problem of discerning whether a bubble can even be identified as it is expanding. Consider, for example, Facebook in 2010.
In 2010, Facebook had about $2 billion in revenue according to USA Today. MSNBC puts the company’s profit for that year at $600 million. Facebook was being valued at $75 billion, based on private transactions from the SharesPost market. If an accurate valuation, USA Today claimed that “this would make the social-media upstart more valuable than Disney.” It would also mean that Facebook had a price-earnings ratio (P/E) of 125. This essentially means that higher future profits were expected. The average P/E ratio for the technology sector was about 25, making 125 extraordinarily high. This could be taken as being indicative of irrational exuberance, as one typically compares a company’s number with the average of its sector. However, the technology sector was quite broad at the time, and one would expect companies on the forefront like Google, Yahoo and Facebook to have much higher numbers than other companies in the sector. In other words, even a very high P/E ratio, even relative to a sector’s average, does not necessary point to there being a bubble. Therefore, it is notoriously difficult to identify one definitively without ongoing debate delaying any regulatory action. Also, if the sector itself is in the grip of irrational exuberance, comparing a company’s ratio to the average is relatively useless in proffering an indication.
In March of 2011, USA Today claimed, “Even big companies are said to be drinking the Internet Kool-Aid. There is speculation that Google and Facebook have considered bidding as much as $10 billion for online microblogging service Twitter.” In December of 2010, according to USA Today, “The New York Times reported that Twitter was valued at $3.7 billion after a funding round. In March of the following year, it was pegged at about $7.2 billion, according to SharesPost.” The sheer variance between these figures indicates high risk, but this did not seem to bother those drinking the kool-aid. Such psychology is a red-flag that a bubble is likely in the works. It is like a tornado watch: conditions are right for one to form.
The risk can be seen by uncovering fallacies in the way the private tech companies are valued. According to USA Today, “Until companies finally go public and the stocks actively trade on major exchanges, the small and relatively thin trading on private markets sets the price. . . . Private marketplaces, including SecondMarket and SharesPost, allow owners of shares of private companies such as Digg, Facebook, Zynga and Twitter to sell to high-net-worth individuals and institutions. Typically, the sellers are employees at these firms looking to cash in on shares they've received. And the buyers are sophisticated investors who understand they could lose their entire investment. These online services provide a way for employees to sell their shares now rather than waiting for an IPO that may never occur. However, with the great power that such marketplaces offer comes confusion. Many of the valuations put on companies are overinflated based on limited sales of shares occurring on the relatively small markets. . . . Before long, estimates for the value of popular Internet companies can soar.” In short, one should not generalize from a highly particularized market to project a total market value because there are unique dynamics going on in that market that would not apply were the firm listed on the NYSE.
Crucially, the generalization is in the direction of overstating; hence, it can camouflage irrational exuberance while feeding it. Therefore, risk is increased by how private companies are restrictively “traded” even as the risk is cloaked—making it even more dangerous. “Given such huge risks, the level of the public's infatuation with shares of privately held Internet companies is again taking on a feel of a mania, Gary Freedman, securities lawyer, said, according to USA Today. He noted that several ingredients that inflate bubbles were all present, including a broad acceptance of the companies' products. Intensifying the distortion, according to him, was the fact that there was very little financial information on these private companies. "It's the same mania," he claimed. "Markets are cyclical. It's really no different than looking at the Internet bust and the housing market." Lest one conclude from this a slam-dunk case, USA Today pointed out that the not all of the practitioners were on board. That is to say, there was serious difference on whether there was any bubble at all.
USA Today represented the other side as follows: “proponents of the next breed of Internet companies say the valuations aren't absurd this time because the companies have fundamentals behind them. ‘We're talking about real companies with real revenue and real profit,’ says Jeremy Smith of SecondMarket. A major shift in technology is bound to create companies with massive market values, the proponents say. The emergence of social media (more than 500 million accounts on Facebook alone), combined with mobile phone use (4.5 billion), is disrupting all of technology, so giant winners are to be expected, say venture-capitalists such as Cohler and Yang. ‘I think this boom is going to last awhile,’ Ted Schlein, a managing partner at KPCB, averred. ‘The trend lines are unlike anything we've seen in history,’ He says the enormous size of the social and mobile Internet market — tens of billions of people — dwarfs the markets for the fledgling Internet (billions) and personal computers (hundreds of millions), putting companies such as Facebook, Twitter and Zynga in prime position to strike it rich in IPOs. ‘This is just the beginning of a big market run,’ says Tim Draper, founder of a venture-capital firm.”
To be sure, the emergence of social media had been a huge phenomenon in defining or characterizing the age from roughly the year 2000. Indeed, the computer and internet may have represented the biggest change in daily life from the world of even the last few decades of the twentieth century. It follows that anything so big would have attracted a lot of money, as per Facebook’s ratio of 125. However, like a jet plane that steeply climbs on take-off and then eventually levels off, the social media companies could not be expected to remain the leading edge forever; they were bound to level off at some point, and then the extended boom would be truncated or even turned to a bust if the market gets stung by the high P/E ratios. Moreover, a bubble just is an expectation of an “extended boom.” The “bubble” lies in the difference between the expectation and the reality that even such a boom is apt to end.
All of this is to say, identifying a bubble in progress with some degree of consensus does not seem to be possible, at least as of 2011. Were such an identification even possible, what would government regulators do to let the air out of the balloon? If Facebook, itself iffy with a P/E ratio of 125, wants to buy Twitter for $10 billion even though the latter had been valued at just over $3 billion a few months before, would blocking the purchase lessen the bubble? Were Twitter in trouble in spite of its growing presumed market value, would its bankruptcy take the air out of the bubble only to provoke a recession? The aim of the regulators would have to be to release air from the balloon without triggering a recession (which is the downside of a bubble anyway). If anything is clear, it is that much more knowledge is needed for the market to be managed, let alone designed, so bubbles are identified and depressed before doing so could do harm to an economy as a whole. In the meantime, we can expect bubbles to top up because markets are susceptible to the human psychology of irrational exuberance.
Click to add a Comment or Question (or View Posted Comments) on whether a social media bubble exists.
Sources:
http://www.msnbc.msn.com/id/41521349/ns/business-us_business/
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