Silicon Valley is booming. Investors are pouring billions of dollars into hot technology startups. Improbably young technologists are becoming stupendously wealthy, and some are throwing lavish, over-the-top parties. And to many people, it all seems eerily like the last days of the 1990s technology bubble.
These skeptics include technology columnist Nick Bilton, who laid out the parallels last week in a piece for Vanity Fair. He was joined by the Nation's Doug Henwood, who marvels at the eye-popping valuations of companies that have yet to attract a profit — or, in some cases, generate much revenue — in their young lives. As both writers note, there's been rapid growth in the number of "unicorns": privately held technology companies whose value, at least on paper, exceeds a billion dollars.
But while there are some superficial similarities between today's technology boom and the bubble of the late 1990s, there's also a huge difference. The internet not only has 10 times as many users as it had 16 years ago, it's also much more central to users' lives and — therefore — the economy. In 1999, big, profitable internet companies were mostly a theoretical concept. Today, companies like Facebook and Google have proven that it's possible to make huge profits online.
So to figure out whether there's a bubble, you shouldn't look at whether Silicon Valley parties have gotten more extravagant. Instead, you want to do some basic math: Has the value of technology startups grown out of proportion to their future earnings potential? This isn't easy to calculate, because we don't know how much today's technology startups will make in the future, and it's certainly possible that some unicorn investors will lose money.
But publicly traded company valuations have risen slower than profits. And if some of the startup prices you see bandied around in the media sound too high to you, that's partly because of the somewhat misleading way these valuations are reported.
The values of big tech companies have grown more slowly than their earnings
There's no question that the value of technology companies has soared over the last few years. But by itself, that doesn't prove that there's a bubble. When you buy stock in a company, what you're ultimately buying is a share of its future profits. A bubble is when company values soar without a corresponding rise in their earning potential.
So a good indicator for whether there's a bubble is to compare a company's stock price with its profits. If this ratio (known as the "P/E ratio") goes up, that can be a telltale sign of a bubble. Andreessen Horowitz, a venture capital firm that has emerged as a leading anti-bubble voice, compiled a chart showing how the P/E ratio of publicly traded information technology companies that are part of the S&P 500 (which includes 500 of the largest companies in America) has changed over time:
The gray line shows that the stock price of big IT firms has risen significantly over the past five years. However, when you divide companies' stock price by their projected earnings — the orange line — it reveals that today's stock market boom is different from the boom of the 1990s. The 1990s saw tech stocks soaring much faster than tech company profits. In the current boom, by contrast, rising stock prices simply reflect rising profitability in the technology sector.
Valuing startups is hard
If we could make a chart like this to cover the technology industry as a whole, we could settle the bubble debate once and for all. Unfortunately, there are several reasons we can't do this.
One is that this data isn't available for a lot of important technology companies. Microsoft, Google, and Facebook offer their shares to the general public, so the Securities and Exchange Commission requires them to release data on their profits. But many technology companies, including Uber, Airbnb, and hundreds of smaller startups, are privately held. We don't know how much profit they've made — if any — so we can't compute P/E ratios for them.
But even if we did have complete earnings data for privately held companies, we'd still run up against a deeper problem: The values of companies are about investors' projections of future profits. For a big company like Apple or Google, past profits provide a pretty good way to estimate future profits. But a startup like Snapchat (much like Facebook and Google in their early years) has yet to earn a single dollar in profit. That makes a P/E ratio a totally useless way to gauge its value. There are tons of technology startups — including some with values over a billion dollars — in the same boat.
Private company values are weird
A final complication to valuing privately held companies is that a company that's worth $1 billion on paper may not actually be worth a billion dollars.
Anyone who owns a share of Apple or Microsoft can sell it and get the current market price. And usually all shares in a publicly traded company have equal value. So to figure out how much a publicly traded company is worth, we can just multiply the share price by the number of outstanding shares. Right now, for example, Apple is worth $644 billion.
Private companies are different. When a company raises funding from a venture capital firm, the deal is usually structured so that the new investors get their money back before anyone else can cash out. This makes good business sense, because it ensures the founders won't get rich unless the investors at least get their money back.
But it also has a tendency to inflate the paper value of privately held firms. Back in July, Uber sold around 2 percent of the company for around $1 billion, giving the company a theoretical value of $50 billion. But if the new investors' shares are given a privileged position (as they usually are in this kind of investment), then they aren't taking as big of a risk as it might appear on paper. If Uber winds up being worth less than $50 billion, the paper losses will fall more heavily on the founders and earlier investors.
What this means in practice is that a private company being "valued at" $50 billion isn't comparable to a public company with a $50 billion market capitalization. If you think Uber's probably not worth $50 billion, you're in good company. Even the people who invested in Uber at a $50 billion valuation probably don't think Uber is worth $50 billion right now. They do believe that if all goes well, Uber could be worth more than $50 billion in a few years. But they may also have structured the deal so that if Uber underperforms expectations (but doesn't go completely bankrupt), they'll still get most of their money back.
And that, in turn, means that the market hasn't gone as crazy as the number of "unicorns" might make it seem. There are more than 100 companies that are worth more than $1 billion on paper, including Uber, Airbnb, Dropbox, Pinterest, Spotify, Square, Stripe, Zenefits, Lyft, Slack, and many you've never heard of. But it's widely understood and accepted that not all of these companies will ultimately achieve values above $1 billion. (Snapchat is a rare exception to this rule — the investors in its latest $16 billion funding round reportedly did not get a preferential position relative to the company's founders.)
The current batch of "unicorns" has a lot of potential
There are also good reasons to think that the current crop of unicorns could earn a lot of money for their investors:
- Skeptics have scoffed at Snapchat, which is rumored to be worth around $16 billion despite the fact that it has yet to turn a profit and didn't even generate much revenue in 2014. But Snapchat has 100 million daily users, and history suggests that you can generate a lot of ad revenue with a user base that large. Snapchat hasn't made much money so far because it focused on growing users first and only recently started its ad program. But there's every reason to think that once this program is firing on all cylinders, the company will be able to make a lot of money.
- Uber's last fundraising round valued the company at $50 billion, and critics have argued that this value is hard to justify even if Uber eventually takes over the entire taxi market, which generates around $11 billion in annual revenues. But this might be looking at the market too narrowly — like trying to estimate the value of eBay in 1999 by looking at the revenues of flea markets. Uber hopes to not only dominate the taxi market — both here and abroad — but also to dramatically expand it by drawing in new customers from the suburbs and smaller metro areas. And it's also hoping to enter related markets like food delivery and self-driving cars. If these efforts succeed, Uber could ultimately be worth a lot more than $50 billion.
- Doug Henwood scoffs that Airbnb — which owns zero hotels — is worth more than Marriott, with its 4,000 hotels. But this is something of an apples-to-oranges comparison. Marriott's business model is to own and operate hotels. Airbnb's business model is to broker the rental of hotels and other lodging owned and operated by others. And Airbnb's business model is a lot easier to scale up quickly. It has taken Marriott 88 years to reach its current size of around 700,000 rooms for rent. Airbnb has gotten to 1.5 million worldwide listings in just seven years, and there's every reason to think it will continue growing more quickly than conventional hotel chains.
This isn't to say these companies — or any of the other "unicorns" — are guaranteed winners. Obviously, technology startups are risky investments, and some of these companies will fail. But taken as a group, there's every reason to be optimistic about these companies' prospects. Unlike the tech companies of the late 1990s, virtually all of today's unicorns are either generating significant revenues already or have an opportunity to generate revenue using the now-well-understood techniques of online advertising.
Low interest rates are a red herring
Henwood and Bilton both point to the Federal Reserve, which has kept short-term interest rates near zero for the past seven years, as a major factor in today's alleged technology bubble. As Henwood puts it, "The latest round of irrational exuberance has almost certainly been fueled by the Federal Reserve’s extraordinary efforts to reflate the economy after the financial crisis."
In one sense, he's correct. Basic economic theory says that as interest rates go down, the value of income-producing assets tends to go up. So there's clearly a connection between today's low interest rates and the relatively high value of stocks generally.
But as Vox's Matt Yglesias has pointed out, that's not what a bubble is:
Low interest rates are not irrational exuberance. They're not mass hysteria. They're not hype. They're not a search for a greater fool. They're not overconfidence. They are very real. You can look them up on the internet. It is a genuine fact about the world that if you want a safe financial asset these days, you need to accept a very low nominal rate of return. That genuinely makes other asset classes — everything from houses to ordinary stock shares to zany digital media startups — look more appealing than they would be in a world of higher interest rates.
Of course, it's true that if interest rates start rising, the value of technology companies (and companies generally) will fall somewhat. And that could be bad for investors who invested at the old, higher value. But this is true even when interest rates are high: Higher interest rates could always cause asset values to fall. Conversely, interest rates could fall further (short-term rates might be at zero but longer-term rates are not), which would push the value of technology companies up.
No one — not even Fed Chair Janet Yellen — knows when interest rates will rise or how high they might go. It's true that investors are calibrating their investments to the current interest rate environment, but that's the opposite of a bubble.
Tech companies are valuable because the internet is a huge market
While people can quibble about the value of any particular startup, the bigger picture here is that the internet is a vastly larger market today than it was in 1999. In 1999, there were fewer than 300 million people online. Today it's close to 3 billion people. And internet users today are far more accustomed to spending money online than they were 16 years ago.
So there's no reason to be surprised that investors are pouring billions of dollars into internet companies.
We don't know if Uber, Lyft, or some other company will eventually dominate the taxi business, but it's a reasonable guess that some technology company will do so, and that this company will be highly profitable.
We can't predict whether any particular messaging or social media app will continue growing in the coming years, but it's a safe bet that users will spend a lot of time communicating online, and that the companies that facilitate that communication will be able to sell a lot of ads.
We don't know if Zenefits will succeed in revolutionizing the HR industry, or if Slack will manage to replace email as the primary way companies communicate. But it's a safe bet that the companies of the 21st century will use the internet a lot more than those of the 20th, so investing in companies that provide online services to businesses is sensible.
In short, the internet is becoming increasingly central to the world economy. So it's not surprising that companies building internet-based businesses are more valuable than ever.