Silicon Valley firms are over-valued; here's why a correction is coming

As Facebook’s shares hit a record high, CEO Mark Zuckerburg will be patting himself on the back for bucking the trend and outperforming financial projections for eight consecutive quarters. Meanwhile, many of his competitors are worried – and they should be.

While Evan Spiegel, 27-year-old CEO of Snapchat, enjoyed a yachting break, his company’s shares sunk below their launch price. The market is losing faith in the social sharing app’s ability to find features that Facebook cannot instantly copy.

Similarly, Travis Kalanick, ex-CEO of Uber, is also enjoying his enforced break as concerns grow around Uber’s business model and whether it can ever generate profit.

Yet both businesses have been enormously effective in raising funds from investors. Uber has raised around US$12 billion and Snap around US$6 billion (if you include proceeds from its float).

Other Silicon Valley perennial under-performers Twitter and Yahoo have similarly raised significant sums from investors but failed to provide any sort of return. Too many tech companies seem to be better at raising funds from investors than generating profits from their operations. This speaks to a fundamental issue with the tech market and the level of investment that is being poured into it.

The search for returns

Since the 2007-08 financial crisis, interest rates have approached zero, forcing businesses and investors with cash to find other means of generating returns. The stock market is the obvious place, as returns from private equity and hedge funds have also been declining.

The sheer weight of money looking for opportunities forces investment into more marginal opportunities that yield lower returns. Conversely, this same weight of money has been pushing share prices ever higher, despite the uncertainties of Brexit and Trump.

Nowhere is the problem of finding destinations for cash more evident than in Silicon Valley. Enormous amounts are channelled into almost any opportunity in the hope of hitting the next Facebook, Google, or Amazon jackpot, and riding the share price surge. In turn, some of the money being thrown off by these mega corporates is dribbling down through the acquisition of other tech businesses at sky high valuations.

Start-ups that are valued at over US$1 billion have become so common they have a name: unicorns. But investors should start to question their value following the stock market launches of companies like Snapchat and recipe and ingredients service Blue Apron, which have both rapidly fallen below their float price.

Valuations of US$24 billion for Snapchat made Spiegel worth US$5 billion. But there is no way of connecting this valuation with any hard statistics, financial or otherwise from Snapchat’s books. And the banks which supported the float are becoming more sanguine on the company’s outlook.

Uber has not yet listed, but is valued at around US$50 billion (down from US$68 billion a year ago), and backers have invested US$12 billion which is principally being used to fund incentives to drivers and customers. Uber is being launched amid significant incentives around the world, whatever the nature of the local competition. In effect, this consists of cheaper fares to passengers and subsidised pay to encourage recruitment of self-employed taxi drivers.

This is risky business. The unregulated taxicab industry is one that is traditionally viewed as unattractive to investors as profits have never done much more than cover drivers’ wages and car running costs due to the plentiful supply of drivers.

Customers are fickle in that they will take the cheapest and most responsive taxi, and will have more than one taxi app. There is no patentable technology and most taxi businesses have their own apps. So once the Uber incentives cease, what is to stop the original taxicab companies claiming back market share? In short, app or no app, competition is fierce in this industry and there is little to guarantee Uber’s success.

Sheer volumes of cash

Silicon Valley firms are also awash with cash and the idea of giving it back to shareholders is apparently unappealing. Instead, much of it is spent on acquisitions which are partly intended to ensure competitor technologies do not reach a dangerous size. This is facilitated by the US Department of Justice, which has still not decided whether normal competition law should apply in Silicon Valley.

Similarly, there is still a pursuit of the next big thing. Microsoft, for example, has spent almost US$60 billion on acquisitions such as LinkedIn at US$26.2 billion, and Nokia at US$7.2 billion, along with more than a hundred others. It is not clear that any are delivering returns. Indeed, Microsoft tried to buy Yahoo for US$45 billion but luckily for them, the bid was rejected. Yahoo was eventually sold to Verizon this year – for US$5 billion.

It is likely that Microsoft’s attitude to risk is influenced by the US$100 billion of cash it is sitting on. Google has bought more than 200 businesses, spending around US$24.5 billion on the ten biggest, including Motorola at US$12.5 billion. Facebook has been more prudent and successful, buying WhatsApp at US$19 billion in 2014 after paying US$1 billion for Instagram in 2012, then a 13 person operation.

Overall, the sheer volume of cash looking for a home is driving behaviour which in more “normal” times would be viewed as profligate and high risk. Indeed, investor behaviour has some similarities to the dot.com era when it was seen as a good thing to burn through shareholder capital.

The canny investor may well be wise to let their cash rot in the bank rather than become involved in this casino, which runs the risk of coming to a sad end. Regulation is growing and starting to catch up with technology, certainly outside the US. Sky high valuations bear little resemblance to future earnings capabilities and result from too much surplus cash and a wish to prevent competition growing up. A correction is coming. 

John Colley, Professor of Practice, Associate Dean, Warwick Business School, University of Warwick

This article was originally published on The Conversation. Read the original article.