Commentary

Is There A Bubble? Putting Today's Internet Valuations Into Perspective

by Dave Morgan , Featured Contributor, May 12, 2011

Earlier this week, The Wall Street Journal did its best to create controversy over Internet valuations by topping its story about Gilt Groupe's recent financing with the headline: "Gilt's Hefty Valuation Puts New Web Boom to the Test." In my opinion, the Journal did its readers a disservice with that headline.

I ran Internet companies during our last two financing "bubbles," the big one in 1999-2000 and the smaller one in 1997. We may very well be in the middle of a bubble of sorts right now, but today's Internet valuation environment is quite different than those two, and Gilt Groupe is by no means a company with a bubblicious valuation. Here is my reasoning:

Today's Internet companies are real companies with real revenues. In 1997, 1999 and 2000, Internet companies were benchmarked exclusively on metrics like unique users, Media Metrix numbers and time spent per user. Gross revenues, revenue per user and profit per user were virtually nonexistent.

No more. Today, most of the companies that are being given multibillion-dollar valuations have a great financial story to tell, in addition to great usage stories. Groupon, LivingSocial and Gilt Groupe all have many hundreds of millions of dollars in annual revenues. Contrary to the Journal's view, a billion dollar valuation for Gilt, given $500 million of trailing revenue, doesn't seem a stretch to me.

Revenues growing fast. Not only do these companies have real revenues, but they are growing those revenues at hundredths of percent per year. While traditional retailers are lucky to have 2%-3% annual revenue growth rates, these folks are growing at 100X that level. Given the likelihood that Gilt's revenue will double or triple over the next year, its valuation at 2X sales is by no means crazy.

Brick-and-mortar incumbents falling away. In the late '90s, the notion that brick-and-mortar companies might someday collapse in the face of digital competition was pie-in-the-sky speculation. Today, it is reality. The Tribune Company and a number of its newspaper brethren are, or were, in bankruptcy. So have been most music publishers. Borders is in bankruptcy, and many believe that Barnes & Noble might not be far behind; same for Blockbuster and the rest of the DVD rental market. So too Sears, Kmart and Montgomery Ward. Who will replace these companies? I think we already know the answer to that question.

Big difference between public market bubble and high venture valuation. The high valuations that we are seeing today are not being placed by public market investors' irrational exuberance. These bets are being made by sophisticated, professional investors eager for pieces of what might become the next Microsoft, Oracle, Google or Apple. They know that they will lose everything on the majority of their bets. That is how they run their funds. That is not what happened in the '90s. Then, the venture capitalists got in cheap and drove premature IPOs that skyrocketed on the hopes of individual investors.

It's too simplistic to point to big numbers and claim that the bubble is building, and picking Gilt as a poster child was like putting a square peg in a round hole. I expect more from our top business publications. To be clear, I don't have any interest in Gilt, though I am friends with its CEO Kevin Ryan. I write this because there should be some recognition that we are not making the same stupid mistakes that we made in the '90s. And quick success does not a bubble make. What do you think?

financing

6 comments about "Is There A Bubble? Putting Today's Internet Valuations Into Perspective".

Check to receive email when comments are posted.

Jesus Grana from Independent, May 12, 2011 at 5:54 p.m.
In response , 3 letters, not words AOL . For more details you can refer to:
The Oracle of Omaha has Spoken, Is Anybody Listening?
http://jrgrana.com/blog/?p=323
Reply

R.J. Lewis from e-Healthcare Solutions, LLC, May 12, 2011 at 7:07 p.m.

Great piece Dave. A metric I like to quote (and it's even better shown graphically) is that in 2000 the NASDAQ touched 5,000, at a time when Internet advertising revenue (the future promise behind most exuberant valuations) was $8B. Ten years later in 2010, the NASDAQ peaked at ~2,700 (not much higher today), and online advertising revenue sits as $26B. NASDAQ roughly 1/2 of what it was... online advertising roughly 3.25X what it was... Oh, and this doesn't factor in eCommerce revenue (or other forms of digital revenues) that may be the only thing to "save" some of those Brick-n-Mortars if they choose to move to where the market has moved.... Keep the commentary coming....

Terence Kawaja, May 13, 2011 at 12:43 a.m.

Great commentary Dave. I completely agree with the "reality" premise of today's internet valuations as distinct from those in prior bubbles. I think of valuations on two different bases: (i) money in (VC financing) and (ii) money out (M&A or IPO values). There has certainly been a rise in valuations on the "money in" side but as you point out these bets are being made by risk-aware professionals and, with some big name exceptions, are based on more realistic results and opportunity. As someone who negotiated M&A valuations in the 1999/2000 period through today, it certainly doesn't feel like a bubble on "money out". Strategic buyers are carefully considering their targets, properly diligencing the acquisitions and negotiating prices which leave upside for themselves. And the public markets are much more discriminating in terms of acceptable business models and multiples. While this may create somewhat of a squeeze on VC returns, overall it should lead to a more stable healthy marketplace.

Dave Morgan from Simulmedia, May 13, 2011 at 10:54 a.m.

Terry, great points about how the VC's are the ones bearing the risks here, relative to the public investors. It will be interesting to see how the public markets react as these companies IPO over the next several years.

Rick Monihan from None, May 13, 2011 at 12:04 p.m.

This is an excellent article, but does fail on one point:
Define a bubble. This, unfortunately, is an impossible task. At one point in time, 8X earnings was considered the "standard pricing model". By the mid 1990's it had become 14X earnings. By the late 90's there was no "standard". I suppose the best way to define a bubble is the old "I know it when I see it."

Bubbles exist in many sizes, shapes and forms. An Internet Bubble like 2000's was based entirely on hopes, dreams and speculation like so many before. On the other hand, the crash in 2008 was preceded by valuations of many things that was based on real assessments of value (some of which have since been questioned, but most were not at the time).

The most common cause of a "bubble" is easy money. The issuance of fiat currency which leads to increased speculation, and increased moral hazard. 2001's decline was not of this nature - it was one which engaged moral hazard but not based on easy money. In fact, easy money was provided afterward in order to "offset" perceived imbalances.

As a result, 2008 WAS the result of easy money AND increased moral hazard. 2008 was VERY similar to 1873, as opposed to 1929.

I'm not making a case that internet stocks are a bubble. I'm not saying they aren't, though, either. In other words, like all markets, the stocks themselves have to prove whether they are or not. They have to back themselves up with good business performance. So far, they have. Good performance begets good performance - until it doesn't anymore. Valuations can get bid up on the back of 100% annual gains....and those gains can outperform for many years (80, 70, 50, 25%) until they don't anymore. At that point, the stocks will decline and another "bubble" will have been declared.

But the internet is also capricious. One year's massive outperformance can be followed by another year's underperformance. And in this economy, who knows what the truth will be? (more to the point, even if they do perform, since many individual investors have left the market, is the liquidity there to keep the ball rolling?)

I'm ambivalent about the discussion of bubbles because few people know they are in one until it's finally over. There are few industries where bubbles are clearly evident as they occur (housing was a VERY clear one), but these tend to be industries which have limited liquidity, which makes price discovery alot more easy by reviewing historical trends.

More importantly, even when you're in a bubble, if you don't see it, you can rationalize your way out of it. In 2007, I had people trying to tell me that I "HAD TO BUY" Florida real estate. I reviewed several buildings, then passed on the idea. Why? Many of the new high rise condos which were 100% "SOLD OUT" had no cars in the parking lot. If there was ever an indication of a speculative frenzy, I'd never seen one better than that. I told my friends I felt Florida (and real estate in general) was a bad idea for an investment. But they were not convinced. After all, rates were low, money was easy, sales were going crazy, retirees coming to Florida in droves......it was easy to rationalize your way out.

So, before I engage the discussion of a bubble (like the current talk of the Gold or Silver bubbles), I always ask for a definition first. What is one, what are the signals that define it, and how big does it have to get before it is a bubble?

Could be we're in one now, but it's just not as big as the last one. So we'll remain ambivalent until the facts roll in....right? Or, could be we're not in one because we were all burned once before and therefore more careful about how we look at things.

It all depends on which side of the fence you're on. As they say - there are 2 sides to every sale in the market. One that thinks it's going up, the other thinks it's likely to be flat or down.

Jay Graves from Wiland Direct, May 16, 2011 at 9:38 p.m.

Dave, I think you are dead on - companies like Groupon, Living Social and Gilt Groupe are likely not in a bubble. They may even be undervalued in the long run. They are proving that many of the promises of the Internet made ten years ago were (eventually) true.

However, there is an another class of Internet companies out there that are getting blended in with these. There are tons of social startups that have zero revenue and huge costs.

There is a big difference between have big revenue/big growth costs and no revenue/no model/big growth costs. Companies with big revenue can always scale back on big growth costs. Not everyone can become Facebook or LinkedIn and there will be a lot standing when the music stops.

A very smart man once gave me great advice: "A successful business requires two things. 1) Revenue and 2) expenses that are eventually less than revenue."

Great article. Everyone wins when digital does well and here's to hoping you are right.