The US tech bubble and coming correction

8/11/2019 The US tech bubble and coming correction

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raft: The US tech bubble and coming correctionBenjamin ean [email protected]

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Introduction

What is going on with the stock performance of a number of tech companies in the UnitedStates? The price-to-earnings ratios of many of the newest and most innovative companies Facebook, Netflix, LinkedIn, Twitter to name a few are presently well in excess of 100.Typically, a P/E ratio of 25 is considered high. Based on these current prices, it will take over100 years for investors to see a return from these stocks were earnings per share to remainat current levels. Faced with this scenario, there's only two possible outcomes: either therevenues of these tech companies will indeed multiply many times over, thereby justifying thehigh stock valuations, or stock prices are currently far too high (we're in a bubble) and amajor correction is coming.

The analysis in this paper shows that we're facing the latter case: right now there is a bubble

in US tech stocks. Many of the tech companies in question are built on an advertisingbusiness model. Some have diversified away from solely using this business model, such asGoogle and LinkedIn, and others are attempting to move away, such as Facebook. However,this business model remains the foundation on which a large proportion of these companies'revenues are earned. Unpacking the unit economics of this business model shows that theonly ways to increase revenues (and thus earnings per share) are either by: 1. adding moreusers or 2. extracting higher prices from advertising.

The slowing user growth of Facebook, LinkedIn and Twitter suggest that multiplying usernumbers several times over, so as to multiply revenues multiple times over (thereby justifyingthe current stock prices), simply isn't possible. Likewise, the revenues derived from targetedonline advertising are minuscule when broken down. Advertisers are only willing to payaround 1c to gain access to each individual user for each day of use on these platforms. Thisis one-quarter of the rate at which advertisers will pay for un-targeted ads in print. It appearsthat investors' bet big that advertisers would pay handsomely for targeted online ads havenot paid off.

This isn't a new phenomenon, it is a recurring feature of financial bubbles dating back to the1800s. Investors pile into companies built on new technologies betting on the inherentlyuncertain future earnings from these technologies. Stock prices rise and rise as more andmore investors chase returns from these ever-increasing stock prices. When earningseventually do not match prior high expectations, the bubble pops. The question now is: whenwill the major stock price correction occur for US tech companies? Unprecedentedly lowinterest rates in the US, Japan and Europe since 2007 have contributed to the inflated stockprices seen in US tech stocks. Investors have essentially been able to plough money intothese stocks at a discount, allowing them to ignore these companies' lack of economicfundamentals. Once the US Fed and other Central Banks begin to raise interest rates,

investors are likely to begin reducing their holdings of US tech stocks. Even a small group ofinvestors selling their stakes is enough to trigger a broader sell-off in the market. Being thatthe US Fed is preparing to raise rates in the coming 12 months, a major correction in UStech stocks is impending.

The major lesson that we need to remind ourselves of requires going back to first principals.For a business to be a sustainable business, it must provide a product or service thatsomeone is willing to pay for. Many US tech companies have built platforms that end-usersget for free and the hope that advertisers would be willing to pay for access to these end-users. That hope has proven ill-founded. Going forward, the task we have to undertake is todevelop and build internet platforms that end-users are actually willing to pay for. Only oncesolid and reliable revenue streams can be developed, can financially sustainable techcompanies be built.



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Section 1: an examination of the current financials of US tech companies

One measure we can use to evaluate the current state of US tech companies is the price-to-earning ratio. This is given by dividing the Last Sale Price by the Average EPS (Earnings PerShare) Estimate for the specified fiscal time period. This measure is, a number that indicatesa level of belief in a company the higher the P/E ratio, the greater the confidence thatinvestors believe the company is capable of growing and delivering profits on theirinvestments . A high P/E ratio is typically considered to be 25+. The P/E ratios of the largestUS tech firms over the past year and P/E ratios for the year to come are contained in thetable below.

Table. Key metrics for US tech stocks, 2014-15

Company Age # users/customers

(millions)

Trailing P/Eratio

(9 Sept 2014)

ForwardP/E ratio

(fye 2015)

Revenue($bn, ttm)

Quarterlyrevenue

growth (yoy)Amazon 20 209 534.07 178.30 81.76 23.20Apple 42 - 16.50 13.95 178.14 6.00Facebook 10 1317 101.02 38.56 10.01 60.50Google 16 - 30.90 0.58 65.14 21.70LinkedIn 12 300 689.55 812.68 1.85 46.80Microsoft 39 - 17.41 14.57 86.83 17.50Netflix 17 44 180.13 72.63 4.89 25.30Twitter 8 255 -15.00 144.44 0.97 124.10Yahoo 20 - 34.87 31.67 4.62 -4.50Source: Capital IQ via Yahoo Finance.ttm = Trailing Twelve Months (as of Jun 30, 2014)yoy = Year Over Year (as of Jun 30, 2014)fye = Fiscal Year Ending

Many of the trailing P/E ratios of stocks like Amazon, Facebook, LinkedIn and Netflix are inexcess of 100. Going forward, these P/E ratios will adjust downward in some cases thoughnot all. There are three reasons why a P/E ratio might be this high:

1. High expected future growth in earnings, or2. The current year's earnings may be considered exceptionally low, or3. The stock may be the subject of a speculative bubble.

Let's start by considering reason #1: that the future growth in earnings for some of these techcompanies could be large and thus these P/E ratios are warranted. For young high-growthcompanies, which are typical of the tech sector, this explanation could be plausible. They aresimply so new and growing so fast that they havent yet reached their enormous potential.The first thing to note is that these companies are by no means young. The youngest on thelist, Twitter, has been around for eight years. Setting that aside, if we look at the threeyoungest companies on the list (Twitter, Facebook and LinkedIn) their quarterly revenuegrowth rates are the highest of all companies in the basket (124.10%, 60.50% and 46.80%respectively). Were this present rate of growth to continue, its possible that these companieswarrant their current stock prices.

When we begin unpacking the numbers a bit more though, this explanation looksincreasingly implausible. Take for example a comparison of two of the companies in thebasket. Within these figures, what these P/E ratios are suggesting is that Facebook, with aratio of 101.02, is presently around 3x more valuable than its closest competitor, Google,with a ratio of 30.90. Another option is to compare some of these internet companies with theperformance of companies outside of the tech sector. Comparing the online retailer Amazon(2014 P/E = 534.07) with other major US retailers, we see that Wal-Mart has a P/E ratio of

14.5, Target has 17.7 and Costco has 24.1. What this implies is that investors think that

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Amazon is around 36x more valuable than Walmart (the retail juggernaut that brought in$480 billion in revenues last year with a gross profit of $112 billion, which by the way, is morethan the total revenue of Amazon last year). For these P/E ratios to be justified, there isgoing to have to be some extraordinary revenue growth in the near future.Section 2: Running some hypotheticals

We have established that the P/E ratios of a number of US tech stocks are currently atextraordinarily high levels. One of two outcomes will have to occur to make these numbersplausible: 1. A huge increase in earnings per share or 2. A severe adjustment (decrease) inshare price in line with current earnings levels. Below are some hypothetical scenarios thatcan be used to estimate what kinds of adjustments, either in the share price or in theearnings per share, are needed to bring this basket of tech stocks to a sustainable level. Forthe purposes of this exercise, lets assume that a P/E ratio of around 25 is a sustainablelevel. This is on the high end of the spectrum but being that these are tech stocks, a highvaluation isnt unusual. The table below contains the current share prices, earnings per shareand the P/E ratios of our basket of US tech stocks. These figures will form the basis for ouranalyses.

Table. Current share price, earnings per share (EPS) and P/E ratiosfor US tech stocks, 9 September 2014

CompanyShare price Diluted EPS Imputed P/E ratio

9-Sep-14 (ttm)

Amazon 329.75 0.64 515.23Apple 97.99 5.96 16.44Facebook 76.67 0.77 99.57

Google 581.01 19.09 30.44LinkedIn 228.74 -0.08 -2859.25Microsoft 46.76 2.67 17.51Netflix 479.01 2.66 180.08Twitter 50.61 -2.5 -20.24Yahoo 40.78 1.2 33.98

Source: Capital IQ via Yahoo Finance

Scenario 1: adjusting the stock price In the first scenario, we hold the earnings per share constant and adjust the stock price to tryand get the P/E ratio to fall around 25. What we find is that many of these stocks areseverely overvalued, with the exceptions being the tech stalwarts of Apple, Microsoft andYahoo. For the rest of the stocks, a huge adjustment is needed to bring the P/E ratio back to25. Note that both LinkedIn and Twitter would have to have negative stock prices to achievea P/E ratio of 25 given the earnings per share they currently provide. Some of theseadjustments are enormous. Witness Amazon requiring a drop of $313.75 off its current priceof $329.75 (a drop of 95%); almost the entire value of the stock. So too, LinkedIn wouldrequire a drop of $230.74 from its current price of $228.74; more than the value of shares.Finally, the Netflix stock requires an adjustment of $409.01 from its current lofty levels of$479.01; equating to a loss of 85% of value.



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Table. Scenario 1: adjustment in stock price

Company Share price Diluted EPSImputedP/E ratio

Share pricecorrection

% change to

current stockprice(simulation) (ttm)

Amazon 16 0.64 25.00 -313.75 -95%Apple 150 5.96 25.17 52.01 53%Facebook 20 0.77 25.97 -56.67 -74%Google 490 19.09 25.67 -91.01 -16%LinkedIn -2 -0.08 25.00 -230.74 -101%Microsoft 70 2.67 26.22 23.24 50%Netflix 70 2.66 26.32 -409.01 -85%

Twitter -64 -2.5 25.60 -114.61 -226%Yahoo 30 1.2 25.00 -10.78 -26%


Scenario 2: adjusting the earnings-per-share For scenario two, we hold the share price constant and adjust the earnings per share to tryand determine what kind of revenue growth is required to bring the P/E ratio to a healthy butnot overly exuberant 25. For Amazon, LinkedIn and Netflix, the current stock prices are wildlyout of whack with the amount of revenue required to provide returns consummate with therisk. Facebooks required increase of $2.23 per share, bringing the total earnings per shareto $3, is plausible though it will require either trebling the user base or wringing three timesmore revenue from advertisers. As was the case in scenario one, it is the tech stalwarts ofApple, Google, Microsoft and Yahoo that have the most realistic earnings per share and P/Eratio differential at present. When we look at the kind of change needed in earnings pershare for Amazon, LinkedIn and Netflix, it seems implausible that these growth rates can beachieved.

Table. Scenario 2: adjustment in earnings per share

CompanyShare price Diluted EPS Imputed P/Eratio

Increase ordecrease % change

9-Sep-14 (simulation)

Amazon 329.75 13 25.37 12.36 1931%Apple 97.99 4 24.50 -1.96 -33%Facebook 76.67 3 25.56 2.23 290%Google 581.01 23 25.26 3.91 20%LinkedIn 228.74 9 25.42 9.08 -11350%Microsoft 46.76 1.8 25.98 -0.87 -33%Netflix 479.01 19 25.21 16.34 614%Twitter 50.61 2 25.31 4.5 -180%Yahoo 40.78 1.6 25.49 0.4 33%




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From our analyses, we have shown that either the earnings per share of some highly valuedUS tech companies (Amazon, Facebook, LinkedIn, Netflix and Twitter) are going to have togrow at an extraordinary rate over the coming years or an enormous adjustment in the pricesof US tech stocks is going to take place. Before we can definitively decide which of these twooutcomes is most likely to occur, we need to unpack the business models on which some ofthese companies are built. The goal is to understand the unit economics of these companiesand, subsequently, what the probability is that they can increase revenues (and thusearnings per share) to the levels required to warrant their current share prices. If the uniteconomics dont stack up, the most likely outcome left is an enormous adjustment in stockprices.

Section 3: deconstructing the unit economics of the advertising business model

To determine whether these earnings-per-share targets can be reached, we need to unpackthe unit economics of the respective companies. One particular model reoccurs though andis worth some closer scrutiny: the targeted advertising business model. Facebook, Google,LinkedIn, Twitter and Yahoo all provide some kind of nominally free service to the end user(email, social networking, internet search, etc) that is used to collect personal informationfrom those users for the purposes of targeting advertising at these users. Not all are asreliant on advertising as others. For instance, LinkedIn also has revenue streams fromsubscriptions and job listings. Google has diversified away from targeted search advertisinginto areas as diverse as the Android mobile operating system and driverless cars. Amazon isa bundle of different businesses and business models including web services and streamingtelevision. For the purposes of this analysis, we will concentrate on the advertising businessmodel because three companies with this highest P/E ratios (Facebook, LinkedIn andTwitter) are primarily built on this model. The analysis will involve deconstructing the uniteconomics of this business model to evaluate whether the P/E ratios currently commandedby these companies are plausible or whether in fact we are in the midst of a tech bubble.

Under the advertising business model, there are two ways to increase revenue:1. Increase the number of users; or2. Increase the amount that advertisers will pay for access to these users.

For Facebook, LinkedIn and Twitter to improve their revenue situation, and live up toinvestors lofty expectations, they needs to either increase their number of users or increasethe willingness to pay of advertisers for each user (in LinkedIns case, it could also increasethe willingness to pay of users through its subscriptions or companies through its job listings).How many users are needed, or how much more do advertisers have to be willing to pay peruser, to warrant the extraordinary stock price that Facebook and other US tech companieslike Twitter and LinkedIn currently command?

How much can user numbers increase? Early on, Facebook's user numbers were growing in an exponentially way. Recording 450%annual growth between 2004 and 2005 was quite remarkable. In time though, this growthrate has gradually slowed to the teens at present. It appears that Facebooks membership isclosing in on its peak. We have almost reached peak Facebook! Tripling the number ofFacebook users, so as to increase earnings the 3x required to warrant the current stockprice, is not likely (unless the Facebook Zero initiative can bring the developing world ontothe platform but even then how much would advertisers pay to promote their products orservices to this audience?). From these numbers, it should be clear that the required revenuegrowth is not going to come from the acquisition of new users.

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Growth in Facebook active users, 2004-2014

Year/month

Activeusers

(millions) Growth (%)Dec-04 1Dec-05 5.5 450%Dec-06 12 118%Apr-07 20 67%Oct-07 50 150%Aug-08 100 100%

Jul-09 250 150%Jul-10 500 100%

Jun-11 750 50%

Jul-12 955 27%Jul-13 1150 20%Jul-14 1320 15%

Source: Ben P. Hoster

When we have a look at Twitters user growth, we see a similar story. While its true that theuser numbers are growing, this rate has been gradually decreasing in recent years. Eveninternationally, where one would hope to see exponential growth to boost ad revenues, therate of growth is declining considerably (from around 50% year-on-year in the year preceding1Q13 to 24% at present in 2Q14). This is certainly not the level of user growth that will feedinto sufficient advertising revenue to warrant Twitter's current P/E ratio.

Table. Growth in Twitter active users, 2012-14

Totalusers(million)

Annualgrowth (%)

International activeusers(million)

Annualgrowth (%)

US activeusers(million)

Annualgrowth (%)

1Q12 138 - 104 - 34 -2Q12 151 - 114 - 37 -3Q12 167 - 127 - 40 -4Q12 185 - 140 - 45 -1Q13 204 48% 156 50% 48 41%2Q13 218 44% 169 48% 49 32%3Q13 232 39% 179 41% 53 33%4Q13 241 30% 187 34% 54 20%1Q14 255 25% 198 27% 57 19%2Q14 271 24% 211 25% 60 22%Source: Twitter quarterly earnings slides, 2Q14.

Finally, the stats for LinkedIn show slowing in user growth. At the beginning of 2010, usernumbers were growing at an annual rate of 73%. While certainly not exponential in fact atno point in LinkedIns history has user growth been exponential this is still a healthy growthrate. Since then, user growth has consistently declined to the current level of 32% annually.

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While not yet at a peak like Facebook, LinkedIn does not appear to be far off from usernumbers plateauing. It doesnt look like additional user numbers are where LinkedIn is goingto generate much additional revenue.

Table. Growth in LinkedIn active users

Period

Totalactiveusers

Annualgrowth

1Q09 372Q09 423Q09 484Q09 551Q10 64 73%2Q10 72 71%3Q10 81 69%4Q10 90 64%1Q11 102 59%2Q11 116 61%

3Q11 131 62%4Q11 145 61%1Q12 161 58%2Q12 174 50%3Q12 187 43%4Q12 202 39%1Q13 218 35%2Q13 238 37%3Q13 259 39%4Q13 277 37%



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1Q14 296 36%2Q14 313 32%

Sources: LinkedIn quarterly financials.Can a the price for targeted advertising increase? So if exponential growth in users is off the table as a revenue growth driver, the only otherway for these companies to increase earnings per share is by increasing the amount thatadvertisers are willing to pay for targeted advertising. To determine whether this is a feasiblepath, we have to deconstruct how much advertisers pay for targeted ads now then askourselves how much higher could this willingness to pay be expected to rise in the future?

One method we can use to estimate how much advertisers presently pay for targetedadvertising on these platforms is to take the total annual revenue earned by the US techcompanies then dividing it by the total number of users. These calculations take into accountthat revenues from advertising comprise 85% of Facebook (2012) and Twitter's (2013) revenues and 25% of LinkedIn's (2014) revenues.

Table. Estimate of revenue per user for Facebook, Twitter and LinkedIn (2014)

Annual revenue($ billions)

# active users(millions)

Revenue/user(annual, $)

Revenue/user(daily, $)

Facebook 10.01 1317 7.60 0.021

(Ads only) 8.50 1317 6.45 0.017Twitter 0.97 255 3.81 0.010 (Ads only) 0.83 255 3.25 0.012LinkedIn 1.85 300 6.16 0.016 (Ads only) .46 300 1.54 0.004

Sources: Quarterly financials of respective companies.Note: These active user numbers contain is a proportion of bots, that is, accounts controlled byautomatic data collecting software applications. Estimates used to be hard to come by but with IPOfilings have come some estimates. Twitter has made public that 8.5% of its users are bots . Facebookhas estimated that a similar proportion, 5-6%, of its users are fake . LinkedIn is also afflicted by thisproblem and has sued those responsible for fake bot accounts in the past , though no estimates ofhow many accounts were involved have been given. While these numbers certainly dont form themajority of the user bases, it is worth remembering that the targeted advertising of these platforms, inmany cases, is fed by bad data - thereby rendering the product itself worthless. Lets not forget eitherthat these bots operate with the explicit purpose of stealing users personal details a privacy breachand cyber-crime threat that were only just witnessing the start of.

The outcome of this computation tells us that advertisers are willing to pay, on average,$6.45 for access to a Facebook user over the course of a year. If we divide this by the 365days in the year, advertisers are willing to pay on average $.012 per day for access to oneFacebook user. The figure for Twitter users is roughly half this amount: approximately 1c perday per user. Advertisers pay half of a cent each day for access to each LinkedIn user.Advertisers clearly arent willing to pay much for these targeted ads.

We could take a different estimation method of the willingness to pay of advertisers for theseplatforms and the results are similar. Felix Stalder has also done an estimate of how much

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Source: The AtlanticGoogle and Facebook generally topped lists of Americans' concerns about the abilityto track physical locations and monitor spending habits and personalcommunications, according to a poll conducted by Reuters/Ipsos from March 11 toMarch 26 2014. But their grand ambitions are inciting concern, according to the poll of nearly 5,000 Americans. Of 4,781 respondents, 51 percent replied "yes" when askedif those three companies, plus Apple, Microsoft and Twitter, were pushing too far andexpanding into too many areas of people's lives.Source: Reuters

These findings are significant because they suggest that societal awareness of theinvasiveness of the practices of companies like Google, Facebook, LinkedIn and Twitter.This would seem to suggest not only that the cap on the total number of users for theseservices is now very close but, more importantly, that attempts to squeeze more advertisingdollars out of each user through more targeted advertising (implying even greater incursionson user privacy) is likely to turn existing users away from these services. This strategy wouldhave the unintended consequence of turning users away, thereby eroding earnings per shareinstead of bolstering them.

Indeed it appears that the exodus is beginning. Take for example the private search engineDuckDuckGo. Since the Snowden revelations regarding US tech companies' (includingGoogle's) participation in the NSA XKEYSCORE program, traffic to DuckDuckGo hasquadrupled . This growth can be tied to a heightened sense of awareness of privacy online. Inthe case of Facebook, while total user numbers are still growing between 10-15% perannum, this masks the fact that younger users (13-24) are leaving the platform and thegrowth is mainly occurring in the +55 category. Estimates vary but it appears that 25% fewerUS teenagers are using the platform now when compared to 2011 . This drop cannot bedirectly tied to increased privacy concerns amongst youth its more likely that they don't likesharing their personal details with the ever-increasing numbers of parents and relatives on

the platform - however it is worth noting that this younger demographic are moving to themore private and ephemeral messaging service SnapChat (being that the pictures andvideos are stored unencrypted on SnapChats servers, this cant be considered totally secureand private though). The latest stirring have been social network Ello, which launched inAugust 2014. The ethos of the platform is what is interesting: Ello doesn't sell ads. Nor dowe sell data about you to third parties. Nudged but Facebook's moves to force a realnames policy (there's those attempts to extract more personal data from users foradvertisers), the gay/lesbian/bi-secxual/trans-gender members left the site en mass. Ello isin beta and quickly snapped up 31,000 new members . While these are admittedly limitedsigns of change, it is important to realise that they signal strongly that the days of exponentialuser growth for Facebook, Twitter and LinkedIn are over. Likewise, the days of userignorance over the consequences of invasive privacy practices of US tech companies arealso over. From now on, these platforms cannot simply suck more personal information upfrom users, so as to boost advertising revenues, without risking an exodus.

To be fair, Facebook's recent acquisition spree of Instagram, Whatsapp and Oculus suggestthat the C-suite has read the writing on the wall and are searching for new, non-advertisingrevenue streams. The company's reliance on advertising ( which contributed 85% of revenuesin 2012 ), is not sustainable in the long run. Google started this process many years ago,hence the driverless cars and Android operating systems, though the lion's share ofrevenues (around 69%) still comes from Google-owned sites' advertising. As was pointed outbefore, LinkedIn has built a business model with three revenue streams, meaning that it isnot as reliant on advertising ( which occupies 25% of all revenues ) as other platforms. Twitterstill makes 85% of its revenue from advertising and the only changes in store for the futureare to derive more advertising revenues from mobile. Whether the transition away fromadvertising will be too little too late remains to be seen, though time is running out as the nextsection explains.

http://www.theatlantic.com/technology/archive/2014/09/why-privacy-policies-are-so-inscrutable/379615/2/http://www.reuters.com/article/2014/04/04/us-internet-ambitions-idUSBREA331R520140404http://www.fastcolabs.com/3026698/inside-duckduckgo-googles-tiniest-fiercest-competitorhttp://www.fastcolabs.com/3026698/inside-duckduckgo-googles-tiniest-fiercest-competitorhttp://www.fastcolabs.com/3026698/inside-duckduckgo-googles-tiniest-fiercest-competitorhttp://mashable.com/2014/01/16/teens-leaving-facebook/http://mashable.com/2014/01/16/teens-leaving-facebook/https://ello.co/wtf/post/about-ellohttps://ello.co/wtf/post/about-ellohttp://www.theguardian.com/commentisfree/2014/sep/26/ello-might-or-might-not-replace-facebook-but-the-giant-social-network-wont-last-forever?commentpage=2http://www.theguardian.com/commentisfree/2014/sep/26/ello-might-or-might-not-replace-facebook-but-the-giant-social-network-wont-last-forever?commentpage=2http://www.thenology.com/2012/03/18/where-does-facebook-revenue-come-from/http://www.thenology.com/2012/03/18/where-does-facebook-revenue-come-from/http://qz.com/136855/whats-behind-googles-record-quarter/http://files.shareholder.com/downloads/ABEA-69T44N/3461953469x0x723940/f4e8258e-a64c-4f6d-a8fd-07aa3ac27c0e/2013_Q4_Earnings_Slides.pdfhttp://www.bbc.co.uk/news/business-24397472http://www.bbc.co.uk/news/business-24397472http://www.theatlantic.com/technology/archive/2014/09/why-privacy-policies-are-so-inscrutable/379615/2/http://www.reuters.com/article/2014/04/04/us-internet-ambitions-idUSBREA331R520140404http://www.fastcolabs.com/3026698/inside-duckduckgo-googles-tiniest-fiercest-competitorhttp://www.fastcolabs.com/3026698/inside-duckduckgo-googles-tiniest-fiercest-competitorhttp://www.fastcolabs.com/3026698/inside-duckduckgo-googles-tiniest-fiercest-competitorhttp://mashable.com/2014/01/16/teens-leaving-facebook/http://mashable.com/2014/01/16/teens-leaving-facebook/https://ello.co/wtf/post/about-ellohttps://ello.co/wtf/post/about-ellohttp://www.theguardian.com/commentisfree/2014/sep/26/ello-might-or-might-not-replace-facebook-but-the-giant-social-network-wont-last-forever?commentpage=2http://www.thenology.com/2012/03/18/where-does-facebook-revenue-come-from/http://www.thenology.com/2012/03/18/where-does-facebook-revenue-come-from/http://qz.com/136855/whats-behind-googles-record-quarter/http://files.shareholder.com/downloads/ABEA-69T44N/3461953469x0x723940/f4e8258e-a64c-4f6d-a8fd-07aa3ac27c0e/2013_Q4_Earnings_Slides.pdfhttp://www.bbc.co.uk/news/business-24397472http://www.bbc.co.uk/news/business-24397472


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To conclude, US tech companies do not possess a sustainable, long-term business model.The P/E ratios at present are not accurate reflections of future earnings potential. Ouranalysis of the unit economics of these companies give us strong reason to conclude that weare in the midst of yet another tech bubble. Taking a step back to look at the macroeconomic conditions that prevail right now only reinforces our reasons to believe in a techbubble.

Section 5: Tech bubbles and 0% interest rates

After unpacking the unit economics of the advertising-based business model, on which manyUS tech companies have built their empires, we have found that this model not sustainable.It cant live up to the expectations that the current P/E ratios suggest because it isnt possibleto generate revenues that match these expectations. We have all the inward signs of abubble. Taking a step back though, looking at the macro economy, we can also see outwardsigns that we are in the midst of a bubble.

The present set of circumstances in the tech sector is not at all new. Indeed, companiesoperating at the bleeding edge of technology are often subject to precisely these kinds ofexuberant financial forces. In a historical account of previous financial crises, The Economistrefers to the events preceding the 1857 crisis :

Railway companies were a popular investment... That their earnings did not justifytheir valuations did not matter much: they were a bet on future growth (emphasis added).

Again, referring to the lead-up to the Great Depression:

Markets were booming, with the shares of firms exploiting new technologiesradios,aluminium and aeroplanesparticularly popular. But few of these new out fits hadany record of dividend payments, and investors piled into their shares in thehope that they would continue to increase in value. (emphasis added)

What these lessons from history should teach us is that there is nothing abnormal orunexpected about the presently exuberant valuations of US tech stocks. Indeed, this is acyclical occurrence that occurs with the discovery and commercialisation of newtechnologies.

So how bad is this bubble? When we compare the present period with previous bubbles, wecan see some striking similarities. Consider the graph below, which plots out the P/E ratio ofthe S&P 500 over the past century. What should be clear from this graph is that P/R ratiosgreater than 25 are typically the precursors to a financial crisis. With P/E ratios of some UStech companies in excess of 100 right now, we are presently seeing the same signs thathave signalled serious and impending financial crises in the past. If revenues cant berealised through the adverting business model, as our prior analyses have shown, the onlyoutcome then will be a major readjustment in prices in the near future.

http://www.economist.com/news/essays/21600451-finance-not-merely-prone-crises-it-shaped-them-five-historical-crises-show-how-aspects-today-s-finahttp://www.economist.com/news/essays/21600451-finance-not-merely-prone-crises-it-shaped-them-five-historical-crises-show-how-aspects-today-s-finahttp://www.economist.com/news/essays/21600451-finance-not-merely-prone-crises-it-shaped-them-five-historical-crises-show-how-aspects-today-s-finahttp://www.economist.com/news/essays/21600451-finance-not-merely-prone-crises-it-shaped-them-five-historical-crises-show-how-aspects-today-s-fina


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Source: Chartoftheday.com

When might this correction occur? Being that 7 years have now passed since the lastfinancial crisis occurred in 2007, statistically we are closer to the next crisis than we arefurther from the last. For a more precise idea of when the correction might occur, consideranother contextual fact: this bubble has emerged during a period characterised by historicallylow interest rates in the United States (and indeed in many industrialised countries aroundthe world). Since 2007, the US Federal Reserve has kept interest rates at unprecedented low

levels (see chart below). At the same time, several rounds of quantitative easing (i.e.printing money) have fed billions of dollars into the economy. These dollars have had to finda return somewhere and it appears as though US tech stocks are one of those places. Thecurrent over-valuations are likely due to the historically low interest rates currently in place,which have had the subsequent effect of allowing investors to plough money into tech stockseffectively at a discount. What this suggests is that when the Central Banks begin tighteningmonetary policy, a sell-off of overvalued US tech stocks will be triggered. The most recentthoughts from Central Bankers is that a tightening of monetary policy in the US is off thecards until 2015, and Central Banks in Europe and Japan are also hesitant to raise interestrates while the economy recovery remains so slow . This indicates that there is no more thanone or two years before the correction in US tech stock prices will occur. Based on theanalysis in section 2, this correction is going to be huge in some cases.

http://www.chartoftheday.com/20130227.htmhttp://nyti.ms/1wpYDgGhttp://nyti.ms/1wpYDgGhttp://nyti.ms/1wpYDgGhttp://nyti.ms/1wpYDgGhttp://www.chartoftheday.com/20130227.htmhttp://nyti.ms/1wpYDgGhttp://nyti.ms/1wpYDgGhttp://nyti.ms/1wpYDgG


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Source: Tradingeconomics.com

To conclude, were witnessing yet another speculative bubble in the stock market and thatthe end result will be a massive readjustment in the share price of US tech companies. Thepresent situation is not unique and bears many of the hallmarks of previous financialbubbles, which were formed on unrealistic valuations of the value creation potential of newtechnologies. This time around, it is the belief that US tech companies, many which are builton the advertising business model, will be able to reap extraordinary returns for investors.The contextual element that sets this bubble apart from others is that Central Banks havemaintained unprecedentedly low interest rates and continued printing money to stimulateeconomic activity. These policy choices have driven much of the investing in US tech stocks.

Investors are essentially able to invest in these stocks at a discount. When Central Banksincrease interest rates over the coming two years, the attractiveness of US tech stocks islikely to wane and a sell-off will occur. The readjustment required to bring the prices of UStech stocks back to reality is coming within the next 24 months and this adjustment is goingto be enormous.

Conclusion: From a popped bubble - a new business model for the web?

Looking around, there are all the inward and outward signs of a bubble in US tech stocks.

The unusually high P/E ratios for US tech stocks, many well in excess of 100, are the firstsigns that something is wrong. Upon closer examination, we find that many of thesecompanies are built on an advertising business model. For these P/E ratios to be justified,either revenues have to increase multiple times or the stock prices have to plummet.

When we unpack the unit economics of the advertising business model, we find that therevenues that can be attracted by targeted advertising even for arguably one of the mostdominant and most sophisticated players in the market, Facebook - are not more than 1c peruser per day; a miniscule amount. Faced with slowing user growth, these companies will notbe able to attain the user numbers required to generate multiples of current revenues. Theonly option is to pursue more targeted advertising (to bolster the prices advertisers will payfor access to users), which requires ever-increasing invasion of user privacy.

Herein lies a conundrum: by attempting to increase revenues from their advertising (bysucking up the personal data of users) - this causes users to turn away from these platform -thereby reducing revenues as user numbers drop. Weve already reached a point where

http://www.tradingeconomics.com/united-states/interest-ratehttp://www.tradingeconomics.com/united-states/interest-rate


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users are disconnecting from these nominally free services when confronted with theircontinued loss of privacy.

Taking a step back and looking at where we sit with relation to the last recession and whereP/E ratios sit historically, we can see that the current tech stock valuations are at levels thatsignal an impending sell-off. Over-exuberance is a common phenomenon in newtechnologies and the latest cycle is no different. Fed by unprecedentedly low interest rates inthe US, tech stock have reached valuations that bear no relation to underlying fundamentals.We are coming to the end of this cycle: interest rates will rise soon and with them, the wholetech bubble will pop.

In the aftermath of this implosion, we will need to begin thinking about which alternativebusiness models might provide a more sustainable financial base for Internet companies?The lesson should be that the predominant model, which involves rapid user acquisition fedby venture capital and delayed plans to monetise users through advertising at anunspecified later date, simply isnt sustainable in the long-term. Only by building productsand services that users will actually pay for can sustainable revenue streams and thussustainable tech companies - be built. There are a number of possibilities that could beexplored but it will require us to abandon some key assumptions we hold about the internet:that growth in user numbers is the only goal; the web services can be offered free to theseend-users; and that users personal data are fair game so as to feed an ever-more targetedadvertising machine.


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The US tech bubble and coming correction