Another Dot.com Gold Rush Is Underway

The Telegraph April 10, 2012

Tuesday 10 April 2012 | Blog Feed | All feeds

By Jeremy Warner Economics Last updated: April 10th, 2012

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Money in their eyes

If you are already worth $100bn, and are about to raise $10bn of ready cash in an IPO, then spending $1bn on acquiring a piece of technology that vaguely interests you and by the way has some kind of personal connection might seem neither here nor there. I say "acquiring a piece of technology" because with just 13 employees and no revenues, Instagram cannot reasonably yet be described as a business. Rather, it's an application, or a service, which its promoters don't yet charge for.

We've all been somewhat anaesthetised to the real value of money by the mind boggling size of the losses clocked up in the banking crisis, but $1bn for a two year old enterprise? That's got to be off the wall, hasn't it? Not to Mark Zuckerberg, for whom it's little more than small change, like splashing out on another sports car or some such other vanity purchase. Is this the dot.com bubble in redux? Yes and no is the answer.

Certainly there are elements of dot.com fever around the valuations attached to some of the better known social media websites and applications. Many of these businesses will turn out to be worth but a fraction of what investors and established companies are paying for them, and some will be completely worthless.

Investors obviously know this, but that doesn't stop them paying silly prices for whatever the more plausible among the spotty young geeks beavering away at their laptops manage to produce, for one of them, or perhaps even two or three, might turn out to be the next big thing. It was this mentality which fed the dot.com gold rush of the late 1990s. Investors believed they had to be part of it for fear of missing out. By the end, they knew they were buying rubbish, but still bought in the hope of flipping the stock to an even greater fool. You don't want to be left holding the baby when the music stops, the fate suffered by many from 2000 onwards.

Now of course it is the case that with any new industry or sector, a small number of market leaders will eventually establish themselves. These will generally be highly profitable businesses, so on one level the chase is entirely rational. Nor does it always pay to be sceptical. At drinks party in Davos during the early noughties, Bill Gates describing Google as "an interesting phenomenon" but, he added, he wasn't yet convinced that search was "a proper business". How wrong can you be?

Much the same thing is now said of social media. It is likely to be equally wrong. Facebook and a number of other social media players are obviously already proper businesses and will do very nicely in future. But are they really worth the heady valuations that investors seem willing to place on them? Google, which has defied the many sceptics at the time of its IPO seven years ago, would suggest that perhaps they are, but then Google is very much the exception.

Very few of the names that came to epitomise the mania of the dot.com bubble are still around today. The vast bulk followed the classic pattern of all new industries, only much more swiftly than the historic precedents. In the early years of the auto industry, there were more than 5,000 vehicle manufacturers in the US. Virtually all of them disappeared. The same fate became of the dot.coms. They just ate capital.

Of the dot.coms that did survive, moreover, hardly any justified the valuations that were placed on them during the bubble. Those who bought shares in Amazon, one of the undoubted winners of the dot.com mania, at the peak in 2000 would still today be nursing heavy losses. The same is true of the big mobile telephony companies.

The silliness of investors in paying huge prices for what was obviously one day going to be no more than a commodity, or utility business, was matched only by the idiocy of the companies themselves, who paid bizarrely over the odds of 3G telephone licences.

Assuming a $100bn valuation, Facebook will be selling at approximately 25 times historic revenues. In terms of net profits, the multiple is 100 times. A market leader in a mature industry would sell on an ongoing multiple of around 10 times. To justify the mooted $100bn valuation, Facebook would therefore have to grow profits 10 fold. Even assuming a relatively generous 10 years for Facebook to reach full maturity, that's an awfully big ask. To double and double again may be relatively straightforward for a company with such low operational gearing, but thereafter the gradient gets much steeper and the competition ever tougher. Eventually, those amazingly high operational margins will get competed away.

Facebook and other social media bank on the network effect – that after a while so many people are using their services that it's pointless being on anyone else's because other users aren't. It would, for instance, be very hard to set up a direct competitor to Twitter. Users who have invested large amounts of time building up followers and followed lists won't easily switch to alternatives. New users naturally conjugate to the same big clusters of users.

Even so. And as for $1bn to buy a two year old venture that doesn't make a cent and is merely a smart way of sharing photographs, well that's just silly isn't it? In time, there are bound to be newer and better alternatives to Instagram.

Still, why knock it? If there are investors out their willing to pour huge amounts of money into whatever hair brained idea that comes out of silicon roundabout (for those who don't know, London's Old Street roundabout on the seedy, northern fringes of the City, has become a centre for London's thriving dot.com sector), then that's a good thing, isn't it? Why yes it is, for the consumer that is, and for jobs too. But if history is anything to go by, it's generally not very good for investors, who as likely as not will end up losing their shirts. Hey ho.

Another Dot.com Gold Rush Is Underway

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