WhatsApp and Tesla set the scene for soaring valuations; Danger that valuations will touch off a wider euphoria

February 27, 2014 6:11 pm

WhatsApp and Tesla set the scene for soaring valuations

By Richard Waters

Danger that valuations will touch off a wider euphoria

It is often a sign of a bubble when analysts and commentators rush to explain away each new upward step in valuations – and then come up with expansive arguments to justify why prices should be even higher.

Two events in the tech world in recent days seem to fit this description all too well.

Exhibit A was Facebook’s $19bn offer for WhatsApp. The most striking thing about the reception to this deal was how quickly Wall Street came to feel comfortable about the eye-popping price. There was universal amazement when the news broke, but most analysts quickly picked themselves up off the floor and rushed to explain why it made perfect sense.

It would be wrong to see the post hoc rationalisation of this deal as part of a wider overheating in tech stocks, though.

Leaving aside $4bn of cash (not a small amount, to be sure) the rest is being paid for in Facebook stock. The question, pure and simple, was how important Facebook believed WhatsApp was to solving its biggest strategic problem – the need to reinvent itself for mobile. The answer turned out to be: about 8 per cent of Facebook.

Most analysts and commentators promptly took this to be a rational act by Mark Zuckerberg, whatever the headline price of the deal, and Facebook’s stock price actually outperformed the market in the following days.

Of course, WhatsApp may not bring mobile salvation. As long as it is run as an independent business and no data about users of the two services is shared, it is hard to see how it can carry Facebook’s existing business over the chasm to mobile. This is more like starting afresh.

If so, then Facebook’s strategic problems may be more serious than Wall Street realises. In that case, rather than showing that WhatsApp was worth $19bn, the real message of this deal might be that it is Facebook that is overvalued, at $175bn.

In discussing the deal, meanwhile, Facebook executives turned to another type of rationalisation that became common during the last tech stock bubble of the 1990s: if a company’s immediate prospects do not seem to justify the price, then conjure up a bigger market for it to play in. As long as the “addressable market” is big enough, it is easy to project enough growth to justify the valuation.

In WhatsApp’s case, that meant first predicting that its audience would more than double to 1bn, then that the number of smartphones in use will also double or treble to deliver an even bigger base of users.

At $42 per user, WhatsApp certainly looks expensive – but think how much more reasonable it will seem if the price falls towards $10 as the number of users increase.

This leads on to Exhibit B. For a company with a tiny slice of the luxury car market, electric car company Tesla Motors hardly seems worth its $30bn Wall Street valuation. The answer: imagine how it might play in other giant markets as well?

A research note from Morgan Stanley this week provided the goods. Tesla already has its sights set on producing a large-volume electric vehicle in three years or so. But Morgan Stanley came up with another reason to feel bullish, with its plans to become a major producer of electric batteries, Tesla could also be the leader in a new business, selling power storage to electric utilities. The potential addressable market: $1,500bn.

For the enthusiasts who had already stoked up Tesla’s extravagant share price, this was an excuse to throw more fuel on the fire. The stock now trades at 135 times its forecast earnings for this year.

Comparisons with the bubble of the 1990s, however, only reach so far. This time, the rising tech stock tide has not lifted all boats. The older guard – companies such as Cisco, Oracle and IBM – have missed out on the latest run-up in share prices. Investors are betting on a new generation of companies coming to the fore. That seems a fair assumption. Even if many of the newcomers never live up to the hype, there will be big winners.

The conditions are certainly ripe for things to get out of hand. In the public stock market, social media and software-as-a-service companies (like Salesforce.com and Workday) are already at heady levels. Prices of late-stage private companies have also been climbing precipitously, as investors pile in ahead of expected IPOs.

The danger is that the striking valuations hit by companies such as WhatsApp and Tesla will now touch off a wider euphoria. If so, then there is likely to be no shortage of commentators ready to justify the higher prices.