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How To Recognise Frothy Valuations

The Motley FoolThe flotation of social media companies could, over the coming months, bear an uncanny resemblance to some Singapore buses – you wait ages for one to arrive and then two come along in quick succession.

In my case, it tends to be the 190 bus service that runs from Choa Chu Kang to Eu Tong Sen Street. I can wait – for what seems like an eternity – for my bus to turn up, only to see two bendy-buses arrive one after another. What’s more, both are full to bursting and sail past without so much as a by your leave.

Milking the cash cow

In the case of social media companies, no sooner has Twitter floated on the market than punters are looking for the next cash cow to milk. Speculation is already rife that technology companies such as Box, Airbbnb and Square might be lined up for possible milking.

On the face of it, the flotation of Twitter can, it might seem, be deemed to be a success. But that depends on which side of the flotation divide you happen to be floating.

From the perspective of the private investor, it was a wild and unexpected triumph. After all, it is not often that shares in billion-dollar companies jump over 70% in a single day. So, for the lucky subscribers of Twitter’s Initial Public Offering, Christmas has apparently come a month early.

How to lose a billion

But the founders and early investors of Twitter might be forgiven for feeling a little peeved. By pricing the shares at $26 rather than $45, they have missed out on almost $1 billion of extra gains. In trying to avoid overpricing the floatation a la Facebook, the company has gone to the other extreme of grossly underestimating demand for its shares.

However, valuing Initial Public Offerings, especially flotation of yet-to-be-profitable companies can be tricky. With nothing but hope to pin valuations on, these companies are only worth as much as enthusiastic punters are willing to pay for them.

The question, though, is this: Does anyone actually know these companies well enough to value them with any certainty?

When we invest, it is vital to understand the companies we own shares in. It is also important to know, with some confidence, that the companies will not change their business model for the foreseeable future.

No one can possibly doubt that technology and internet companies are useful. And micro-blogging sites such as Twitter have changed the way that people communicate. Who would have thought in a society where verbosity trumps brevity that people would be able to say what they need to say in 140 characters or less.

Hype and hope

However, it is important to appreciate that internet and technology companies need to be disruptive to stay ahead of the competition. This invariably means their valuations can be volatile as they continually evolve to meet the changing demands of the market. As such, they should be valued less than the market, not higher.

That was not the case with Twitter, or at least that is not the case for the moment. Currently, Twitter, which has no earnings to speak of, is reckoned to be worth 22 times estimated revenues. Meanwhile, shares in, say, the 30 companies that make up the Straits Times Index (SGX: ^STI) are collectively valued at around 12 times profits.

By almost every conceivable measure, Twitter has a frothy valuation. And if something looks like froth and smells like froth, then it is quite likely to be froth. It is currently worth three times more than SIA Engineering (SGX: S59) and twice as much as Singapore Exchange (SGX: S68). In fact, it is within touching distance of industrial conglomerate Keppel Corporation (SGX: BN4).

But it is not just internet and technology companies that can sport frothy valuations. It can happen anywhere. Consequently it is important to recognise hype and hope whenever we see it.

Warren Buffett once provided a valuable insight on how to identify froth. He said: “If you are in a poker game and after 20 minutes you don’t know who the patsy is, then you’re the patsy“.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.