How the tech-stock valuation curve inverted

By Felix Salmon
July 29, 2012

Is a bubble bursting in Web 2.0 stocks? The NYT says there is, and says indeed that this implosion is even more dramatic than the one we saw in 2000. In reality, of course, it isn’t.* In 2000, trillions of dollars of wealth evaporated as the share prices of thousands of companies plunged to earth; in 2012, by contrast, we’re talking about a mere handful of companies, including Facebook, which, with its $65 billion market cap, still looks pretty well valued to me.

That said, most of the public self-described “social” companies — with the prominent exception of LinkedIn — have indeed seen their share prices hit hard of late, to the point at which many recent private rounds look decidedly rich. The result is that there’s a pretty strong case to be made that we have what you might call a steep inversion in the valuation curve.

In general and in aggregate, corporate valuations are meant to rise over time. There’s a lot of volatility in the process, of course, and individual companies go bust all the time. But in the Silicon Valley model, companies begin as startups at relatively low valuations, and then as they raise more money in successive rounds, their valuation steadily rises. Eventually, if and when they go public, they’re worth so much that anybody who bought in during one of the private rounds will be sitting on a nice profit.

That’s not just a matter of growth over time, either: it’s also a matter of a much larger investor base. There are only a relative handful of individuals and institutions who buy into private rounds; in contrast, there are millions of investors around the world who can buy stocks listed on public markets. If the number of people bidding against each other to buy equity in any given company suddenly rises by many orders of magnitude, it stands to reason that the price is going to rise as well.

With the latest crop of tech stocks which have gone public, however, that hasn’t been the case — despite what seemed to be enormous appetite, for Facebook stock in particular, from investors all over the world. Instead, even if valuations are still getting steadily richer from round to successive round in the private markets, there’s no a significant drop at the end of the curve — the point where private markets go public.

So what’s going on? The answer, I think, can be found in the psychology of the dot-com bubble. Back then, there were a lot of people making enormous amounts of money by investing in technology stocks. You’d put together a portfolio of tech stocks, the portfolio would rise in value, and you would conclude that you were doing very well, and therefore buy ever more tech stocks. After all, your brokerage statements were proof positive that you knew exactly what you were doing, and were very successful at it. A bull market, especially a soaring bull market, creates confidence and momentum and inflows.

Turn that story on its head, and you wind up where we are today. There are still dedicated technology investors and funds in the public markets, but all the top technology investors have moved, at this point, to the private markets. If you’re in the public markets, your performance has been mediocre for over a decade, and you’re liable to take any brief buzz-induced inflow of funds into the sector as an opportunity to cash out and make a rare and precious profit.

In theory, the fact that the public markets are so much bigger than the private markets should be great for any tech company going public which cares mostly about its valuation. There’s a finite number of shares out there, and the demand for those shares is now vastly bigger than it was. Therefore, price must go up.

In practice, however, it doesn’t work like that. Instead, we have a very small pond of private investors, where valuation momentum can pick up incredibly quickly. But the minute the gates come down and the company’s valuation wave spills into the ocean of the public markets, it just gets absorbed into the broader tech-valuation sluggishness, and disappears.

Yes, Facebook had a very large IPO, but it was always a bit ridiculous to hope that a single offering could change the psychology and momentum of the entire technology sector — even if it had gone well, which of course it didn’t. Stock markets are moody animals, and they don’t like being told how to behave by Sand Hill Road types with an eye to a big payday. The tech sector might turn around and begin a rally at some point. But chances are, that point won’t come until after Silicon Valley’s VCs have been properly chastened.

*Update: I apologize for mischaracterizing the NYT article; it did not say that the current pop was as loud as the one we all heard so loudly in 2000. I misread the article, or read it too quickly. Sorry.


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Felix, what percentage of private equity deals actually pay off? Perhaps one in ten? If those few *didn’t* generate tenfold returns, they would be losing money overall.

In theory, the private equity investors ought to end up with very nice percentage gains on average. They take a lot of risk — risk which can’t wholly be averaged out by participating in a multitude of deals — and typically need to wait many years before cashing out. Investments that are risky and illiquid SHOULD promise high returns, or nobody with any sense would buy into them.

The problem is that (as you say), private equity has been flooded by investors buying into this concept without actually testing the numbers. So the private equity valuations may be unrealistic at this point.

Posted by TFF | Report as abusive

“psychology and momentum of the entire technology sector”

What about “valuation”? The tech sector is facing some real challenges right now, which is holding valuations down.

If you can successfully identify which companies will NOT see their markets evaporate in the next five years, you can make some nice profits. But you’ll need to get it right at least three times as often as you get it wrong.

Posted by TFF | Report as abusive

I’m not sure what your overall point is here, Felix, but I’ll offer a couple of observations:

>>If you’re in the public markets, your performance has been mediocre for over a decade . . .

If you’ve achieved mediocre performance since around 2000, you’re doing much better than the market at large.

And unlike circa 2000, the focus today seems to be primarily on social media. The revenue model for social media is advertising, and it’s not yet clear that it has the heft to take advertising to the next level (LinkedIn has a couple of other revenue models that may be setting it apart right now).

But the fact is that web properties by and large continue to be brain dead on making money. Unlike 2000, that seems to be important now. Advertising may work for some, but it’s not a universal business model. That may be holding down any tech bubble in the public markets.

Posted by Curmudgeon | Report as abusive

Today the line between private and public listed stocks is blurred, with Facebook’s presence on Second Market a good example. The IPO of FB on Nasdaq certainly did not mark the day when shares in that company were first freely traded.

Posted by ottorock | Report as abusive

Felix I think the issue if fairly straightforward here. On the private markets, data is opaque, as there are no regulatory requirements to release anything. A company like Facebook, which has millions of users and touches nearly everyone is a great story. What’s not a great story are the fundamentals: where the profit is coming from. On the secondary market, you can bid this company up on hype. Once you go public and the hype dies down, you’re left with the numbers.

And let’s be clear, Facebook’s numbers are terrible, it’s CEO tosses word salad in the air on calls, and a lot of people got royally screwed for believing the hype so that’s dragging down an entire sector. But the main problem remains…how do any of these companies actually outperform? How do they make money that justifies the high multiples? When was the last time you clicked on a Twitter or Facebook ad? Do you reveal your Facebook profile publicly? Do you even really pay attention to Twitter (I, frankly, don’t know many people who do)? How about LinkedIn? Do you realize they monetize their back-end by allowing headhunters and other professionals to search it so they don’t have such a reliance on ad revenue? So it’s pretty clear to me what’s happening. Unless Facebook can grow revenue in line with it’s user base, it’s a bad investment. Not to mention the insane structure of its stock tiers. Don’t even get me going on the uselessness of Twitter…

Posted by skyman123 | Report as abusive

“…Facebook, which, with its $65 billion market cap, still looks pretty well valued to me.” -
A sentence that speaks more about the lasting power of repeated hype than about the value of facebook.
After its recent free fall, this company’s stock is still overvalued by a factor of one order of magnitude, and there is still absolutely nothing that can remotely justify such value in the real world.
It’s a multi layered bubble: When the external layer bursts, there’s enough hype left to support another layer…
Does the name ‘Netscape’ ring a bell here? Many people once thought it would rule the Internet, because it had such a great browser. Sounds funny, isn’t it?
Others thought that Yahoo would be the biggest winner of all, because it was such a great Internet ‘Portal’ – as if people needed a door to enter and navigate the web…
AOL went through a similar hype cycle, etc.
When Silicone valley and Wall Street decide to produce a new fad and put their hype machine to promote, nothing can stop them. Everybody get their mind obscured, and their senses blurred, and eventually, they lose contact with reality.
But reality is there, all the time.
I wonder why facebook doesn’t buy back its devalued stock… Do they know something others don’t?

Posted by reality-again | Report as abusive

“still looks pretty well valued to me”

Perhaps he meant “pretty richly valued”? Is how I read it, at least.

Posted by TFF | Report as abusive