Apr 112012
the emotions of investment bubbles

You know you’re in an investment bubble when the pundits declare “we’re not in a bubble”.

A good example of this is Andy Baio’s defence of Facebook’s billion dollar purchase of Instagram.

Justifying the price, Andy compares the Facebook purchase with a number of notorious Silicon Valley buyouts using two metrics; cost per employee and cost per user.

Which proves the old saw of “lies, damn lies and statistics”.

The use of esoteric and barely relevant statistics is one of the characteristics of a bubble; all of a sudden the old metrics don’t apply and, because of the never ending blue sky ahead, valuations can only go up.

Andy’s statistics are good example of this and ignore the three things that really matter when a business is bought.

Current earnings

The simplest test of a business’ viability is how much money is it making? For the vast majority of businesses bought and sold in the world economy, this is the measure.

Whether you’re buying a local newsagency outright or shares in a multinational manufacturer, this is the simplest and most effective measure of a sensible investment.

Future earnings

More complex, but more important, are the prospects of future earnings. That local newsagency or multinational manufacturer might look like a good investment on today’s figures, but it may be in a declining market.

Similarly a business incurring losses at the moment may be profitable under better management. This was the basis of the buyout boom of the 1980s and much of the 1990s.

Most profitable of all is buying into a high growth business, if you can find the next Google or Apple you can retire to the coast. The hope of finding these is what drives much of the current venture capital gold rush.

Strategic reasons

For corporations, there may be good strategic reasons for buying out a business that on paper doesn’t appear to be a good investment.

There’s a whole host of reasons why an organisation would do that, one variation of the Silicon Valley business model is to buy in talented developers who are running their own startups. Google and Facebook have made many acquisitions of small software development companies for that reason.

Fear Of Missing Out

In the Silicon Valley model, the biggest strategic reason for paying over the odds for a business is FOMO – Fear Of Missing Out.

To be fair to the valley, this is true in any bubble – whether it’s for Dutch tulips in the 17th Century or Florida property in the 20th. If you don’t buy now, you’ll miss out on big profits.

When we look at Andy Baio’s charts in Wired, this is what leaps out. Most of the purchases were driven by managements’ fear they were going to miss The Next Big Thing.

The most notorious of all in Andy’s chart is News Corp’s 580 million dollar purchase of MySpace, although there were good strategic reasons for the transaction which Rupert Murdoch’s management team were unable to realise.

eBay’s $2.6 billion acquisition of Skype is probably the best example of Fear Of Missing Out, particularly given they sold it back to the original founders who promptly flicked it to Microsoft. eBay redeems itself though with the strategic purchase of PayPal.

Probably the worst track record goes to Yahoo! who have six of the thirty purchases listed on Andy’s list and not one of them has delivered for Yahoo!’s long suffering shareholders.

The term “greater fools” probably doesn’t come close to describe Yahoo!’s management over the last decade or so.

While Andy Baio’s article seeks to disprove the idea of a Silicon Valley bubble, what he shows is the bubble is alive, big and growing.

One of the exciting things about bubbles is they have a habit of growing bigger than most rational outsiders expect before they burst spectacularly.

We live in exciting times.

  One Response to “Bubble economics”

  1. […] you might like the Wired analysis of the numbers compared with other internet startup buyouts, Paul Wallbank’s refutation of that analysis, and a witty piece in NYMag — as well as my own piece for […]

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