Another Tech Bubble? Maybe Not

A sign in front of the Facebook headquarters in Menlo Park, Calif. i i

A sign in front of the Facebook headquarters in Menlo Park, Calif. Justin Sullivan/Getty Images hide caption

itoggle caption Justin Sullivan/Getty Images
A sign in front of the Facebook headquarters in Menlo Park, Calif.

A sign in front of the Facebook headquarters in Menlo Park, Calif.

Justin Sullivan/Getty Images

It's beginning to feel frothy in Silicon Valley. Here are a few numbers:

On the first day of its initial public offering LinkedIn was valued at nearly $9 billion; today the social networking site is worth more than $10 billion. Instagram, a company with no profits, no revenue and no plan to make money, was just bought for a cool billion. The buyer was Facebook, a firm in the process of going public.

And those values are nothing compared with what Facebook may be worth itself. That company is expected to be valued at between $80 billion and $100 billion after its IPO later this spring.

But is this a bubble? Is the considerable exuberance in this part of the world irrational?

Here in Silicon Valley you hear some version of this statement all the time: "This is different. I was here in the 1990s and these companies are not Pets.com."

Investors and entrepreneurs have been saying this to each other for years, in part because it is true. Facebook generated $1 billion in profit last year. It's still almost doubling its revenue and profit year to year and it's doing all of that with a relatively small workforce.

Instagram created a social network of 30 million people with just over a dozen employees. These companies have created ways to connect millions and build enormous audiences incredibly efficiently. That is worth something. The question is, what?

Jean-Paul Rodrigue, a professor at Hofstra University, published an influential chart just before the financial bubble burst in 2008. He broke bubbles down into four stages:

The four stages of a bubble i i
Jean-Paul Rodrigue/Wikimedia Commons
The four stages of a bubble
Jean-Paul Rodrigue/Wikimedia Commons

Steve Blank is a serial entrepreneur in Silicon Valley and an adjunct professor at Columbia Business School. He says we have sailed through the stealth phase of the current technology investment cycle. We are past the point where big investors are aware of the opportunities in mobile and social companies and we're rapidly entering into a period of manic excitement of the next wave of Internet companies.

But Blank says not all bubbles are created equal — not all bubbles are bad. "Bubbles built the railroads," he says. "Bubbles built the steel industry." He believes many of the technologies that are attracting so much excitement right now have the potential to change the way we live and how the economy works.

That may be. But prices are high enough now that many wonder whether companies like Facebook can justify their own hype. When investors talk about bubbles, typically they end up comparing a company's profits with its share price. The price-to-earnings ratio is a staple of evaluating a stock. ExxonMobil's P/E ratio hovers around 10. That means the company is valued at something like 10 times its annual profit.

Apple has a P/E ratio of 17. That's high compared with historical averages, but Apple's earnings have been growing incredibly fast and the company is sitting on $100 billion in cash. And its stock looks positively cheap in comparison with the latest crop of social media companies that are going public.

If after Facebook's initial public offering it's valued at more than $100 billion it will have a P/E ratio of 100 to 1. And that's a bargain compared with LinkedIn, which is trading at a ratio of between 800 and 900 to 1. These are bubblicious prices.

To justify its projected IPO price to more conventional investors, Facebook will need to double its earnings every year for the next three or four years. Those who sell now may realize windfalls and those who buy have to hope for years of exceptional growth or they will be left holding the bag.

But Blank says this may not be bad news for the economy as a whole.

"Unlike other bubbles — housing bubbles and financial bubbles — nerds don't buy yachts. They seem to reinvest in their own domain," he says.

Technology entrepreneurs who strike it rich often end up pouring a significant amount of their wealth back into new companies founded by friends and colleagues.

The most famous example is the PayPal mafia. The original investors and founders of PayPal have helped launch dozens of companies, seeding them with money and expertise. Those firms included LinkedIn, Zynga, Facebook, SpaceX and Tesla, to name just a few.

Younger generations of entrepreneurs reinvest this way as well. Rather than turning over their newfound fortunes to Goldman Sachs, entrepreneurs here tend to look around for other technology ideas that seem clever and entrepreneurs who remind them of themselves.

Take Aaron Patzer. He founded Mint.com in his early 20s and sold it to Intuit a few years later for $170 million. Patzer then invested a bit of his windfall in Milo, whose founder, Jack Abraham, was also young and hungry. Within months Abraham sold his business to eBay for $75 million. Abraham then invested in Pinterest, which now is one of the hottest social startups in the country.

Stories like this repeat again and again and again. And Blank believes that makes a tech bubble — at least this tech bubble — more productive than others where investors in effect take their winnings off the table. Each new windfall leads to a new round of investment. Maybe some firms are sold for too much, but in the end much of the money is reinvested in innovation.

"The last 10 years have taught us a ton about what the next 10 years are going to be," Blank says. "We are much smarter, much better, much more efficient at building early-stage ventures."

As more technology entrepreneurs experience big paydays, Blank is optimistic about what the next wave of investment could bring.

"We actually think we have found a way to take the most advanced research in our labs and insert it into our economy," he says.

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