WSJ: Easy Money and the IPO Boom

http://online.wsj.com/article/SB10001424052702304066504576345740316053266.html

It's no coincidence that last week, as the minutes from April's Federal Reserve meeting suggested interest rates won't go up for months or even years, Web professional network company LinkedIn went public at $45 a share. Its stock zoomed past $100 per share and settled at $94 on the first day. This valued the company at $9 billion, 30 times sales and 666 times earnings.

Yandex, also known as "Russia's Google," started trading on Monday and is now worth $10 billion. That's a lot of rubles.

Overvalued? Undervalued? Stocks are worth whatever the market says they are worth. On Wall Street, perception becomes reality, though often fleeting. Of course, it's not a real market. First, less than 15% of most IPO shares trade freely for the first six months (by longstanding practice, the rest are locked up). Worse, the Fed's current near-zero interest rate policy distorts everything.

Let's go back to fundamentals. Put simply, a stock is worth the sum of what investors think it will earn in the future discounted back to today. No one really knows a company's earnings, its growth rate, or what discount rate or risk adjustment to apply. That's what makes markets such a wild and crazy ride—stock prices change minute by minute. Industry news, new product uptake, interest rates, inflation, risks of recessions or wars or tsunamis all pose some form of risk and change collective perceptions.

The primary function of the stock market is to allocate capital to companies whose prospects it likes and starve those it thinks are past their prime. Yet these allocations and reallocations are based on guesses.

The Federal Reserve policy of quantitative easing hasn't helped. The economy doesn't need all the extra dollars sloshing through the economy, so the money goes elsewhere. The stock market is already within 15% of its all-time high but seems stuck, and now even the commodity bull-run feels tired. It's as if the market has run out of places—other than the Web—to park capital.

Until last week, there had been a drought of IPOs, but the private secondary market for companies like Facebook and Twitter and Groupon has been on fire—with Facebook hitting $70 billion in value. Haven't we seen this movie before? Is it the one where the dot-com ship hits the iceberg and sinks?

In 1983, as interest rates plummeted from the inflation-ravaged 1970s, we saw an IPO boom based on the availability of inexpensive chips lowering the cost of personal computing. While the easy money only lasted until 1984, over the decade it became cheaper to do work on PCs and workstations than clunky mainframes, so a new economic model forced massive shifts in corporate America. Some companies that went public in 1983 took until the end of the decade to make enough in earnings to justify their lofty IPO valuations. Others disappeared. But capital did get allocated to productive growth.

In 1999, an IPO boom to end all IPO booms (or so we thought) was driven by cheap bandwidth, lowering the cost of commerce. An economic model of lower connection costs to vendors was powerful enough to drive growth. Then policy mistakes in Reed Hundt's FCC Telecom Reform Act twisted incentives by keeping data rates artificially high, so that anyone with a spreadsheet and a Ditch Witch to dig a trench could raise billions to lay fiber optic cable.

The IPO mania finally got out of hand when Fed chairman Alan Greenspan flooded the market with dollars to stave off the looming Y2K disaster that never arrived. The Fed pulled them back in, the fun ended. Amazon thrived, though it took that company and many others the rest of the decade to justify their 2000 valuations. Infospace and Pets.com didn't. But productive growth ensued.

And now? An "IPO boom to be" could be driven by cheap servers and smart mobile devices that are lowering the cost of interpersonal communications. And there is an economic model to justify it. Google has shown the way. I call it the "gimme half" rule. Google runs ads against search results, with vendors bidding in an auction for top billing. If you dig into Google's numbers, which unfortunately isn't easy, I think you'd see that Google, based on click rates and successful checkouts, collects ad revenue of about half of gross margin from plasma TV or mortgage loans or insurance sales. In other words, vendors are willing to give up half their profits to connect with customers and make the sale.

LinkedIn is doing the same for recruiters. By creating a network of 100 million professionals, my guess is their usage fees represent about half what it formerly cost, in total, to find, recruit and hire workers. For the savings, companies will gladly pay and change their manual process.

Facebook has lowered the cost of interpersonal communications for a network of 600 million of us. Their economic model relies on inserting ads during our most influential point of decision—while being talked into buying things by our friends. Whatever the model, I bet it ends up as half of someone else's profits in exchange for the influence peddling. At a far extreme, couponing sites like Groupon and Living Social collect half of actual sales, not just profits, in exchange for the introduction to a new customer.

So what are these companies worth? I like to use a 10 times rule. If a company is worth $10 billion, can they someday, any day, make $1 billion in profits in one year? If so, maybe it's worth holding on to. Can LinkedIn make $900 million after tax in the next 10 years? Can Facebook make $7 billion? Google made $8.5 billion last year, seven years after its IPO. So it's possible. But then again, there is a saying here in Silicon Valley that Google is the exception to almost every rule.

Just don't forget that zero interest rates are not real—they are a construct of the Fed, not the market, and they are dangerously distorting the crucial capital-allocation process. Now capital will inevitably be over-allocated to growth companies, good and bad. Enjoy the ride, but buckle up.

 

 

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No one really knows a company's earnings, its growth rate, or what discount rate or risk adjustment to apply