Googling the capital markets
The Google IPO has now been announced, and there are some more figures to analyze. In addition, I wanted to talk a bit about the option, suggested by one of the commenters on Kevin Drum’s blog of arbitraging by short-selling overpriced dotcoms and buying those with more reasonable valuations.
Looking at this NYT report, that doesn’t seem likely to be an option.
In 2003, Google reported an operating profit of $340 million on sales of $960 million. But the 2003 figure appears to understate the company’s cash profit margin, since it includes very high expenses related to stock options that will probably decline in future years. On a cash basis, Google had an operating profit of $570 million in 2003, and an operating margin of 62 percent.
Given those figures, Google will easily command a market valuation of at least $30 billion, and perhaps much more. EBay, which had an operating profit of $660 million on sales of $2.2 billion last year, is valued at $54 billion; Yahoo, with sales of $1.6 billion and operating cash flow $428 million, is valued at $36 billion.
I’m not an accountant, but I think the “operating profit” referred to here is EBITDA (earnings before interest, tax, depreciation and amortisation): in any case, it’s more than the profit accruing to owners of equity. So it appears that all of these well-established businesses are valued at more than 100 times annual earnings.
As I recall, the ratio for profitable companies during the hyperbubble was around 400, so some progress has been made. But these values still look bubbly to me. To match an investment in 10-year bonds, without allowing for any risk premium or for the inevitable increase in long-term interest rates, all these companies need to more than quadruple their earnings, then maintain those earnings for at least 20 years. Maybe Google can do this, and maybe Yahoo can do it, but it’s most unlikely that both of them can.
At one time, I would have tried hard to think of an explanation consistent with some notion of aggregate market rationality, in which capital markets allocate capital to its most productive us. In the light of the evidence of the last ten years – the dotcom bubble, the US dollar bubble, the (still continuing) bond bubble – I no longer bother. Capital markets are driven by fashion (in this case, the continuing desire to be part of the Internet happening, in the face of mounting evidence that it provides almost exclusively public goods), fear and greed. On average, capital markets do a better job than Soviet central planners, but I think they do less well than the mixed economy that was dominant during the postwar Golden Age.
Eventually, no doubt, reality will prevail. If I knew that was going to happen within the next twelve months, I’d be shorting the remnants of the dotcom sector for all I was worth. But, as Keynes apparently didn’t say, the market can stay irrational longer than you can stay solvent.