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Googling the capital markets

April 30th, 2004

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.

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  1. Tony Healy
    August 19th, 2004 at 18:44 | #1

    JQ has pointed out I’m on the wrong thread.

  2. PK
    May 1st, 2004 at 01:03 | #2

    “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.”

    Presumably you mean when living standards in Western countries were around half what they are today?

  3. John Quiggin
    May 1st, 2004 at 10:33 | #3

    PK, you’ve confused levels and growth rates here. The relevant criterion is the growth rate, and the correct statement is “if the growth rates of the Golden Age had been maintained, living standards would be about twice what they are today”.

  4. PK
    May 1st, 2004 at 14:44 | #4

    John

    You are assuming that growth is a given, which it certainly isn’t.

    In fact, following WWII Western governments would have been seriously incompetent not to have maintained high growth rates, whatever economic model they followed. The fruit was pretty low hanging. With regard to growth rates, we’re not in as priveledged (for want of a better word) position as them.

    In fact, growth under the model you favour stalled in almost every country it was used. And – surprise, surprise – this happened about the same time as most of the low hanging fruit had been picked.

    Productivity growth and technological advance is what we rely on today, as opposed to economies recovering from devestating war. There is pretty overwhelming evidence that the market model is better at delivering these.

  5. Harry Clarke
    May 1st, 2004 at 16:49 | #5

    There should be an explanation for extreme valuations of firms, such as Google, given the rise (and rise) of finance as an discipline these days. Mum and pop investors are not an important part of the investment scene and the finance graduates who are employed by large mutual funds, while well-versed in constructing optimal portfolios and martingales, often don’t have much business sense, because they don’t study much industry economics and don’t grasp the forces driving innovation, entry and competition. They certainly don’t know about public goods and non-appropriable social values.

    Many in finance don’t have interest in seeing what’s in front of their eyes because their brains have been lobotomized by an instinct that markets are efficient. Fundamentalist appreciation of what makes a good business is lacking because it is irrelevant. If most believe markets are rational and few actually do assess business prospects using sound economic theory it is easy to see how valuations go astray and are driven by fad. Indeed one has a non-bubble-based theory of daft valuations.

    The rise of finance as an academic discipline should have produced better outcomes than it has. Finance has been granted its independence too early — it sould have remained an economist province.

  6. John Quiggin
    May 1st, 2004 at 17:11 | #6

    “Finance has been granted its independence too early — it should have remained an economist province.”

    I couldn’t agree more, but I guess we are both biased.

    PK, the points you raise now are serious ones, unlike your first. I will attempt a full-length post in response, rather than debating them in the comments thread. My conclusion is that relatively modest refurbishment of the institutions of the Golden Age was needed in response to the breakdown of the 1970s, rather than a return to the policies of the 19th century. I will try to spell out my reasons for thinking this in more detail as soon as I get time.

  7. Tony Healy
    August 19th, 2004 at 11:09 | #7

    A couple of points to bear in mind – first, Google refused to use the usual IPO structure that lets merchant banks cream the early profits. There are suggestions this may have inspired underhanded attacks on the IPO by that industry. The spate of negative media reports after Google let the merchant bankers know they would not be screwing retail investors this time bears this out.

    Secondly, the dot com boom is generally misunderstood. Most dot com companies were not technology companies at all. They were wet dreams of MBA’s, graphics arts people and accountants. That’s why they were mostly useless.

    By comparison, Google is a first class technology company with fantastic technology, people and prospects. Search is an abstract concept and thus it’s difficult to appreciate the complexity of the technology involved. Google is not a dot com company.

  8. Tony Healy
    August 19th, 2004 at 14:47 | #8

    Test – the total of posts on the blog front page is wrongly listed as 0. I’m seeing whether it needs a reminder.

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