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Why Tech Valuations Can't Be Too High or Too Low

October 28, 2013
URL: http://www.entrepreneur.com/article/229629

It's that time of the market cycle again where we have to stop the hand-wringing over tech valuations.

Every so often, we hear breathless concerns that valuations of private technology companies have gotten out of whack. This time, The New York Times questions the price tags of companies like Pinterest, Fab and Snapchat. This comes in advance of the upcoming Twitter initial public offering, which itself is supposed to command a large valuation.

Are any of these companies overvalued? Some would say it is impossible to know, but it is actually an easy question to answer: They are not. That doesn't mean that investors, public and private, won't be digging deep to back them. Nor does it mean that any or all of these investors won't lose every wheat penny they put in.

But they are not overvalued – or even undervalued, for that matter. Truth is, the market has already decided what these companies' values should be, and that is the price that is reflected. People can make decisions whether to hop on board or stay away, but the price is the price. That value, set by a free-market system, is fair.

Related: 5 Things Twitter Needs to Answer on Its IPO Roadshow

It is not a hard concept. The value of any product or service is simply what someone is willing to pay for it. Probably the best example of this is in Detroit, where the TV show Hardcore Pawn is produced. In that show, a fellow in need of cash walks in with a gold watch he says has been in his family a hundred years. He won't part with it, he says, for anything less than $1,000.

Les Gold, who owns American Jewelry and Loan, where the show takes place, looks at the watch in his loupe and offers $50. Eventually, after some haggling, Les goes up to $75, and the seller takes the money.

Les, though, will likely put a price tag of $500 on that watch. A buyer may come in and get it for $400, depending on how long its sits in the display case.

So was this family heirloom worth $75 or $400?

The answer is both. Les and the seller set a price to buy it. Les then set a price to sell it, but took a lower price because he had a willing buyer.

Notice that none of this haggling had much to do with the watch itself. No one is talking about the weight of gold in it, how many jewels it had, or how much wear and tear it suffered. Sure, that probably went through Les's mind when he set his prices, both to buy and to sell, but all that was crowded out by a bigger calculation: At what price can I get this to make the biggest profit when I sell it?

The same goes for anything that can be purchased or sold, even technology companies. Private companies raise capital because they need it. They want a higher valuation, but they have to haggle with venture investors, who want to set a price based on how they can maximize their own profit when they sell their stake.

The warnings over valuations, of course, are designed to protect investors from losing their collective shirts. (The Times mentions Pets.com, which went from IPO to shutdown in just nine months, shorter than the lifespans of most of the hamsters they sold.) But you could also warn people away from making a boatload of scratch.

Related: How the Robertsons of Duck Dynasty Conquered America

And that's why it is time for me to kneel in the confessional and seek shrift. Nine years ago, I was among the pundits questioning the valuation of a little tech company called Google. I once wrote that investors were “shocked” that at an offering price of $135, this company had the gall to propose a valuation that would put it on par with McDonald's and Sony. Even at $85 a share, its eventual offering price, I argued Google was overvalued. After all, that price gave it a total valuation of $23 billion. The nerve of some people.

That was nine years and, in my case, 40 pounds ago. Oh, and $318 billion in lost market-cap gains for the people who sought my sage counsel. It's another lesson why you should take neither marital nor financial advice from me.

Of course, smarter people than I set valuation guides, too, notably the number-crunchers on Wall Street. Research arms at financial firms make a very good living deciding what is overvalued or undervalued or fairly valued. Then they set buy, sell and hold ratings. Those ratings are then promptly ignored by the sales arms at their own firms, because Wall Street, better than most places, knows that value isn't something so easily quantified. If valuations were set in black-and-white by metrics like price-earnings ratios, we would actually not have a market at all. Instead, we would have set prices for assets. Ask a Soviet you know how that worked out for them.

What folks need to realize is that more good than bad happens when valuations rise. Money follows money, so when hundreds of millions of dollars find their way into Snapchat's coffers, other venture firms take note and decide they want to throw millions of dollars at things, too. That raises the overall valuations of whole sectors, and everyone wants their own piece. Et cetera, et cetera. Even Silicon Valley isn't immune to human nature.

So don't cry over bubbles. They grow and they pop, but very rarely do investors go all in and then go bust. It's our market system – imperfect, yes, and with swings that would make the bipolar blush. But it is the only system where ideas once scribbled on a cocktail napkin can become multibillion-dollar enterprises, and make a lot of people rich along the way. It's hard to argue with the value in that.

Related: Everything You Wanted to Know About VC Liquidation Preference But Were Afraid to Ask