Market turmoil in recent days has resulted in a brutal examination of the value which underpins shares in many different areas of business and nowhere are the prices looking more overstretched than in the technology sector.
This time is different.
In the world of the internet, the valuation of stocks has shifted from traditional measures such as pre-tax profits and cash returns through dividends, to more ephemeral indicators such as revenue growth and the number of people using a particular service.
The danger is that, the further valuations stray from the anchors of value such as a company’s pre-tax profits and cash generation, the more likely investors are to incur painful losses.
Investors were still wary of paying more than 100 times forecast earnings for technology stocks, having been burnt during the bursting of the previous dotcom bubble, so the industry needed to find another way to justify the valuations.
This is easily done through the old retailers’ trick of suggesting “hurry now while stocks last”.
Anatomy of a tech float
Markets can only discover the real value of shares when demand and supply are in balance. In a perfect world, that can only happen with 100pc of the shares in issue. Now imagine what happens when you create a huge amount of hype over a fledgling internet company, ascribe a stratospheric valuation and then only offer 10pc of the shares for sale.
The bounce in many technology stocks shortly after listing is no indicator of the underlying value, but rather a result of hopelessly optimistic growth forecasts combined with excess demand for the shares.
Once the first-day pop in the shares has been achieved, it sends a false pricing signal as to the underlying value. Behavioural economics does the rest as investors respond to a price signal set in the market.
At this point, the remaining 90pc of the shares can slowly be drip-fed on to the market, allowing the initial investors to cash in.
The music stops
The shares in the technology sector are now desperately trying to discover their true value as “easy” central bank money comes to an end, and investors begin to question what level of actual profits these companies are likely to achieve.
In the US, the Nasdaq index of technology shares has fallen 14pc so far this year, with business networking site LinkedIn down 55pc and Twitter falling 32pc. Even shares in Google owner Alphabet are down 9pc, and the mighty online retailer Amazon is down 25pc. Amazon is enjoying rapid growth at Amazon Web Services, the company’s cloud computing division that supports millions of websites for other companies, but earnings fell short of expectations in the most recent fourth-quarter results.
The latest move by Amazon to open bricks-and-mortar bookstores in the US seems to mark the ultimate realisation that dominating the online marketplace will mean a struggle to generate meaningful profits, especially once the elevated cost of offering next-day delivery is included. Amazon’s scattergun approach to investment in TV, film, and drone delivery appears to be a worrying indicator of a company lacking direction.
In the UK, it is online retailers which have borne the brunt of the tech-linked sell-off. Just Eat, the online takeaway service, is down 33pc, online clothing retailer Asos is down 24pc, and grocery delivery group Ocado has fallen 20pc so far this year. Only fridge and freezer retailer AO World and clothing retailer Boohoo.com have escaped the sell-off, rising 2.5pc and 6.4pc respectively this year.
However, that will come as little solace to investors in AO World and Boohoo.com who are nursing yawning losses after painful profit warnings during the past 18 months.
Profits mirage
So, the operating model of website and warehouse is simple, but that also means the barriers to entry are low. As new online retailers enter the market, existing names like Asos are ramping up capacity. This battle for online market share has sparked a price war that has pushed meaningful profits way into the future.
Many online retailers are also finding that economies of scale from selling more clothes from bigger warehouses, which should reduce average costs per item of clothing, are proving hard to come by. The high street clothing retailers are causing further difficulties by fighting back. Traditional shopping environments have been transformed into clicks-and-mortar platforms where customers can order online and get their choice delivered, or pick it up.
Return of risk
The lower growth and lower profit future has undermined the hopeless maths behind many technology valuations. Amazon trades on a PE ratio of 110, Ocado 100 times. Boohoo.com is not alone; many internet companies were showered with investors’ money as they came to the stock market. Just Eat raised gross proceeds of about £360m from investors, while AO, the online white goods retailer, raised £423m.
The problem is that the central bank backstop for equities has been removed and the risks involved are being reassessed. Shares in companies that make little profit, have very few assets, no unique technology, easily replicable warehouses, and that face increasing competition, are now deemed far less attractive.
But we should rejoice as the market rediscovers risk. In such a world, capital allocation within the economy is far more efficient, and it gives the UK a much better chance of generating the growth needed to escape the shackles of a downturn.
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