Another Tech Bubble in the Offing?

The dotcom boom at the end of the 1990s was a classical and magnificent bubble. Venture capitalists and other investors were throwing tens, and often hundreds, of millions of dollars at Internet startups and fledgling biotech companies that usually were not making profits, and frequently did not have any sales. The bubble burst in 2000, and the huge valuations placed on these companies disappeared, along with many of the companies.

It is only a decade later, but a second dotcom boom has begun, and some early signs are surfacing of a possibly another bubble. This boom is being fueled mainly by social networking companies like Facebook, Twitter, and LinkedIn, and also by Chinese Internet companies. Other Internet companies, like the Internet phone and video company Skype, are also in the mix. Microsoft recently purchased Skype for $8.5 billion, which is ten times Skype's sales, and several hundred times its operating income last year.

During the dotcom frenzy of the '90s, tech companies that were traded publicly, usually on the Nasdaq, had greatly inflated valuations. Share prices were often immediately bid up by more than 100% after tech company shares started trading on public exchanges.LinkedIn is one of the few social networking companies that have had an IPO, and its market value already has soared. LinkedIn started trading on the New York Stock Exchange on May 18 at a share price of $45 that valued the company at about $4.3 billion. Its price rose the next day to close at $86 per share, almost double the offering price. It now trades at around $88 per share. The company had revenues in 2010 of about $243 million, but indicated in its filing that it did not expect to make profits this year.

Facebook and Twitter have not yet had IPOs, but they are actively traded in secondary markets. In an excellent discussion in its May 14th edition of the boom in tech stocks, The Economist shows that Facebook is valued on this secondary market at over $75 billion, and Twitter at almost $8 billion. These are enormous valuations relative to the sales and profitability of these hugely popular social networking companies.

Adding to the froth in the tech market is the successful listing of many Chinese Internet companies on either Chinese or American stock exchanges. To be sure, China has almost 500 million Internet users, and this number is still growing rapidly, but the valuations place on these tech companies is quite high relative to their sales, and much higher relative to their profits.

Does all this add up to a new bubble in the making? I would like to believe that a company like Microsoft, which has had so much success in the past, knows what it is doing in paying an apparently very high price for Skype. But Microsoft has stumbled badly during the bad decade or so as it tries unsuccessfully to compete against Apple and Google. This suggests there is a reasonable chance that Microsoft is stumbling again as it desperately tries to find its way. Recall too that Rupert Murdoch, an enormously successful investor in newspapers, television, cable, and film companies, apparently greatly overpaid in 2005 for Myspace.com, an online social networking company.

The present situation is not yet close to the situation in 1999 and 2000, when tech stocks listed on the Nasdaq had risen to ten times their prices in 1995. Still, if Microsoft and Murdock paid inflated prices for Myspace and Skype, it would be no surprise if other investors who have more limited business experience with Internet companies would have inflated expectations about future earnings prospects of these companies.

In trying to determine the likelihood of another bubble, there is on the one hand, the large worldwide growth in the number of Internet users since 2000, and the improvement in the business models of online companies. This might well mean that the present situation is very different than the bubble in the late 1990s. But there also is, on the other hand, the present love affair with social networking companies, which could mark the beginning of another bubble in tech companies. The prospects of a bubble, therefore, are uncertain at present, but if these high valuations of social networking and other online companies continues and worsens, a bubble could build that would cause great harm not only to careless investors, but also to the many basically solid social networking and other new tech companies.