NEW YORK (TheStreet) -- The first Internet bubble burst less than 15 years go and we seem to be at it again. Companies like Amazon (AMZN) , Twitter (TWTR) , Uber and Lending Club (LC) are all materially overvalued and it's probably only a matter of time before investors realize this.
Is Amazon, which has rarely shown any material profits, worth nearly $174 billion? Is Uber, which is in vicious battles with regulators in nearly every market in which it operates, worth $40 billion? How can the fundamentals of these companies and the industries in which they operate justify such valuations?
Twitter is trading at a price-to-earnings ratio of 121 (based on S&P Capital IQ 2015 estimates). On the same basis, Amazon is trading at a forward price-to-earnings ratio of 1,008. Lending Club meanwhile is at a forward price-to-earnings ratio of 545. Very high price-to-earnings ratios can only be justified if you believe current low levels of earnings will grow dramatically over the foreseeable future. But the level of earnings growth required to justify these levels must be beyond the dreams of even the wildest optimists.
Take Uber, which is not yet listed. It raised $1.2 billion in the middle of 2014 at an implied value of $18 billion. Just six months later, it raised a further $1.2 billion at an implied value of $40 billion. The total U.S. revenues of the taxi industry is estimated at $11 billion -- so Uber is now valued at nearly four times this total U.S. sales figure. To justify the last Uber valuation, an investor needs to believe Uber will take over the equivalent of the whole U.S. taxi industry and then expand it at huge growth rates.
Currently, Uber is just a mobile app. Yes, it is catching on all over the place, but it faces huge headwinds -- legal objections throughout the world by other taxi companies and by local taxi regulators, public relations issues, safety issues and more . It may turn out that the investors who came into the last round of Uber fundraising will be the biggest losers, having bought at a peak valuation. But probably not. The stock will no doubt IPO at a still more irrational price and the inevitable collapse may still be years away.
Amazon has pulled off this trick for years. The stock has relentlessly risen notwithstanding that the company's earnings have always been very limited (certainly relative to valuation levels). It's the ultimate "lottery stock," and Amazon's management have become pros at playing this market mania. They go into new strategies every year (groceries, e-commerce, IT hardware, cloud computing, entertainment), announcing that this new strategy is the one, finally the one, that will deliver the earnings pop its investors have been waiting for. The market is suckered by this story every time. Amazon's opaque financial disclosures and limited guidance on earnings growth helps to keep the game going.
Aswath Damodaran, from the Stern School of Business , argued compellingly at the time of the recent Twitter IPO that we should not see this exercise as a meaningful "valuation" at all. It was solely a "pricing" exercise, a fine bit of deal-making where investment banks got investors to buy a stock at a ludicrous price because they could point to other over-hyped comparables (Facebook (FB) , for example). Damodaran speculates (perhaps not so cynically) that some spurious fundamental analysis (based on discounted cash flow analysis and assuming huge projected growth rates) was then probably just backed out from the expected Twitter IPO price to justify the deal.
Lending Club is another one -- an online loan broker now valued at about $7.95 billion. Lending Club is supposedly exploiting a new community model of lending, providing borrowers and lenders a new direct, community-based market place. But Lending Club is brokering unsecured, consumer loans. Has anyone thought what might happen to unsecured loans in the next recession? Well you can be pretty sure default rates will shoot up and lenders will be stung -- then said lenders will just stop making these consumer loans. So the likelihood is that sooner or later, Lending Club's volumes will actually decrease, not rise. And yet it is only massive future rises in Lending Club's volumes that can justify the current stock price.
But these periodic dislocations between fundamental value and market value are nothing new -- they are as old as the markets. The trick is for investors to avoid being caught in the likely collapse, while simultaneously taking advantage of this irrational market sentiment. Timing is everything.
Timing -- a Note from History
In early 2000, I was working in the investment banking department at Citigroup (C) . I was supposed to be looking solely after clients in the financial institutions sector, but Internet IPOs were so ubiquitous that all of us were dragged into working on these deals.
One was an early version of an Amazon-type company -- an online second-hand bookseller. The company was going to be valued at close to $500 million at IPO. The company had not made any net profits, nor even had they made much revenue. It had a Web site, an idea, a management team, some limited initial sales and that was it.
When we met to start the IPO process, there was a cohort of Citigroup bankers, major corporate lawyers and big accounting firms present. We couldn't all fit in the office of the issuer, since it was just a shack above a railway station. I did ask at the time how this business could seriously be worth $500 million, given that second-hand books usually only go for a few dollars a piece. Any discounted cash flow (or fundamental) analysis, even with the most generous assumptions, required this firm to sell about one million books over the next year or two -- at that point, it had sold about 200 books. I was told by the stock analysts this was a silly question, that I simply didn't understand the Internet revolution.
They would have got the IPO away, but they were just about one month too late. In a meeting in the second quarter of 2000, a broker from the equity sales team came in and said that market sentiment seemed to be "changing." Everyone ignored him, at first. But you can't ignore the market for long. Within two weeks, Internet stock valuations had totally collapsed and every IPO in the sector was pulled.
Some analysts and economists had been calling the valuations in the Internet market irrational as far back as 1997. They were right, but if you had followed their advice and shorted Internet stocks in 1998, it would have been a very costly strategy.
The irrationality ran on for years, until the day of reckoning came. And that's the crux of it: markets are not very rational after all. Credos, hope, greed, the power of brokers, habit -- they all mean prices are often totally dislocated from fundamental value. It is called the "greater fool" paradox -- buy today since by next week you'll be able to sell an asset at a still higher price to a still greater fool.
Of course, someone is always left holding the hot potato when the music stops. When it comes to companies like Amazon, Twitter, Uber and Lending Club, the potato is red-hot. Perhaps investors should keep buying those stocks as the ride might go on and on -- but, rest assured, the music won't play forever.