One of the most talked about topics in the technology sector is whether or not the industry is facing a new bubble. People wonder if the current valuations of the likes of Uber and Facebook are sign of a looming tech bubble or if we are unnecessarily painting doomsday scenarios.

When You Know You Are in a Tech Bubble

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But what are tech bubbles and should you be worried about them? This guide will look to answer these questions and see what experts are saying about the current situation.

WHAT IS A TECH BUBBLE?

Before we can start to analyse whether or not there is a tech bubble, let’s make sure we have the same understanding of what a bubble actually is. According to Investopedia, a tech bubble is:

“A pronounced and unsustainable market rise attributed to increased speculation in technology stocks. A tech bubble is highlighted by rapid share price growth and high valuations based on standard metrics like price/earnings ratio or price/sales.”

Basically, a bubble means that companies are valued higher than they should be based on their fundamental value. Hence, investors have begun thinking a specific technology stock or stocks offer an irresistible opportunity, which leads to stock purchases at prices deemed unsustainable in other circumstances. Investors justify their purchases by using different metrics, while they often become blind to traditional fundamentals and analytical forecasts.

During this time, technology companies tend to seek initial public offerings (IPOs), as they hope to capitalise the enhanced investor mood.

A tech bubble can appear in any particular technology sector, or it can be a broader bubble covering the whole tech sector. Eventually, the bubble will end either in a crash or deflate slowly.

Example: The dotcom bubble in the early 2000s

Different levels of tech bubbles have been around since the sector took off. The so-called dotcom crisis in the early 2000s, for example, was the result of a a tech bubble. It was created by emerging internet firms that were based on unsustainable business models. This tech bubble is a great example of the phenomena and its potential dangers.

The dotcom bubble resulted in a number of business collapses and investors losing quite a lot of money. Around 1997, investors started to speculate heavily on Internet-based companies. During the period of 1997 and 2000, Internet-based companies, or the “dot-coms”, began appearing rapidly. Often times, they didn’t have a compelling business model, but investors were fascinated by the new opportunities that came with the internet.

Stock prices soared and investors overlooked the traditional metrics such as price/earnings ratio and based their confidence on technological advancements instead. The interest from investors led to companies simply adding “.com” to their name in order to attract investors and equity. The era has even been referred to as ‘prefix investing.’ Some dot-com firms were able to raise substantial amounts of money even when they hadn’t made any profit so far.

Since the investor activity was largely speculative and company valuations weren’t based on a fair value, the companies began to show signs of failing between 1999 and 2001. Many companies became victim of their unstable financial strategies and were forced to file for bankruptcy.

As companies run out of capital, liquidations and mergers became commonplace. In the US, the US Securities and Exchange Commission fined a number of investment firms for misleading investors. The market crash of 2000-2002 caused losses of $5 trillion in market value of technology companies.

Only 48% of the companies survived the initial crash. Amazon.com and Google escaped relatively unscathed and have become the dominant companies in the technology sector.

Perhaps because of the huge impact of the previous bubble burst, analysts continue to be wary of technology bubbles. Moreover, the dotcom bubble and the resulting downturn of the overall stock markets had a negative impact on the whole economy, which shows how dangerous tech bubbles can be for other sectors as well.

WHY SHOULD YOU CARE ABOUT TECH BUBBLES?

There’s growing concern among analysts that the technology industry might be heading towards a new bubble.

What does that mean for you? There are a number of reasons a tech bubble should cause concern. Whether you are an investor, a business owner in the technology sector or an employee in such a business, the consequences of a tech bubble will have an impact on you.

If a tech bubble bursts, private funding can become harder to obtain. Investors will lose their trust in the tech sector and hesitate to give money at all or only to unfavourable conditions. When the dot-com bubble burst, private funding to technology companies dropped by over 80% and it took nearly a decade to recover. If the bubble bursts in the near future, it will become tougher for tech companies, especially startups, to raise funds.

Furthermore, you don’t even need to be directly involved with the technology sector to suffer from a bubble. In a broader sense, bursting tech bubbles come with a systemic risk for other industries, because tech companies are interconnected with other sectors, e.g. because they operate as service providers. The problems in the tech sector can spill over to other industries, as the example of the dot-com crisis highlighted.

Whilst your business might not operate in the technology sector, you are likely using third party services from the industry. For example, you might use a tech company to deliver your online services to people or use a 3D-printing manufacturer for parts of your products. If these companies end up losing money, your business might suffer indirectly. Either because the companies fail completely or because they need to increase prices as a consequence.

Additionally, financial companies are invested in the tech sector as well. For example banks, pension funds or mutual funds run by investment companies. If the stock market gets a hit, these companies will be affected as their investment portfolios lose in value.

The above is just a short insight into the consequences of tech bubble. The main takeaway from it is that you are likely to face problems if, and when, the next bubble bursts.

WHAT ARE THE SIGNS OF A TECH BUBBLE?

So, what are the most common signs of tech bubbles? Why are certain experts convinced the technology industry is currently heading towards a bubble?

Start-ups are overvalued

A bubble means that companies are vastly overvalued. Especially when it comes to tech start-ups, it’s often difficult to predict their future revenue potential, as nobody knows how valuable their technologies will become in future. These companies are often referred to as unicorns, and believe their valuations shouldn’t be subjected to P/E ratio analysis.

The marketing firm CB Insights has studied a number of technology companies and noticed the overvaluation issue. For example, the ride hailing app Uber received a valuation of 100 times its sales. AirBnB’s $25 billion valuation is over 90 times its sales. However, others argue that these companies have sustainable business models and great growth prospects and are therefore worth their valuation.

Increasing numbers of IPOs

IPO market saturation tends to be higher during a tech bubble. As mentioned above, during the dot-com bubble, companies flocked to the stock market at alarming rates. Worryingly perhaps, the level of IPOs is getting closer to the levels of the 2000.

In a bubble, stock prices are generally higher than they should be, which makes IPOs more attractive. However, since the stock price is not fundamentally justified, the initial hype fades away later on (in most cases) and prices come down to earth.

Funds and investors moving out of the industry

There’s also the element of investors and funds beginning to move out of the tech industry. In a way, this condition is the final stage of a tech bubble, as it often highlights the end of the bubble.

Since the bubble cycle is run by speculation and hope of future fortunes, if companies don’t start providing returns at some point, investors may disappear. Certain investment firms are openly starting to warn about the bubble and investors find it harder to simply throw money at technology firms.

Unsustainable business models

Finally, one important sign of a bubble is that many companies operate with unsustainable business models. This was certainly true during the dot-com bubble, where technology companies failed to generate earnings that would justify their sky-high valuations.

Consider the example of Webvan.com. The grocery delivery company attracted plenty of interest in 1999, expanding its services across the US. But a sustainable growth model didn’t drive its expansion. In fact, after its 1999 IPO, which raised $375 million, investors noticed the customer base wasn’t large enough to justify the expansion. The margins simply weren’t there for the business to grow at that rate.

The problem for start-ups is that while private money might be easy to come by at the moment, the company still has to match this investment at some point in the future. If the business model isn’t there to justify the valuations, the bubble conditions become blindingly obvious.

ARE WE CURRENTLY IN A TECH BUBBLE?

It’s extremely hard to answer the question “are we in a tech bubble?” because there are a number of factors at play. While you might look at data from one angle and conclude conditions for bubble are evident, another data set might suggest a completely different picture.

Even analysts and industry insiders cannot agree whether or not the tech bubble is real. Fortune asked influential insiders in the tech industry in 2015 and the results showed a variety of opinions.

Michael Dubin, founder and CEO of Dollar Shave Club, said the tech bubble is real. Dubin told Fortune, “When companies are getting funded that sell subscriptions to sustainable footstools made from Alpacas, you’ve reached the hilt.” XiaomiGlobal’s Vice President, Hugo Barra disagreed stating, “Data does not show a tech bubble. Today’s tech companies are supremely more sound and mature than the IPOs of 1999.”

Perhaps the best analysis came from co-founder and CTO of FitBit, James Park, who told Fortune, “Much like Schrödinger’s cat, I feel that if we don’t look too closely, we are simultaneously in a tech bubble and not in a tech bubble.”

So, is there a tech bubble?

The “yes” argument

The sign most experts point out to as evidence of a bubble is the high valuations of tech companies. CB Insight’s list of unicorn companies puts the number of private companies with a $1 billion or above valuation to 152. But only a small minority of private companies listing on the stock market manage to raise that kind of money.

A number of these highly valued start-ups are also betting on future expectations, with their focus being on market share size rather than earnings. Take the example of Uber, which relies solely on its disruption of the taxi industry. Investors have, so far, been happy to bet on this market disruption, with the company’s valuation increasing from $17 billion to $40 billion within a six-month funding period.

Danah Boyed, a principal researcher at Microsoft research, told the Atlantic, the concern is whether the valuations meet the business model possibilities. “Too much is focused on hype instead of substance and a few will win the lottery on idiocy, but that’s not what’s propelling this current phenomenon,” Boyd said.

The “no” argument

But experts are also calling for caution and saying the current situation is not comparable for the tech bubble of the 1990s/2000s. First, Bloomberg columnist Barry Ritholtz said the IPO numbers of today are not comparable to the dot-com levels. Furthermore, Ritholtz argues even the valuations, which are currently high, are not close to levels in late 1999.

In addition, while the valuations of tech companies are high, the business models of the companies make it hard to evaluate whether the valuations are inflated, and by how much. For example, social media technology stocks have high valuations, with analysts predicting the bubble is about to burst in 2015. However, these technology companies have managed to keep the share price relatively steady.

Comparing companies such as Facebook to the dot-com companies is not reasonable. The user base of Facebook is huge and the company generates sustainable revenue monetizing its traffic.

Therefore, analysts who deny the existence of a tech bubble argue that the current situation is considered more of a cycle and the high valuations mean we are at the start of this cycle. The valuations will begin to normalise as times goes on.

THE BOTTOM LINE

Predicting bubbles is not easy, especially in the tech industry. It’s difficult to predict how new technologies will develop and what the market reaction will look like.

There’s a tendency for industry experts to agree that there are tech companies out there, with valuations that don’t match the reality. Whilst some might consider the bubble as obvious, others argue there is no bubble at all, because valuations are justified by the fundamentals.

Kevin Kelly, a co-founder of the Wired, told the Atlantic last year, “Technology is a bubble machine. It makes clouds of bubbles. After each one pops it is replaced by another.” Hence, there will always be bubbles, the difficulty is to recognize them and jump of the train soon enough.

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