Bubble, My Ass: Some Unicorns Might Be Overvalued, But All Dinosaurs Gonna Die.
Summary: pundits argue billion-dollar startups are overvalued, but few realize why public company valuations might also be too expensive. Traditional P/E ratios of 15–20+ are likely too optimistic, relative to how long the future cash flows and operating margins of big dumb companies can be sustained. Unless they innovate more rapidly (or acquire their internet peers), expect most S&P 500 Dinosaurs to be disrupted and destroyed by an endless march of VC-funded Unicorns that will bash their tiny little reptile brains in with software and internet marketing.
Lately it’s become fashionable to suggest that Unicorns are Overvalued.
For sure there’s a ton of billion-dollar valuation companies that seem to come out of nowhere recently. And while a few appear to be well on their way to becoming huge wins (Uber, Xiaomi, Airbnb), there are arguably as many losers ahead as winners. But it’s exactly due to these asymmetric outcomes that most unicorns become overvalued, and also why a lucky few Power Law outliers are always going to be severely UNDER-valued as well.
The nature of venture capital is such that for any given category, one big gorilla will run away with most all of the value, and the remaining chimps and monkeys will be worth little or nothing at all. But prior to the dust being settled, all the monkeys (and their investors) want to believe they are going to be the big damn gorilla… unfortunately almost all of them will be wrong.
Still, while it may be easy to predict the future demise of many unicorns and gorillas, we are probably overlooking the fact that many public companies (hereafter “Dinosaur Companies”) are substantially overvalued as well.
Why do I believe this to be true? There are three basic reasons:
- Dinosaur Companies Don’t Innovate. This isn’t a new story; smarter & more eloquent folks than I have written about this topic (Schumpeter: Creative Destruction, Christensen: The Innovator’s Dilemma), so I won’t belabor the point. Dinosaur companies are easily addicted to mature lines of revenue & profit, and don’t take much risk going after possibly better alternatives. Over time, they slowly lose their edge to upstarts.
- Dinosaur Companies have a tough time recruiting & retaining top technical talent. Dinosaurs may know that technology is important, and they might even realize that Software is Eating the World, but regardless most geeks dream of tomorrow’s million-dollar stock options over the more mundane reality of today’s fat paycheck (note: sometimes Wall Street does pay well enough to be an exception to this rule). As a result, Dinosaur Companies lose the competitive battle for tech talent, and thus also the larger war on innovation. Game over, man… game over.
- Dinosaur Companies don’t get how critical internet marketing is becoming. They also don’t understand how important online platforms are to acquire & retain customers, and thus sustain operating margins and future profits. This third point is perhaps the most subtle, as it may not be obvious to most public companies how quickly their customers are shifting from offline to online. For the same reason as #2 above, acquiring and retaining top online marketing talent is extremely competitive. Yet most Dinosaur Companies don’t have any idea they should be racing as quickly as possible to hire growth-hacking nerds.
Fundamental to all of the above is the following observation: most public companies have not taken to heart how absolutely mission-critical software technology & internet marketing have become to business competitiveness. Thus, almost every Dinosaur Company is extremely vulnerable to a Startup Unicorn eating their lunch (stated so eloquently this past week by none other than JP Morgan Chase CEO Jamie Dimon).
Put simply: the average public company P/E ratio of 15–20 means Mr. Market assumes Dinosaur Company X will have 15–20 years of continued cash & profits from business as usual. HOWEVER THIS ASSUMPTION IS VERY WRONG — Dinosaur Company X will get its ass kicked by a venture-backed Unicorn in less than a decade.
By now, you’re probably saying to yourself: clearly this over-eager internet VC moron is clueless about how capitalism & economics work. Because if any of this were really true, the market would correct & gradually reduce the stock price & associated market cap of any such “overvalued” dinosaur company… right?
Since I’m such a well-behaved venture capitalist and armchair economist, I’d like to agree Mr. Market will usually find a balance. Except for one little problem: you can’t short the public market for an extended period of time, and certainly not for five to ten years. There isn’t really an appropriate short or hedging / derivative instrument that captures this Unicorn Disruption effect, and so the only practical alternative is to go long on the Unicorns themselves.
Which is exactly what Mr. Market is doing, and exactly why those pesky Unicorns seem to be so overvalued, and why All Dinosaurs Gonna Die.
