A combination of company-specific concerns and a marked tightening of global monetary conditions has seen the stock market valuations of leading internet platform companies such as Apple and Amazon fall sharply since October 2018. This marks a significant shift in how capital markets view the collective growth opportunity and potential for future returns.
As business risks and interest rates have increased, cash flow growth and sustainability ought to be more carefully monitored
Since "Red October" (red referring to the color usually used in financial markets to denote falling share prices), listed internet platform company valuations have seen falls that mark a wholesale reappraisal of value in an industry sector widely perceived as one of the world's growth engines.
Apple and Amazon were the world's only two companies to command a stock market valuation of over $1tn but have since lost this accolade. Both produced decent 3Q18 earnings but gave weak outlooks for the future, with Apple notably announcing a refusal to disclose unit sales in future quarters, followed by warnings by related companies in the value chain, notably Lumentum and IQE. Alphabet (Google) and Facebook have been tainted by regulatory and taxation risks and privacy scandals. Other plausible business risks include increases in long-term interest rates and geopolitical concerns such as worsening trade relations between the US and China.
It is important to place recent turmoil in context: Amazon's hybrid retail and cloud computing business is (at the time of writing) still worth nearly four times what it was five years ago (Apple almost two and a half times, Alphabet around double, Facebook around treble despite its woes this year, and Netflix more than five times). This merely serves to illustrate the extraordinary run-up in company valuations and does not account for buybacks and dividends.
Future cash flow or dividend estimates, discounted by an appropriate interest rate and risk premium, are key to assessing the value of businesses today. When seemingly tantalizing cash flows from highly specialized business models are anticipated, the risk that these cannot be sustained (or might not increase) ought not to be underestimated.
"A rising tide lifts all boats" is an appropriate aphorism to describe the 10 years of low interest rates since the global financial crisis of 2007–08, when almost any financial investment project expected to capitalize on growth areas could be seen as value enhancing. Most internet platform business models are established and deliver good customer value. However, several are premised on (definitely) investing today to (possibly) expand into new and potentially less-proven business models or to gain market share that may not generate positive cash flow for several years. New regulations need to be complied with, and cash already made might also be taxed.
As Warren Buffett famously noted, you only find out who is swimming naked when the tide goes out. Investors are becoming more discerning. When considering where to deploy cash in acquisitions and future expansion, finance and strategy professionals should take note.
The Road to 2022: Key Consumer and Entertainment Trends, CES003-000266 (September 2018)
Upin Dattani, CFA, Principal Financial Analyst