Tech Stock Valuations, COVID-19, and The Efficient Market Hypothesis: Enough Already

Either the markets are efficient, or we are in the middle of a Greater Fool market for technology stocks. I am convinced it’s the latter.

COVID-19, the resulting government intervention in the markets, and social unrest have propelled so-called “Work From Home” company valuations to unprecedented levels. The valuation of Zoom, which reported Q1 earnings on Tuesday and had “the best quarter of any technology company in history” according to one analyst, has more than doubled since the end of March. The valuation of DocuSign, which will report earnings on Thursday, has increased by more than 50% since the end of April in the absence of any updates from company management. Slack, which also reports earnings on Thursday, has followed a similar trajectory in the absence of company updates — with its valuation more than doubling since its mid-March low.

At any given time, according to the Efficient Market Hypothesis, the market value (and share price) of a company fully and accurately reflects all information about it. According to accepted finance theory, the value of a company is also the sum of the cash flows it will generate in the future, discounted to the present.

Using the Efficient Market Hypothesis, we can approximate the cash flows that market participants, supposedly behaving rationally, expect these companies to generate in the future. In the table below, I have used the Gordon Growth Formula to estimate the future cash flows that Zoom, DocuSign, and Slack would need to generate in order to justify their current market valuations.

The formula, exhaustingly familiar to any banking analyst or business school student, states that the present value of a stream of annual cash flows growing at a constant rate (“g”) in perpetuity is equal to the annual cash flow in year one (“C”) multiplied by “g”, and divided by the discount rate (“r”) less “g”. Although this formula is typically used to estimate the Terminal Value in a Discounted Cash Flow analysis, it is suitable here as it will underestimate the cash flows required to justify the current market valuations. The calculations below assume a discount rate of 8–12%, a perpetual annual growth rate of 0–3%, and no dividends.

According to the table, Zoom would need to generate at least $2.97 billion of cash flow (~7x TTM cash flow) beginning next year, and grow it by 3% every year in perpetuity, in order to justify its current valuation. DocuSign would need to generate $1.3 billion ( ~6x TTM cash flow), and Slack would need to generate ~$1 billion (~3.5x TTM cash flow) growing at 3% every year in perpetuity in order to justify their valuations, according to the Efficient Market Hypothesis.

If investors actually believe that these levels of cash flows are sustainable in perpetuity, they are likely delusional. All three companies enjoy widespread brand recognition, but operate in niche and highly competitive industries against more established and better capitalized incumbents. For these reasons, an acquisition of Zoom, DocuSign, or Slack by one of these incumbents is unlikely at current valuations.

The more probable explanation is that we are in the middle of a Greater Fool market for technology stocks, with Zoom, DocuSign, and Slack being some of the most egregious examples. In such a market, the value of a company bears little relation to its intrinsic value. Rather, speculators buy that company’s shares at prices they may feel are excessive when they believe someone else will buy them for even more. This type of behavior has been typical of every asset bubble from Dutch tulips to subprime mortgages, and is at play with “Work From Home” technology stocks. It is also how Ponzi schemes are able to perpetuate in a bull market.

One only has to turn on CNBC or look up the ticker of their favorite tech stock on Yahoo Finance to see evidence of this exuberance: a cabal of boosters, from sell-side analysts to television pundits, bloggers, armchair investors, and algorithms advise people to buy these “winning stocks” at seemingly any price.

Investors should tune out this noise and proceed with caution, lest they end up the greater fool.