Most people in the world know that Apple is something of an anomaly, having become the first company to cross the $1 trillion mark for market capitalization. Perhaps more striking, however, is its valuation: despite hefty margins and solid growth, Apple only commands a price to earnings (PE) ratio of around 14, compared to nearly 24 for Alphabet, 79 for Netflix, and over 84 for Amazon. Indeed, the rest of the tech sector as a whole seems to be on a valuation tear not seen since the late 1990’s during the throes of the dotcom bubble.
This has been evident in M&A activity as well with companies paying top dollar for acquisitions. Salesforce recently purchased MuleSoft at over 15x trailing revenues, which is about what Cisco paid for AppDynamics, while Microsoft’s acquisition of GitHub clocked in at a splashy 25x trailing revenues – an eye-popping valuation by nearly any metric. Of course, while these numbers will make nearly any acquisition target salivate, buyers must be certain that these staggering prices are worth the value they’ll be able to extract in return, or risk their mega-deals turning into mega-duds.
Why is this happening?
One of the biggest questions right now is why exactly the tech sector has been on fire. Strong growth in the US? Record levels of dry powder held by PE firms and industry titans alike? While there’s no single variable responsible for driving these valuations, a lot can be boiled down to attitude – with such a large number of overnight success stories, the tech industry knows it can command enormous multiples and does so liberally.
It sounds like circular logic and, in a way, it is: High valuations boost the confidence of both the acquired and the acquirers, making them willing to pay prices for companies now that would make them balk in leaner times. It’s a classic case of the bandwagon effect. In a recent report, M&A Valuation: Trends, Challenges and Horror Stories, 68% of dealmakers surveyed said that the bandwagon effect in a hot sector was a common human bias that plays a role in valuation judgment, resulting in a buyer paying more for a target:
“Hot sector syndrome affects most of the valuations. We usually assess the cycle, trajectory, duration and the spread of this hotness in the sector and the level of impact it is showing. Many times, brands ride short-term demand in the market, after which the valuation subsides.”
The fear of missing out, or of failing to catch that next big thing on the ground floor, can be a powerful impulse to reign in, even for the most seasoned players in the M&A game. Corporate executes aren’t immune either: They often wrestle with the fear that if they don’t jump on the latest tech trend early, they’ll end up paying an even more exorbitant price later on. A recent example of this is blockchain: not so long again, everyone and their brother was scrambling to add some kind of blockchain exposure. These tech bubbles aren’t very different from housing/real estate bubbles that grow out of the same basic human concern: “If I don’t stretch for this now, it’ll be out of reach forever!”
The degree to which technology, particularly Internet and mobile technologies, has massively transformed our lives in the past 10-15 years may also be a factor, creating the mindset that the rising tide of tech will float all boats. The challenge is judging the tide so you don’t get stranded: Many market participants and strategists have said we’re in the later parts of the economic cycle. If this is true, it’s likely that, in the near term, the tech tide will begin to recede, or at least calm down, rather than rising any higher. Growth in tech will continue, but the risk of overpaying is elevated today compared to less exuberant environments.
But for many, a lot of this extra swagger and exuberance has been earned, with strong growth fundamentals underpinning the upward trajectories of new and innovative companies. Salesforce’s purchase of Demandware and Oracle’s acquisition of Opower, for example, are both are driving strong revenue growth and represent solid Software-as-a-Service (SaaS) purchases. There are, however, some obvious, and expensive, exceptions.
For some investors, the hottest sectors are just too hot to handle. Investor David Einhorn’s Greenlight Capital, for example, sold tech stocks in Q2 in favor of a bundle of retail stocks, such as Gap Inc., Best Buy Co., Dollar General Corp, Dollar Tree Inc., and The TJX Companies. This exodus from tech to retail is an example of many investors’ move out of high-valuation sectors into more affordable ones.
Separating the wheat from the chaff
If you are looking to make an acquisition in today’s hot tech market, you want to make absolutely certain that you’re getting solid value for the money you’re shelling out. This is more than just crunching numbers into a spreadsheet at this stage in the business cycle – the mega multiples at play here mean acquirers must be extra cautious to avoid making mistakes and overpaying. It may sound pedantic and overly simplistic but, as we’ve written about before, many highly valued companies are simply wearing tech’s clothing, netting them multiples over and above what their business models justify and this can result in enormous sums of overpayment – not to mention substantial underperformance after the fact. Buyers need to consider the actual business model used, particularly when it comes to many SaaS companies. Simply having a subscription-based revenue model enabled by a piece of software does not mean a business is following the SaaS model, something that is clearly shown by the struggles of Shyp or Blue Apron. Remember: software for a service is not the same as software as a service.
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Finding the right payment method
For tech companies looking to purchase other tech companies, it may be best to consider paying for a target using a mix of both cash and equity to take advantage of their own high valuations, much like Microsoft did for the GitHub deal, paying entirely in stock. While this is obviously an extreme case, a mix of cash and equity can be a useful way to reduce risks for acquisitions with higher multiples.
As major shareholders in target companies are quite often also involved in the day-to-day operations, an equity swap transaction can help align the acquired entity’s goals with those of the buyer, which may help them to integrate more easily into their new roles. Paying in equity also helps share risks should the value and synergies realized be less than expected – if losses are taken on the deal, acquired targets effectively end up sharing in that loss to some degree.
Of course, acquiring companies must be careful of the obvious effects of issuing equity for large transactions, most obviously being the potential dilution of ownership. While rare, in some cases, “acquired” companies may even become the majority shareholder of the “acquiring” company if deal terms aren’t crafted well – witness the Starwood and ITT fiasco. Further, target companies may require even higher valuations if the deal is to be paid largely in equity, as they will still be retaining some amount of risk. Many investors are wary of such deals, given their prevalence during the boom years of the dotcom bubble, so finding a ratio of cash and equity that works for everyone involved is paramount.
With tech confidence soaring into the stratosphere, M&A activity has heated up in the sector as well, sending valuations skyward. Acquisitions are tricky business even under the best scenarios, with large sums of money risked in the hopes of reaping even bigger rewards, and having to pay top dollar only diminishes an acquirers’ margin for error. Being sure of what you’re buying and finding the right funding mix for the purchase can reduce the risks involved, but with the market looking frothy, such ventures are not for the faint of heart and if you’re not 100% sure it’s the right move, it may be best to sit out until things calm down. In the wise words of Warren Buffett, “you don’t have to swing at every pitch.”