Is Big Tech Overvalued?
Some key things to consider before investing in the stocks of FAANG and other leading technology companies.
Authored by Amay Shenoy, Anne Fang, Benjamin Lee, and Oscar Yu, with guidance and editing by Conor Romano
Introduction
In the year that’s passed since the declaration of COVID-19 as a pandemic, the market capitalizations of Big Tech stocks have soared. Our definition of Big Tech is FAANG (Facebook, Amazon, Apple, Netflix, and Alphabet/Google) plus Microsoft and Tesla. The combined market capitalization for just these seven companies is more than $6.5 trillion USD and together they make up about one fifth of the total market cap of S&P 500. In this article we will attempt to shine some light onto these companies and their recent growth, in an effort to determine whether or not their valuation in aggregate should be cause for concern.
A few different factors will be investigated when conducting our analysis. Firstly, averages of a few different key multiples will be compared to the broader S&P in an attempt to quantify the premium on these companies. From there, we will take a look at the competitive advantages of a few players in the space to see if their premiums are justified. After that, we’ll dig in a bit to some of the more mature players in the group to see if their already high market penetration with their core businesses appears to be a limiting factor for future growth. Finally, we’ll look at COVID-19’s impacts and recent regulatory developments to see how they have changed the Big Tech landscape.
State of the Industry
Although Big Tech companies operate in different segments and utilize different business models, they are all alike in that they have achieved significant and sustained growth. Take Microsoft — the company’s stock price has grown from around $42 in June, 2020 to nearly $233 currently, in March, 2021. Facebook, also as the owner of Instagram and WhatsApp, has grown its stock price from $55 to $264 in a similar time frame. Microsoft’s revenue growth has come from the expansion of their ecosystem in mobile and cloud, whereas Facebook’s growth has been generated primarily through online advertisements and the purchase of popular apps like WhatsApp.
Another few companies to highlight that have grown substantially are Apple and Amazon. Apple has seen a 10x return on their stock price in the last decade. Their growth has been primarily due to sales of their core technology products. Lately, the company has further diversified its revenue stream with services like Apple TV, Apple Pay and Apple Music. And Amazon’s investors have witnessed extreme growth in their share price from about $178 in 2010 to over $3000 today. Many factors have contributed to this price boost, including the expansion of overseas operations, the acquisition of startups with promising technologies, and advancements in cloud-computing.
Netflix and Google have both also witnessed a large jump in revenue and stock price, having also grown their prices more than 10 times over the past decade. And Tesla… well it’s its own story all together. The company has more than tripled their share price just in the past two years. Given their extreme deviation from the average multiples of the other companies in the group we don’t want to focus on them as much here, but they too are blazing upwards.
Current Pricing
The stellar performance of these Big Tech stocks in the face of the pandemic is quite eye-opening. However, concerns that these stocks have become overvalued have also grown. Tech stocks have notoriously high price-to-earnings ratios (P/E), or the ratio of a company’s share price to its earnings per share, due to investors’ expectation of future growth. To put it into context, FAAMG (Facebook, Amazon, Apple, Microsoft, and Google) stocks are trading at a significant premium to the S&P 500, as they trade at a forward 12-month P/E ratio of 33.09x while the S&P 500 average is only 22.94x. For the forward 12-month price-to-sales ratio, FAAMG stocks are currently trading at 13.19x compared with the S&P 500 average of 4.34x. Evidently, from these metrics, these tech stocks are priced higher than other industries. However, there are other factors that need to be taken into consideration when trying to assess if value is misaligned with price.
Are Prices Justified Based on Amazing Competitive Positions? Amazon and Tesla Spotlight
Given the dominant competitive positions of Big Tech companies, the fact that they trade at a premium to the S&P 500 should not be too surprising. In the past year, companies like Amazon and Apple have seen jumps in their share prices of 60% and 70% respectively. These companies trade at high multiples as well; for example, Amazon trades at 75 times earnings.
That said, the undoubtedly strong moats and fundamentally-sound business models that these companies possess may justify their valuations. For example, Amazon and Apple enjoy big supply advantages. They are two of the world’s largest patent-holders with well over 2,000 registered patents. Additionally, they benefit from network effects. Amazon uses a rating system for the products that it sells online. As more users review products, reviews become more accurate, and more shoppers and sellers flock to Amazon. And for Apple, it’s suite of proprietary apps and devices allow for enhanced functionality with a person’s friends who are also on their platform. All else being equal, this means that the overall value of the platform to an individual is increased when a new friend of theirs joins them in the ecosystem.
One other competitive advantage enjoyed by Amazon in particular is high switching costs. Since Amazon provides order fulfillment services and runs an online marketplace, the company charges higher fees to third-party sellers that use their fulfillment services but not the online marketplace. This makes it expensive to switch away from their full product suite, and incentivizes sellers to operate exclusively on Amazon’s platform. This final unique competitive advantage paired with Amazon’s staggering 50% market share in the e-commerce retail market may convince investors that a 75x P/E ratio might not be too far off, given the company’s dominance in its market. But what if that P/E ratio increased tenfold to 750x or even 1000x?
Well, we don’t have to imagine as Tesla, the world’s largest automaker by market capitalization, currently trades at a P/E ratio of 1122x. The company’s meteoric rise has been well documented and the automaker has a larger market capitalization than the next nine largest car companies, including giants such as Volkswagen and Ford. The company was not profitable until last year, so it’s evident that investors are expecting the company’s fate to turn around in the near future. However, the company will have to grow at an incredible rate in the future to justify its current price tag. Electric vehicle manufacturing is expected to grow at an 11% annually through most of the next decade–a high growth rate, but not high enough that it makes the explosive growth priced into Tesla’s stock easy to attain. Now Tesla’s competitive advantages are undoubtedly strong. Brand loyalty exists. The company has a supply advantage through vertical integration; Tesla controls everything from battery production to self-driving algorithms. However, are these competitive advantages strong enough to overlook its abnormal valuation? After all, investors are currently willing to pay over $1000 for just $1 of Tesla’s earnings! That’s a higher P/E than almost every other stock in the S&P, including all technology and automaker stocks.
Although growth investors may still say “yes”, most value investors have said “no”. There comes a point when investors cannot ignore the price tag, regardless of how fundamentally-sound the business is. While it is likely that Tesla and the other Big Tech companies will be profitable in the long term, the valuation of the former right now prices in incredible levels of growth.
Will High Existing Market Penetration Impede Future Growth? Apple and Microsoft Case Studies
A high-valuation does not necessarily mean a company is overvalued. Yet, when a company is already a dominant player in a saturated market like the Big Tech companies are, it begs the question as to if their high growth can be sustained into the future. In our opinion, this concern is partially mitigated for Big Tech companies thanks to the proven ability of some of them in the past at leveraging their existing strengths to expand into new, unsaturated, and fast-growing markets. We will look at Apple and Microsoft as examples of this.
Apple used to face a grim outlook from the street when over 50% of its revenue was generated from iPhones. The concern was that there is only a finite number of phones that consumers buy and without a diverse stream of revenue, Apple’s sales growth would stop in the near-future. Apple quashed these fears by pivoting toward the wireless and wearable device market, a $45B market with a CAGR of 5%, diversifying their revenue streams and increasing their TAM. The synergies of these new devices with the other core devices in Apple’s iOS ecosystem pushed consumers to purchase them. The increase in convenience in their day-to-day experiences proved to be a compelling value proposition. Sales from these devices have reached over $35B, with sales growth of over 50% each year, even surpassing Macbook sales. This is a great example of how a company can still provide stellar growth while having high market penetration on their existing products.
Another example in the same vein is Microsoft. The TAM for Microsoft’s core product, Windows OS, is shrinking as mobile phones are rising as an alternative for PCs and as Apple grows their presence in the OS market. Windows does not have the dominance it once had, with the number of Windows-installed devices having decreased by 300M from 2017 levels, and Apple reaching one billion active devices. However, Microsoft is successfully expanding its market towards cloud computing, while strengthening its core business model. Microsoft Azure, their cloud computing platform and infrastructure service is a dominant player in the cloud computing market with a 28% market share. Cloud computing has an estimated market size of $371B and is rapidly growing with a CAGR of 17.5% — the highest estimated growth figure for any vertical of all Software as a Service (Saas) or Platform as a Service (Paas) subcategories. There are no concerns around growth in this area, and Microsoft has proven its ability to utilize its network of Windows devices to incentivize many consumers to choose Azure over other platforms in the transition from on-premises data management to cloud solutions. Thanks to strong strategic moves in this nascent market, Microsoft is well positioned to capitalize on the tail winds of this rapidly growing industry.
In the cases of Microsoft and Apple when the markets for their core businesses looked saturated and the growth prospects dim, their existing consumer base having a high incentive to stay on their platform provided them with a competitive advantage for successfully tapping into emerging markets with high-growth prospects. In the process of doing so they also increased their TAM. This demonstrates the power of platform effects for Big Tech companies, and does well to mitigate some of the fears of muted future growth from Big Tech companies due to their already high market penetration with their core offerings.
COVID-19’s Impact on Big Tech
In March of last year, when pandemic related fears were at an all time high, the market was hit hard. The S&P 500 and other major indices dropped more than 30% from their all time highs in February just a month before. The S&P took 5 months before it would recover its pre-pandemic high, but things were different for Big Tech. At this same time, FAANG was trading at an all time high, up almost 30% on average from historical peaks, and the other Big Tech companies followed similar trends. A few questions come to mind after hearing this, one, why did this happen, and two, will this pandemic-driven increase in performance be sustainable?
The number one driver for growth in the tech space during COVID has been the enormous increase in demand for products to help people thrive in the pandemic. From home office necessities like computers and cloud software to digital entertainment services, the tech industry was there to meet every need. One of the more prolific examples is Netflix, which managed to post record breaking subscriber growth numbers and revenue figures throughout 2020. Though not under the Big Tech umbrella, Disney+ managed similarly impressive growth, almost doubling their subscriber count from 26.5 million in December 2019 to 50 million in April 2020, an unimaginable increase in other times.
As for whether this level of growth is sustainable, at a glance it would appear unlikely. While some of these numbers are natural growth from attractive content offerings and marketing, it’s obvious that a major factor driving consumers to these services is lack of choice. As alternative venues for entertainment and consumption start to regain viability, growth will slow dramatically. To back this up, management projections from Netflix for Q1 of 2021 have returned to pre-COVID levels, offering another viewpoint that while the surge of new customers was impactful for businesses this year, it ultimately doesn’t affect long term growth prospects all that much.
Another notable impact of COVID-19 was retail and physical stores being shut down for months, some indefinitely, and ecommerce and other online alternatives services thriving in turn. Apple, in particular, was one of the driving forces behind the massive growth in FAANG stocks, beating analyst estimates for almost every figure in 2020. While many of their stores were affected by the pandemic, massive growth in their digital services offerings and online sales for products like iPads and their new iPhones more than made up for the loss of in-store revenue.
The trend toward online sales and services has existed for years now, and has only accelerated with COVID. New and existing technology businesses are opting for either limited physical locations or fully online sales of hardware and products, foregoing the need for retail space altogether, and hardware vendors are transitioning to subscription based software value-adds for revenue.
Many tech companies, especially software focused ones, found it much easier and less impactful on workflow and productivity to transition to work-from-home and hybrid digital workspaces than businesses in other industries. Some tech giants, including Twitter and Shopify, even announced their intentions to continue plans to work from home indefinitely. Shopify, in particular, converted itself to a fully digital-by-default company, with CEO Tobi Lutke tweeting: “After that, most will permanently work remotely. Office centricity is over.”
The impact on business for these companies in the long term, however, is not limited to workflow changes. From a fundamental perspective, companies that can effectively work mostly or fully virtually have a competitive advantage over those who can’t, as rent and leases make up a large portion of operating expenses for many technology businesses, who often have smaller fixed costs to begin with compared to other industries.
While many tech companies like Netflix managed to capture a significant temporary boost in demand from COVID, there is reason to believe that the other changes ushered in will affect the fundamental business model and operations of tech companies well into the future. From shifts in workplace dynamic to distribution models, COVID has accelerated the inevitable change in the tech industry that will play out for years to come. This could be a sensical partial explanation for the value premium on Big Tech companies.
Do Recent Regulatory Advances Pose a Significant Concern?
Amidst a time of rapid growth, questions and scrutiny have sprung up recently around Big Tech companies, and the risks that arise from their massive level of influence and power. The main players affected by this chance of increased regulation are the social media and data platforms, such as Facebook and Google. In terms of what kinds of regulatory pressure is on these companies, there are two major things to look at: antitrust concerns and content moderation responsibilities.
Antitrust and Monopoly
Antitrust concerns have been mounting for three key Big Tech companies: Apple, Google, and Facebook, with the concerns around the first two falling into the same category. The antitrust situation with Apple escalated in February when Epic Games filed antitrust suits with regulators in the US, Europe, and Australia. The company believes that the 30% cut that Apple takes from in-app purchases on the app store is anti-competitive. In 2020, various US States also investigated Google for the same reason. A key decision on the matter came out from North Dakota last year, which ruled in favour of Apple and Google. A similar Arizona case opened up a few days ago however could end up with a different verdict.
Facebook’s antitrust suit is in a different vein than the others, and is more centred around monopoly risks from their acquisitions. In December of 2020, the FTC and 46 other states sued Facebook for perceived anti-competitive practices. Much of this was driven from their purchases of leading social media competitors Instagram and WhatsApp. If the FTC were to win the suit, Facebook would have to divest Instagram and WhatsApp, effectively breaking up the company. Typically these lawsuits take years to unfold, but if Facebook does lose, their competitive positioning could be seriously hampered. This is something to keep in mind as a risk when considering Facebook’s current valuation.
Content Moderation and Responsibility
In October 2020, just a few weeks before the U.S. presidential election, the leaders of three of the largest social media companies in existence — Jack Dorsey of Twitter, Mark Zuckerberg of Facebook, and Sundar Pichai of Google — were called to a U.S. Senate hearing to testify on Section 230, a federal law that limits liability of digital platforms as a result of user-generated content. At the hearing, government representatives grilled the tech executives on content moderation and digital security, as concerns of interference from foreign agents like Russia were once again raised.
As the meeting continued, it became clear that while representatives from both political parties agreed that Section 230 should be rewritten, opinions as to why differed greatly. Republicans argued that the platforms had been actively censoring conservative content, and that social media platforms should be held responsible for their moderation. On the other hand, Democratic representatives argued that with the possibilities of hostile foreign actors, platforms should be made to take greater responsibility for patrolling and moderating activity for interference.
Regulatory intervention is a notoriously difficult thing to predict. That said, investors in Big Tech should be aware of these concerns. The monopoly risk is likely the most substantial, particularly for Facebook, and further monitoring of the situation is definitely warranted. Fortunately for Big Tech investors however, the closest precedent case for antitrust in technology was Microsoft’s court case in 2001, and in that case the government ultimately opted not to break the tech giant up. Nevertheless, this was only after an appeal to an initial verdict, and a lot has changed in 20 years. It’s hard to say if these risks are baked into current valuations, but buyer beware.
Conclusion
Though it’s tough to say for certain whether Big Tech companies are currently overvalued, a few observations can be made. It’s impossible to deny that there’s a premium for Big Tech companies when looking at the quantitative exhibit, seeing as the companies trade at a premium to the market. That said, it’s tough to say for sure if these prices are justified based on their competitive positions, and even across the companies within the group, inclinations on the subject vary widely. Despite this uncertainty, concerns about high existing market saturation impeding future growth can be mitigated to some extent thanks to the outlined ability of Big Tech companies at leveraging legacy products to expand into adjacent, high-growth industries. Add to this the benefits realized from COVID-19 both in the short and long term for these companies, and the valuations in aggregate may not seem all that far fetched. That is, if the investor is comfortable with overlooking the impending regulatory risks.
