In my previous posts, I have indicated that Linkedin and Facebook trading in the secondary markets are overvalued based on fundamentals. This reasoning extends beyond these two companies and into other social media companies just making it into the mainstream. However, we have to treat the future valuation of these companies slightly different from publicly traded ones. Hence, a few players overpaying for current piece of the company does not necessarily mean the whole industry is in the bubble mode. Bubbles will eventually form in the social media arena for it is inevitable for a new economy to arise while weeding out the weak. That is exactly what the tech bubble of the late 90s did for us. Out of the tech bubble companies such as Amazon came out stronger and more valuable redefining how books are sold after suffering a set back as result of overvaluation created by the market. Nevertheless, right now for private investors, the market is bullish in the social media arena.
For the purpose of this argument, we have to understand the three different markets:
1. Public Market.
2. Private Market.
3. Secondary non-public market (in order to create liquidity)
In the public markets, information about the company (financial statements) are accessible across multiple parties trading on a single market. The speculated price and actual value will eventually converge making the market efficient in the long run. For example, buying stocks in the public market is a lot like buying strawberries. In our experience in shopping for strawberries we know what the expected going price of strawberries should be at a certain season. We can also browse several stores in the surrounding areas to get a good understanding of the average current price. Hence, if one supermarket is selling strawberries for $20 and everyone else is selling the same strawberries within the same vicinity for $4, we would know right away that $20 is too expensive. Eventually, supply and demand will bring the price down towards $4, the equilibrium price. Likewise, public markets are driven by supply and demand. This market is most suspectable to bubbles for demand can artificially increase the price.
In private markets, the terms and the price is negotiated between parties and the actual price is very subjective. There is no single guideline for the valuation of the company, especially if the business is newly developed concept with no other comparable. This is where institutional investors such as venture capitalists and private equity firms has the greatest advantage. There is no supply and demand to determine the going price of the company. There are only bidders at the time of exit whether it is through an IPO or a sale. The other advantage in these markets for institutional investors is information asymmetry. That is, one party (usually the seller, i.e. institutional investors) has more knowledge on the actual value of the firm and thus can charge a premium knowingly controlling the amount of premium.
The third and final market is the secondary non-public market. This market is heaven for venture capitalists, early investors, and founders looking for quick cash and liquidity but not so much for other participants. The bearer of risk is usually the speculators purchasing the equity in hopes to exit at the IPO or a sale. For the speculators, the bubble may come at any time. But that will be determined by the supply and demand created in the public market.