Why is Big Tech so Big?
A historical and user centric approach to understanding the behemoth valuations of the largest technology companies
Intro
Over the past few weeks, the monstrous size of technology companies has once again come into the public’s view. As COVID has forced companies across the economy to adapt, tech companies have come out on top- propelling their market share to new levels and taking the tech heavy Nasdaq up over 26% with them. This has come to a spearhead as we’ve watched anti-trust testimonies in front of congress, calls for the ban of Tik Tok, and Apple’s valuation hit $2 trillion. In seeking to understand the role of technology companies in our lives and try to comprehend how these companies swelled to the size they are, I began looking at them in the lenses of both typical valuation methods (DCF, revenue multiples, precedent transactions, and comparable companies) and their integration with our daily lives.
DCF
To start, I wanted to look at how these companies may be valued utilizing one of the most common accounting methods: Discounted Cash Flow. In short, Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future. While popular for companies with consistent revenue growth within a handful of product lines, technology companies have shown that they grow at inconsistent rates over time and have incredibly diverse product offerings. Using Microsoft as an example, “Productivity and Business Processes” accounted for 33% of the companies FY19 revenue and grew YoY at 14.8%, which was down from 20% YoY growth in this sector in FY18. In the financial period of FY19, its “Intelligent Cloud” business line accounted for 31% of revenue, but grew 21% year over year. In this simple example, we can already see that growth at technology companies, even within a singular product line is inconsistent, which renders this method of valuation to be inconsistent and hard to work. In case you do want to check out what the results of this technique might be, I’ll attach links to live DCF tools for various tech companies below.
Microsoft Amazon Alphabet (google) Facebook Apple
Precedent Transactions & Historical Comparisons
Another key valuation method utilized by investors is looking at companies through a market relative approach. This is typically analyzed via comparable public companies and precedent transactions. This section could be extremely short by just saying that there is no true comparables to today’s technology companies, but for the sake of my own curiosity I looked at the largest mergers and acquisitions in history and companies throughout history that had similar impacts and innovative growth markets to establish a true lack of precedence.
Precedent Transactions
There are obviously no transactions throughout history that involve companies as large as today’s big tech being acquired, however, let’s look at how transactions throughout history mimic those made by some of these companies. By understanding the industries that have engaged in mergers and acquisitions of these proportions, we can draw parallels to the players in the technology industry and the direction it might move.
In looking at this data, we see that over the years, the largest players in corporate development transactions have shifted as industry growth has. The industries most innovative often fuel growth inorganically, consolidating their strongest minds and synergies to the largest company of the day. This also shows us that, even the largest companies of the day can end up forgotten. In order to stay relevant, companies must undergo constant innovation and market creation.
Historical Comparisons
To understand historically how companies, investor preference, and industry performance has shifted, I analyzed market cap data dating back to 1999. In the late days of the 90’s prior to the dotcom bubble, technology companies such as Microsoft, Intel, and Cisco thrived. Around 2004, energy companies such as bp and Exxon ruled the day, as well as financial institutions such as Bank of America and Citi. This all changed after the financial crisis of 2008. As American companies struggled, Chinese conglomerates such as PetroChina took the scene. Between 2004 and 2009, Microsoft’s market cap actually dipped around $70B. In this post-recession world, it was obvious that China was dominating while American companies such as General Electric and Walmart were lagging behind. This shifted in the mid 2010s as companies in the innovation industry began their rise. While oil industry players such as Shell and Exxon still were large, Apple and Microsoft began to lead the market. Since this time, the technology companies have only further expanded their reach, innovating and addressing new user centric markets.
Revenue Multiples Method
As we’ve seen, it’s hard to compare today’s technology companies using traditional valuation methods due to volatility and high growth rates. To solve for this, I turned to an investing industry known for volatile and risky growth investments: venture capital. Known for investing high potential startups, venture capital has burst onto the scene in recent years as more and more companies go public as “unicorns”, having valuations of $1B+. I looked into the differing methods that investors within this industry utilize to value potential investments to see if we could find comparison between behemoth companies such as Amazon, Google, and Facebook and their high growth counterparts such as Uber, Slack, and Cloudflare around the time of their IPOs. While valuation methods such as First Chicago and scorecards stuck out to me as interesting ways to dive into a high growth company’s value, I looked at these companies from the lens of revenue multiples (Enterprise Value to Revenue Multiple) to directly compare across companies. This method looks at a company’s growth rate, revenue model, and management to assign a multiple to the revenue that will equate to the enterprise value (market value of the company). Using this approach, extremely high growth software startups may have valuations of 10 times their current revenue; while regional consumer goods companies may be looking more at a valuation of 1.5–2 times their revenue. Let’s dive in and see how today’s big tech companies compare with familiar high growth startups before their initial public offerings across metrics.
Looking at this data, we see that although the large tech companies may not have revenue multiples comparing to that of extreme high growth, first to market companies like Slack, they are still comparable to high growth startups around the time of their IPO. This shows the emphasis on the growth and potential market size that investors still see in these markets. While the growth rates of tech companies are obviously huge, what is more impressive is the potential market size yet to be attained. Within the technology and innovation industry, a key difference from other industries is that much of the market is yet to be even created. This means that for as long as firms prioritize innovation and differentiation, the potential markets of these companies will continue to grow and their valuations with it. So, for even as massive as these companies are, their focus on innovation and digital creation will allow them to continue to grow and drive investor value.
User Integrations
In looking at today’s big tech companies and how they compare to other historically massive companies, I wondered what the difference in business model was that created the growth that tech companies see. While most companies plateau in size as they address increasingly more of their potential market, tech companies seem to have only exponentially grown over time. So why are we not seeing the technology companies’ experience a bubble bursting moment, or even a plateau? The answer to that comes from the perspective of innovation and user centricity. In looking at technology companies and how their focus is differentiated in comparison to some of the other largest companies throughout history, technology companies have put their users first and profit second. While this may not make sense from a pure financial perspective, by putting customers and users at the center of their growth, technology companies are able to continually innovate their products to align with their users’ priorities, not only in the current day, but in the future as well. This alignment with the core priorities of their users allows companies to create new markets and capture revenue at every step of the way. As our lives as consumers continue to shift to be increasingly digital, these companies will continue to transform to remain at the forefront of that growth, as long as their emphasis remains on the user.