The Interwebs are aflame with alarmist stories heralding a new technology bubble threatening to wipe out all investors in the sector. The truth, however, is that aggregate valuation levels are well within historical norms.
The naysayers have a point, however – the dangerously high valuation levels are in the sector's most recognizable names.
This Business Insider post is a good example of the "It's going to blow!" meme that has recently infected technology sector coverage. Amid various beef jerky-related anecdotes, the post makes the very important point that the technology IPO market does appear overly exuberant. New issues are both more frequent and at suspiciously high price-to-sales ratios. IPOs in tech should be avoided by all but the most sophisticated investors. That means you, Twitter-watchers.
There are definitely companies within the Russell 3000 Technology Index (I used it because it has the most members) where valuations look insane. A patent-licensing company called Unwired Planet Inc., for instance, trades at almost 1100 times revenue.
On the whole, the median price-to-sales ratio of 2.4 times is not distressing relative to the post-crisis average of 1.9.
The perception of impending doom is fuelled by some startling growth projections and high valuation levels in stocks garnering the most attention – Facebook Inc. (18 times sales, 119 times earnings), LinkedIn Corp. (18 times sales, 748 times earnings ), Yelp Inc. (22.5 times sales, no earnings) and Salesforce.com Inc. (9.4 times sales, trailing 12 month loss).
Investors in those four stocks are playing with fire by accepting high valuation risk in exchange for expected growth. They're also getting rich – those four companies' trailing 12-month return averages 143 per cent.
As a general rule, longer-term investors should avoid crazy valuation levels no matter how recognizable the companies' brands are or how much they personally use social media. Even shorter-term, hyper-attentive traders should keep their finger poised over the sell button when owning these types of high flyers.
That said, the Russell Technology Index includes 60 names (out of 385) trading at trailing price earnings levels of 20 times or less, and there are many more companies with profit growth at multiples of the S&P 500 average of four per cent. As long as investors are careful and selective, the technology sector remains one the best hunting grounds for profit growth despite the negative hype.