“Oh man, there’s gotta be a tech bubble. What about all those crazy mergers and buyouts? Obviously that’s a bubble.”

Recently, I analyzed the tech market from a valuations perspective and concluded that, while certainly frothy, it isn’t looking as if it’s a true bubble in search of a pin. But unrealistic earnings expectations aren’t the only reason cited by those for whom the market’s bubble status is self-evident. They often advance opinions like the one above, claiming that merger mania is another sure sign of the imminent apocalypse. Like Facebook’s $19 billion acquisition of messaging company WhatsApp. Isn’t that indicative of the insanity running rampant in the sector?

I hate to answer a question with a question. But I have two of them.

First, did Facebook really overpay for WhatsApp? A very good question that I’ll deal with in a moment.

Second, even if it did write too big a check, does it necessarily mean we’re in a bubble and everyone else is overspending too? Let’s tackle that one first.

The fact is, astonishment is a natural reaction when we hear big numbers like $19 billion. They almost seem to trigger some dramatic movie music in our heads:

And let’s be honest, when someone plunks down billions for a company we’ve never even heard of, it pushes an emotional button. “That just has to be crazy,” we automatically think.

Ultimately, though, a business decision like this can only be judged by the value it brings or doesn’t bring to the buyer—not by the size of the deal alone. Which is why it is frustrating to read simplistic diatribes about market bubbles like MarketWatch’s recent foray into the tech bubble hype zone with its article, “Cash-Rich Spending Spree Is Sign of a Growing Tech Bubble.”

The data cited to back that thesis:

U.S. tech companies were involved in 62 deals in the second quarter, valued at a total of $26.7 billion—an 87% jump from the year-ago quarter. Cash balances among the top-25 tech giants grew to more than $350 billion.

Indeed, some major deals are expected to close in either the third or fourth quarter, including Facebook Inc.’s mega-deal to buy the mobile texting company, WhatsApp, for about $19 billion, Applied Materials Inc.’s purchase of Tokyo Electron for $9.5 billion, and a $5.3 billion deal by Oracle Inc. to buy Micros Systems, a hospitality software developer.

Many of these deals are driven by the older tech stalwarts that are trying to buy technology they cannot develop fast enough on their own. or to beef up their current business, such as Microsoft Corp.’s $7.2 billion purchase of Nokia Inc.’s handset business.

Yes, those are some big numbers. But are they a sign that valuations have gotten frothy? Or are things actually on sale cheap? The assumption with the former is that the CEOs of major multinational companies are shooting blind, just following a trend and not properly evaluating their acquisitions. That’s quite an accusation to make. Surely, there have been past times when it was true—see 1999. But in order to make the case that history is repeating, the math has to hold up.

Unfortunately, math seems to be a class that many mainstream reporters and analysts snoozed through. When you do the arithmetic, things don’t seem nearly so crazy. This takedown of the consensus analysis about Apple’s acquisition of Beats by a young writer at Forbes is an excellent example of the value of doing the math: “Apple’s Beats Deal Is Tech’s Worst Acquisition, Except for All the Others.”

Over at Forrester, the research firm, they appear baffled by Apple’s decision to do this. “I cannot do the math on the offer,” said James McQuivey, as quoted in the Los Angeles Times. “Nothing that I can compute adds up to $3 billion.” That’s odd. Here’s a company that at a bare minimum—the lowest estimates of Beats’ revenue are north of $1 billion—has tripled in size in two years and McQuivey can’t see why someone would pay $3 billion for that? Of course, Forrester has become a laughably anti-Apple “trend spotter” of late. Last year, it claimed 200 million people wanted Windows tablets, but not Apple iPads. Since then, Apple has sold 70 million more iPads. Microsoft has not sold 1/10 that many Surface tablets. (Forrester also thought Kindle could seriously challenge iPad. It hasn’t.)

An acquisition at 3x gross revenue (at worst; 2x is closer to the revenue numbers I’ve seen for Beats, though much of the difference could be channel stuffing, so let’s be conservative) is not generally considered expensive if the revenues are stable, let alone doubling year after year. And when you mix those high-priced, high-margin products into the one of the strongest retail sales franchises in the world, the Apple Store, then give organic demand a boost with a whole new headphone tech rumored to be coming with the iPhone 6—well, the acquisition plausibly becomes accretive in short order.

It remains to be seen if Beats, Nokia, WhatsApp, or any of the other major acquisitions will go bad. But even if they all sour, that’s still no indication we’re in a bubble. Bad tech acquisitions—big ones—are a dime a dozen, especially when the mega-caps are pushing the shopping carts. Microsoft’s wrongheaded purchase of aQuantive for $6 billion in 2007 was close to one market peak… as was Yahoo’s $4 billion waste on GeoCities.

But big money is flashed during harder times, too. HP’s purchase of Palm in 2010 was a flop. And 2009—an anti-bubble year if ever there was one—saw the very bottom for the tech market. Yet it produced a whole raft of high-end deals. Among them:

  • Amazon.com spent $1.2 billion on shoe company Zappos
  • Adobe bought Omniture for $1.8 billion
  • Cisco got Tandberg for $3.4 billion and Starent for $2.9 billion, just a few months apart
  • Xerox bought Affiliated for $5.75 billion
  • Oh yeah, and Oracle paid $7.4 billion for Sun Microsystems to get into the hardware and Java lawsuit games.

These companies were cash-rich and busy bargain shopping during the sidewalk sale Wall Street’s mess teed up.

You can go look at nearly any year in any market cycle, up or down, and find a boatload of questionable multibillion-dollar acquisitions. Go all the way back to ATT’s purchase of NCR in 1991 for $7 billion (which it was forced to spin out a few years later for half that amount… and NCR has yet to get back to that lofty valuation 23 years later).

Nope. If you want to evaluate a market, looking at individual deals is not the way to go. You’ve got to crunch the right kind of numbers, the ones that tell you if overall relative deal volume or valuation has increased or decreased.

Thankfully, there are many firms that track this kind of data. M&A bank and advisory firm Cognient is one. It calculated the acquisition multiples for the last six quarters across multiple sectors, and the trend it came up with shows a decided uptick in valuations for all of them:

As you can see, technology is far from alone. All sectors except staid utilities have seen a jump. Tech companies, relatively, are no more bloated than those in other industries. While the Q2 data crunching hasn’t concluded yet, I doubt we will see information technology shoot up out of proportion—after all, Q1 included such whoppers as Google’s $3.2 billion purchase of barely launched thermostat maker Nest.

Digging a little deeper in the IT sector specifically, thanks to the excellent data compiled by PitchBook, we can see a few interesting trends.

There was a major spike last year in private equity buyouts in the IT sector, driven in large part by the $24 billion take private of Dell. 2014, however, doesn’t look likely to continue the upward trend.

That said, there is expansion in one particular area that’s worth noting: software. The softer side of technology has increased its share of buyout activity in a big way, reducing hardware investments to almost nothing as buyers chase businesses that should, at least in theory, provide higher margins.

We’re seeing similar skewing toward software in the venture capital industry as well (but that’s a topic worthy of its own article). The rise in hunger for software might just be investors getting smarter, or less risk tolerant of the high capital-cost business that is technology hardware.

But it also could be a harbinger of things to come. Software’s share of investment tends to peak along with markets. Software’s previous highs as a percentage of M&A activity came in 2007 and 1999. Same for venture capital investments. Even the pros get swept up in trends.

Overall exits for the private equity investors in technology remain low for 2014, though, with very few IPOs (those have been reserved for the venture capital guys, it seems) and thus far less than half the corporate acquisitions we saw last year, or any year since 2009.

But, like the public markets, there are some signs of what might be froth. Median M&A deal sizes are increasing (at a decade’s high), and software is occupying the bulk of the activity. Multiples are up everywhere too… a trend that is not sustainable.

That said, 2014 is not shaping up to be a 1999-like bubble… not that we can see from mergers and acquisition data. Still though, like we saw before with rapidly expanding equity valuations, there are some distinct signs of froth to be wary of.

What’s up with WhatsApp?

Let’s return now to the question of WhatsApp. Is it a totally unhinged deal, like some of those analysts mentioned earlier claim? Or might it be a real value buy for Facebook?

To put the price of the deal in context, you have to compare it to other big acquisitions. One way to do so is to look not at revenues today, but at cost per user. Why? Because Facebook is a media business. And like most other media businesses, it make its money largely selling ads. And, like other media companies, that makes its prime directive getting as many eyeballs as possible on its ads, by hook or by crook. The best kinds of buys are the ones where you can get a lot of those eyeballs from someone not as good at monetizing them. Thinking along similar lines, TechCrunch published this rundown on the subject. It clearly shows that Facebook’s premium for WhatsApp, which you’ll find at the end, is hardly out of line. In fact, Yahoo, Google, and others (the gray ones) have often paid far more per user:

Looked at this way, Facebook’s deal seems rather reasonable. Plus, what Facebook got out of it is arguably a much more active user population with more stickiness. WhatsApp’s application users are all verified, identified (using emails and cellphone numbers), and installed. Those people can be pushed notifications and app updates and are much more likely to keep returning to the app than, say, visitors to an Aerosmith fan page on Geocities.

You also have to understand why Facebook might have spent a small country’s GDP on WhatsApp, beyond just eyeballs…

Facebook’s biggest issue lately is retaining the attention of its users. The more time people spend on Facebook, the more of those ad dollars it makes, yes. But, it also makes more ad dollars per user because it has one of the few accurate maps—willingly supplied by users—of who people know what they talk about and what they “like.”

So Facebook’s got a powerful incentive to react (or even overreact) when its Messenger app falls behind some upstart on the app store… one which suddenly has millions of daily users taking time away from Facebook, mapping their friends list into the app, and chatting about their favorite things. To Facebook, that time and data is as good as gold, and it simply can’t afford to miss out. Nor can it afford for someone else to have access to data of that level. With a few hundred million users and growing, WhatsApp was becoming a credible threat to Facebook’s social networking hegemony:

Helped along by the media attention the acquisition brought, it’s now growing even faster. Only time will tell if WhatsApp was a smart buy or just the next MapQuest, the hot first mover bought right on the verge of losing its top spot. So far, it doesn’t appear so.

As with our earlier public markets checkup, the numbers here don’t seem to add up to “bubble.”

Still, there are definite signs of excess. Companies rich in highly valued stock are spending big bucks (or shares at least) to acquire users, talent, market share, etc. That makes sense for them when P/E ratios are at 14-year highs, and thus their currency for buyouts is worth more than it was last year—and may be worth less next year.

Still, neither valuations nor the number or amount of M&A deals in technology show any signs of approaching bubble levels… yet.

But that’s just tech. If you consider the broader market, we may be closer. When you see some of the big deals in telecom (Level 3 Communications bought TW for $5.7 billion) or health care (Medtronic bought Coviden for $42.6 billion) or poultry (yep… Tyson is trying to buy Hillshire for $8.5 billion), then the graph starts to look a little scarier:

The bottom line is that equity valuations are up in every sector, and large-cap companies are holding record amounts of cash. Those two elements coming together are inevitably going to result in some measure of merger mania—not just in technology, but everywhere.

When a market looks like this, with high equity valuations, increased merger activity, and a lot of deployable capital still sloshing around, it’s certainly not the time to be value investing or holding big indexes. But that doesn’t mean it’s a market without opportunities. Instead, the way to deploy capital right now is the same place where big companies are putting theirs: growth. During markets like this, the best of breed of smaller technology companies—those growing revenues quickly or with the potential to in the near future—make the best investments.

If merger mania continues to pick up, then you are holding exactly the assets others will be looking to buy. If it doesn’t come to pass, you’ll have strong companies with growing earnings, whose prices will rise regardless of expanding or contracting multiples as the market discovers their value after the fact, as it always does. We maintain exactly such a portfolio of growth companies in Casey Extraordinary Technology. Take a look at the portfolio today, and we’re sure you’ll agree that they are exactly the kind of companies you’ll want to own on the other end of the next 18 months or so, whatever that time span might bring.