If anyone ever tries to convince me that markets are rational, I will laugh politely and point to three telling events that have unfolded in the last month or so:

1. This hilarious Tweeter / Twitter mishap
2. A “financial innovation” sure to raise eyebrows
3. The increasingly absurd valuations of social media companies: Facebook ($104.7bn), Twitter ($24.2bn), Pinterest ($3.8bn), Snapchat ($3.0bn)

The three corresponding conclusions I draw from these stories are:

1. Markets are not only irrational, but also borderline stupid (for lack of better word) at times.
2. We have not learned much from the Financial Crisis of 2008. Finding novel ways of securitization without applying common sense can lead to potentially disastrous results.
3. We really have not learned much from the last technology/internet bubble. Markets should not be viewed as an archetype for the “wisdom of the crowd,” but rather as a broad manifestation of human psychology. In fact, human psychology is largely what drives cyclicality in the markets and the broader economy as a whole. This has been true throughout history, and will likely continue to hold true in the future.

Now, I could go into a whole rant on moral hazard and why I find the impending tech bubble so infuriating, but that’s best left for another day. Instead, I will turn my attention to point #3 and point out why current valuations of social media companies have gotten out of hand. In particular, I will focus on Twitter (TWTR), which has made much news in recent weeks for its IPO. Let’s start with a few facts:

October 15, 2013 – SEC filings reveal that Twitter more than doubled revenue in the nine months ended 9/30/13, but also doubled its net loss as well in the same period. User growth also slowed in the last three quarters.

October 24, 2013 – Twitter sets IPO price of $17-$20 per share, valuing the company at ~$12bn.

November 4, 2013 – Twitter boosts IPO price to $23-$25 per share, valuing the company at ~$15.5bn.

November 6, 2013 – Twitter sets IPO price at $26 per share.

November 7, 2013 – Twitter pops in the first day of trading, closing at $44.90 per share (a 73% increase from the IPO price).

One week later (and as of this blog post), shares have held steady ($43.98 per share) with a Market Cap of $24.0bn and Enterprise Value of $24.2bn.

Now, let’s pretend you know nothing about what Twitter does as a company. How would you justify such a dramatic increase in valuation over a mere two week span? Nothing material has occurred at the company to justify such a change. In fact, financial results were filed prior to the initial release of the IPO price range, and they were lukewarm at best. An argument could be made that the investment banks arranging the IPO purposely set a low price range in order to be conservative and generate pre-IPO buzz. Even if this is generally true for IPOs, a price jump of 73% in the first day of trading is  highly uncommon and means that banks (and the company) have left a fair amount of money on the table. Typically, a 5-10% increase on the first day is the number that arrangers aim for, as it conveys a positive tone to the market while allowing the company to raise as much money as possible. Even if we can attribute all of the increase from the initial $17-$20 range to the final $26 price to marketing and syndication strategy, we still cannot explain the drastic 73% jump in valuation. So now what?

We know that the value of a company is equal to the discounted value of its expected future cash flows. An increase in valuation can be driven by either one or a combination of the following factors:

1. An increase in the amount of expected future cash flows
2. An acceleration of the timing of cash flows (time value of money)
3. An increase in the certainty of cash flows (i.e. a lower discount rate)

I would argue that in the last three weeks, none of these drivers has changed materially. Again, keep in mind that the company released financial results prior to setting its IPO price. Furthermore, considering that the Twitter’s current free cash flow position is negative, the company would have to make a quick and significant (re: miraculous) turnaround to justify its current $20bn+ valuation.

Sound insane? Welcome to Tech Bubble 2.0.