Eugene Fama, who believes share prices reflect all the available information, shared this year's Nobel Prize in Economics with Robert Shiller, who in contrast believes greed, fear and animal spirits drive markets and cause bubbles. Looking at the media love affair with Xero, I'm with Shiller.
Xero has a fantastic product. The business has 150,000 customers and $40 million a year in revenue, but it loses money. Its board says that if it prevails it will become the dominant market provider. There are precedents such as Microsoft, Google and Trade Me, where a natural monopoly evolved and made shareholders rich.
But at more than $3 billion, the market has priced Xero as if it has already reached those elevated heights. It hasn't and it might not.
Products such as Microsoft Exchange increase their utility the more users they acquire, but is this true of accounting software? I think it is more like Microsoft Explorer, a program that works well but if I am the only person who uses Chrome I am not disadvantaged by my isolation.
The business has $45 million in costs compared to $37 million in customer revenue. But unless they can get more customers they will be unable to sustain their overheads without drastic changes.
Xero is aiming for the stars, passing first through the cloud. Early investors have done well but what is driving the current frenzy? Is it a cold rational expectation of future growth, or greed and animal spirits? By contrast, Meridian Energy is a stable business that last year made $295 million after tax and has $6 billion in fixed assets. It has been valued at $4 billion.
For Xero to catch up to Meridian in profitability it must gain vast economies of scale. Even if it increased revenue tenfold it would struggle to catch Meridian; yet both enjoy similar market capitalisation.
This means Fama's investors may believe there is a 50 per cent chance Xero will increase its revenue 20 times; this would make it a $6 billion company; discounted by half to account for risk.
Schiller, however, might say investors know nothing about the business and are blindly following the herd.