Just how much is Facebook or Twitter really worth?
Any time the latest valuation of prominent tech firms hits the airwaves, it generates hysteria in the blogosphere, with some people seeing it as the looming Internet Bubble Part II.
As Internet Evolution’s Nicole Ferraro summed it up: “So... $50 billion, for Facebook. Justifiable? Makes sense? Or is this a sign of hideous things to come?"
Even optimistic folks like me who tend to justify these high valuations grow wary at hearing multibillion-dollar figures, and we do understand the concerns shared by people like Nicole. How can a relatively new tech firm like Twitter with a paltry annual revenue of $150 million, one that is still struggling to establish a viable business case, be valued anywhere near its current valuation of $7.7 billion?
Back in 2008, Andrew Keen wrote here:
Even in today’s irrationally exuberant Web 2.0 economy, how is it possible that a 450-person startup without a coherent business model or an experienced management team should be worth the annual GDP of a real country like Jordan ($16 billion in 2007) or Bahrain ($14 billion in 2007)?
Andrew made that statement when Facebook was reportedly valued at $15 billion. I wonder what he would have to say now that it is valued in the region of $100 billion!
I myself wasn’t too knowledgeable of the mathematics behind such high valuations until I came across this Huffington Post blog by John R. Talbott:
Analysts attempting to arrive at a fair value for these and other hi-tech firms typically estimate the firm's earnings power and then apply a P/E multiple to arrive at the company's market value. This is not that different from how most firms are valued in the marketplace, but with tech firms a much higher P/E is applied reflecting the greater growth prospects of the firms.
So there you have your magic parameters, which can instantaneously convert a tech firm with paltry annual earnings to an overnight multibillion-dollar franchise.
You can rightly call the P/E ratio the speculative multiplier -- or the hype index. For instance, a P/E ratio of 100 means that investors are willing to pay $100 for every $1 of earnings generated by the firm.
This was precisely what happened during the dotcom bubble. During the Internet boom of the late 90s, many high-tech firms consistently had a P/E ratio near 100. However, when investors finally realized that their earnings weren’t going to improve, high-tech stocks took a big plunge, and P/E ratios nose-dived, bursting the bubble.
So on what basis do today’s high-tech firms get P/E ratios higher than real blue chip stocks? It is simply based on the belief that Facebook will continue to be the dominant social networking site for decades to come and that Google’s search engine will continue be the unrivaled No. 1 in the long term.
But how true are these assumptions in an industry that is characterized by the lightning pace of innovation? Will Google or Facebook be relevant a generation from now? What will happen to Facebook’s valuation if a formidable challenger should grace the social networking space?
Viewed from this perspective, it becomes easy to see the absurdity of the speculation driving some of these ridiculous and over-the-top multibillion-dollar valuations.
— Paul Whyte is a Fulbright Scholar and was recently awarded a PhD in Civil Engineering at Michigan Technological University.