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?
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.
The collective health of the tech industry *shouldn't* be tied to the IPO market... but unfortunately, big investor institutions have created an environment where things that *shouldn't* be connected -- are connected more than ever.
The toobigtofail banks have created a marketplace that is skewed towards big payoffs and big losses... it would be nice if there were some kind of regulation scheme that could mitigate these huge swings, but it doesn't look like there's a simple solution for that...
You brought up a very important point. It is like the old adage that says “Beauty lies in the eyes of the beholder”. It all boils down to our perception and expectations of the company in the long term. It's definitely not an exact science as you alluded to because of the inherent risk involve in some of these high valuations. We can never fathom the high risks’ games these investors involved on a daily business
My fear though is how these risks affect the collective health of the tech industry
I am just wondering if we've ever seen investors outside the high tech sphere placing vast valuations on companies which are not turning a profit. Maybe they do - I don't know.
I guess any kind of investment involves a risk, so it is up to the investor to estimate that risk and act on the market. An important aspect raised in Paul's article and in comments is the time scale of your investment strategy, which totally changes your perspective of risk!
Valuations are difficult to objectively price. Two public companies can have the exact same market cap and financial statements, but if the perception is that one of the two companies is expected to grow while the other is expected to diminish, then their valuations are completely different. So companies that are not yet public are even harder to evaluate b/c the expectations of growth are complete shots in the dark.
But if you had a chance to invest in Google before its IPO... you'd probably have done okay, right? If Facebook and Twitter turn out to be similar to Google in terms of revenues in a few years, then their valuations now are not that outrageous.
Hi Paul, I think P/E as a metric to measure a company's worth going forward is highly unreliable. Sadly, it is what financial analyst use as a failsafe. Some analysts’ prefer to look at cash flow and balance sheets to determine a company’s economic health.
Unfortunately there is no silver bullet. Despite what people consider due diligence when attempting to value a stock price, many times amounts to no more than lawyers and bankers trying to get the highest possible valuation to bring a company to market.
Also keep in mind, privately held companies like FaceBook do not legally have to disclose all their financial information. This makes any forensic accounting guess work. Once they become a publicly traded company the SEC requires that they adhere to GAAP (generally accepted accounting practices) That require full disclosure of Income Statements, Cash Flow Statements and Balance Sheets.
It's a fair point. I don't have the time, but be sure the VCs have probability weighted growthrates to feed in to a cashflow model, and do a better job. I was just pointing out that with some not completely crazy assumptions, you can get there.
The real driver of value, I suspect, is growthin advertising, fed partially by changes from platforms that currently run most ads, but aren't useful, to new ones. Advertisers spends 1/4 of their budget on print ads, and 1/2 on TV. (http://www.oaaa.org/marketingresources/factsandfigures/mediacomparison.aspx) If the 10% spend on Internet changes to only 30%, which would be low in my estimation, you have a factor of three revenue increase there alone - and that is very possible over the next decade. And that assumes no premium for perfectly targeted ads.
I guess in part my response is (as I alluded to) not only a boost for the New Media, but a jab at the old. Adverstising is very...tempermental. Are dollars spent related to dollars gained? At the highest amounts. Not at all...at least in no measurable way.
Again, I raise the question: how much attention does, say, Saturday Night Live take up in the mindshare compared to how much your Facebook wall does? More...less...maybe we're not just valuing Facebook, but re-valuing everything else. Walls may crumble.
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