Over the last few days, there has been a lot of buzz around social media businesses fetching insanely high valuations including Facebook's acquisition of WhatsApp for $19 billion. On one hand, the conservative traditional investors are perplexed with the high valuations of social media companies, on the other hand some traders with investments in social media are laughing their way to the bank.
The fact is that ‘Social Media’ businesses differ from ‘Traditional’ Businesses both in terms of 'Value' they create and in terms of the methods used for 'Valuing' these companies.
While products and services of traditional businesses serve tangible needs of the market, digital social businesses mostly create new needs either by enhancing user experience, or by seducing users with an unique experience or an emotional appeal.
Traditional businesses generally have a fixed organization structure, start from a local market and later expand to global markets. In contrast, digital/social businesses are global from day one and thrive on collaborative structures based on interaction with online communities; if such companies manage to capture imagination, growth can be instantaneous. Candy Crush, the mobile phone game has been downloaded more than 500 million times since its launch in 2012 and is worth $5 billion now in 2014.
So whilst traditional businesses focus on break-even and profits, for digital businesses expanding and owing the Network becomes the first and foremost priority. The ‘value is in the network’: own the network first, and find a way to profit from those connections later.
For traditional companies valuations are obtained by appropriating all the potential earnings of the company in future to the present date. The future earnings are found based on the growth estimates of the revenue & costs.
For digital companies the valuation is guided by the user base and is based more on the intangible assets. Hence the digital businesses continuously strive to improve user engagement and grow the user base. Though it is possible to attain a spectacular growth in user base within a very short period, say with a particular app, it might be difficult to maintain that level or replicate a similar level of engagement with another app.
Twitter saw the share price plummet more than 20% after quarterly results in Feb 2014, showed that the social network was not adding users as fast as it once did. Zynga, the maker of Farmville, has seen its share price halve since its late 2011 initial public offering (IPO), while Finland's Rovio has struggled to replicate the success of its 2010 hit Angry Birds.
Secondly valuation of intangible assets in digital businesses requires understanding the full global potential of the assets and valuing them accordingly.
Facebook is currently being valued at $170 billion, at about $130/user, given their existing user base of 1.25 billion. The high price of $19 billion that Facebook paid for acquisition of WhatsApp a co with no (proprietary) intellectual property, almost unlimited competition can perhaps be explained in terms of the strategic value that FaceBook sees in owning a IM service with 450 million users and killing the potential competition.
Had WhatsApp listed on a stock exchange, it possibly might have fetched a lower price.
As it may be difficult for digital businesses to continuously dish out products one after the other, so it is very likely that after having accumulated a user base, the founders of some of the smaller digital businesses opt for selling their product to a bigger player who sees strategic value in the product and can leverage the digital platforms to provide value added services to their customers.
It could also happen that in a year or two from now that social media companies see a deceleration in the exponential growth in user engagement and valuations of these companies come down to more realistic levels commensurate with their earnings and return on investment. In such a scenario, the investors who are late entrants and buy at peek valuations may suffer if the market stops seeing the same potential or prices the companies differently than how the initial price is arrived at.
However a fact that seems almost certain is that with time most of the traditional businesses will work on their digital strategies and start using digital channels to tap the ecosystem & engage online communities. This in turn will benefit the digital businesses that can extend their platforms to individuals as well as to the corporate sector and enter into a symbiotic relationship with the traditional businesses.
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