This short essay is my part of a larger group essay on public social media companies completed for the course Understanding the Stock Market (EXP — 088) at Tufts University. It addresses, briefly, obstacles with the valuation of early-stage social media & tech companies, as well as why investors choose to make big bets on companies without established cash flows.
On May 18, 2012, social media company Facebook (NASDAQ: FB) underwent its initial public offering at an initial price of $38 per share and an initial valuation of $104 billion, beating previous estimates that capped Zuckerberg’s company at a humble $75 to $84 billion(1). Today, Facebook is trading at over $80 a share, with a market cap of $228 billion, a value that many predicted would never be possible for the tech company. During the days leading to and following its public debut on the NASDAQ, however, Facebook lacked clear revenue stream and hadn’t come up with efficient ways to translate users into money income, making it an obviously risky investment(2). Only now in 2015 have we started to see Facebook finally begin to capitalize on its one billion users, which has resulted in it trading at a value higher than most retail stocks on the market despite their obvious sources of revenue.
This phenomenon in which social media companies receive wide-ranging valuations that seem almost too good to be true is not unique to Facebook; similar stories have been seen with other popular social media companies like Twitter (NASDAQ: TWTR) and, more recently, with Snapchat, who received a $15 billion valuation from Alibaba in March of 2015 despite only mild progress with experimental forms of potential revenue(3).
If these numbers seem astronomical or too good to be true, venture capitalists disagree; this past year alone, over eighty social tech companies have received valuations of over a billion dollars, a figure almost unheard of in traditional deals with startups before the age of social media(4).
Because these companies receive valuations that are often hard to quantify — and thus even harder to rationalize — social media and tech companies create important questions in finance. It is important to understand what makes investors decide to take such large leaps of faith on companies that do not maintain current sources of revenue.
Although there are dozens of different ways that investors analyze what a company is worth, most investors look at a company’s earnings and revenue growth history then use valuation methods like Discounted Cash Flow (DCF) or an analysis of different Multiples to predict the amount of cash that a company should be earning in a certain period of time, allowing them to get a feel for the company’s future(5). These methods have worked fairly well for traditional companies because they are dependent on their sources of income and revenue from the beginning in order to prove their company’s value.
However, the increased prominence and access of venture capital has redefined what is expected from companies in the short and medium-term; venture capitalists today compete for the opportunity to invest in promising tech companies that have high potential to scale despite few, if any, sources of revenue. Investors and prominent venture capitalists believe that the Internet has created a new business model that requires a company to scale and reach a large audience to reach its true value, and entrepreneurs are using their venture capital to be able to sustain cash flows in the absence of revenue in order to achieve these high stages of growth(6).
Because a majority of these companies monetize their services through large advertisements and the collection of user data, it is necessary to have a large user base to make a profit. Investors thus buy equity in social media companies because they believe in the company’s ability to scale in the future. Traditional investors have begun to adjust to these facts by combining traditional valuation techniques with other important metrics more specific to social media companies, notably number of users and user growth rates(7).
Many Silicon Valley critics have claimed that there is a tech and social media bubble a-la-dot-com-crisis that is nearly ready to pop(8). At the same time, venture capitalists that have established themselves as thought leaders in the tech and social media industry by investing in early-stage ventures that have become household names — think Peter Thiel, early investor in Facebook and LinkedIn, or Shark Tank VC Mark Cuban — continue to reap the profits of their early investments. With companies like Facebook turning over $10 billion in profit at the end of 2014, it is evident that private investors have created a new understanding of valuation in which the company’s potential to scale and make large revenue in the long-term is prioritized over early lack of profitability.
- Schonfeld, Erick. “Pre-IPO Filing, Facebook Trading Privately At $84 Billion Valuation.” TechCrunch. 30 January 2012.
- NASDAQ: FB. 2 April 2015. On risk of IPO, see Segal, Jeff. “Buzz rises for Facebook IPO.” CNN. 2 April 2009
- Scott Austin, Scott, Canipe, Chris, Slobin, Sarah. “The Billion Dollar Startup Club.” Wall Street Journal. 18 February 2015.
- Powers, Edward. “5 Key Numbers a Buyout Firm Uses to Value Your Company.” Inc. Magazine. 31 January 2014.
- Sharma, Rakesh. “3 Reasons Why Silicon Valley’s FOMO Is a Tech Bust in the Making.” Business CheatSheet. 1 Mar 2015.
- Shemen, Jesse. “The Story Behind Social Media Valuations.” New York University Leonard Stern School of Business. May 2013. Page 13.
- Rusli, Evelyn. “Startup Values Set Records.” Wall Street Journal. December 2014.