Facebook is currently valued at $100 Billion, while Forbes estimates that Twitter is valued at around $10 Billion. To some, this might be slightly reminiscent of 1999, the dreaded dotcom bubble. So what is it about internet companies that drive such high valuations?
To answer this question we need to delve deeper into the topic of why internet companies, including those that make no money (yet!), have “high” valuations. It can be due to a variety of reasons, such as:
- A highly successful team
- The space is buzzing with investors who compete to fund, and thus drive up the valuation.
- High potential to be bought out by a bigger player like Google or Yahoo
- The focus is on building the product/brand/user base, and monetization is not a priority at the moment
Valuation does not just denote the current performance of a company, but its potential for future growth.
Let us take the example of Dropbox, which has a $4 Billion+ valuation. As of 2011, Dropbox had revenues of about $240 Million, a user base of 50+ million (currently pegged at 100+ million) and only 4% of these users had paid account. Quite impressive at that time for a 4 year old company!
Juxtaposing the above points with Dropbox,
Team: Dropbox seems to have a great team and attracts a lot of smart talent from across the globe. The fact that the founders are still with the company says a lot.
The Space: A large majority of the users are yet to pay, and 2GB is hardly enough space these days. Besides, Cloud Computing has seen 50% plus growth rates in recent times and is a very lucrative sector to be a part of.
Exit Potential: With major players in the industry such as Google and Microsoft, each with their own offerings in cloud storage, the competition is bound to intensify. There are high chances that one of them will attempt to buy Dropbox to hold a majority share of the market.
To address the question of high valuations for pre-revenue firms, let’s consider Quora, a Q&A website with a $1 Billion valuation.
The focus of the firm currently is to develop its user base and product offering. Despite not having developed a solid way of bringing in money, it has acquired millions in funding from VC firms.
This can be attributed to the fact that the market potential has been proven. Quora is a treasure trove of information and there are multiple B2B or B2C methods to use it. And of course, there is always advertising.
So…. are these astronomical numbers justified?
Internet and other tech stocks were overvalued in 1999 shortly before the dot-com bubble burst but the sector is not in the same kind of peril today. Wharton finance professor Jeremy Siegel notes that it is a “world of difference”. Back then, notably in April 1999, tech firms such as AOL were trading at around 700 times their Earnings per Share (EPS), and had close to 20 million subscribers. It is not the same case as today, where firms like Google and Microsoft are trading at about 18 times EPS, which can hardly be classified as overvalued when the Nasdaq index as a whole is trading at 15 times EPS (as of 22.03.2013). Besides, the number of internet users in 1999 was a meagre 250 million, compared to today’s 2.8+ Billion.
One anomaly is Facebook which is currently at close to 200 times EPS. In 1999, the uncertainty was centred on whether and how Internet companies would make money; it turned out a lot of them couldn’t, or at least not enough. This time around, talk of another tech bubble is focused on firms that have revenue streams and even profits. There are few doubts that seven-year-old Facebook is viable. The uncertainty is focused on what additional revenue streams it might leverage from the community it is amassing and how big those revenues can grow.
In the end, it is not a question of inflated numbers but whether each firm can live up to the expectations.