Opinion

Felix Salmon

Understanding Twitter’s valuation

By Felix Salmon
February 10, 2011

Count me in with Paul Kedrosky: there’s something extremely irritating about Shira Ovide’s Deal Journal blog post this morning kvetching about how high the mooted valuation of Twitter is.

The valuation — somewhere between $8 billion and $10 billion — is explicitly not based on Twitter’s current revenues. Yet Ovide insists on calculating silly ratios designed to make the valuation look as outlandish as possible:

Twitter’s revenue last year was $45 million, our Journal colleagues reported. So a $10 billion valuation would be more than 200 times the company’s revenue, or nearly 100 times its estimated 2011 revenue of $100 million to $110 million. Help me out here, folks: has any real business ever been slapped with such a high multiple?

Or, let’s pick another valuation metric. At $10 billion, Twitter is valued at $105 for each of the 95 million tweets its users write every day. (I’ll wait for my share of the check for those Twitter messages.)

I’m sorry, Shira, but “capitalization per tweet per day” is not a “valuation metric.” And in any case, your share of the check is likely to be pretty small: you’re averaging 0.4 tweets per day yourself, so far this month.

And valuing Twitter based on its revenues is exactly what Twitter’s suitors aren’t doing:

“Are these prices justifiable based on financial multiples? No,” said Ethan Kurzweil of venture capital firm Bessemer Venture Partners. But these start-ups are building social services and have lots of data about their users and “the market is valuing that mightily right now.”

In fact, the value of Twitter’s user data is just a part of what’s making it attractive right now. The interesting question about Twitter’s valuation is not how high it is, but rather the way in which it can be justified. People are putting real cash money into Twitter at massive valuations — the company just raised $200 million at a $3.7 billion valuation, and Andreessen Horowitz just bought $80 million of stock in the secondary market at levels which might well be higher than that. These investors aren’t stupid, so what’s their reasoning?

Ovide actually provides a hint, early on in her post, although she doesn’t realize it:

Twitter has swaths of devoted users, but it still requires repeated explanation to my mom –- and to many regular Joe Web users. Of the people who use the Internet, just 12% use Twitter, according to a recent survey by Pew Research Center. Compare that to Facebook (used by 62% of Internet users), and text messaging (used by 74% of cell phone owners), Pew found.

If you take Ovide’s own comparisons, Twitter’s valuation makes pretty good sense. If Twitter is 20% the size of Facebook, and Facebook is worth $50 billion, then Twitter can be worth $10 billion, no? And the proportion of the market capitalization of all the telcos around the world which can be attributed to text messaging is so mind-bogglingly enormous as to make $10 billion seem like a rounding error.

The point here is that Twitter is becoming central to how people communicate with each other — a key part of the new social architecture. Maybe not for Ovide’s mom, to be sure. But Twitter serves a very important purpose in the lives of the people who have adopted it, and it’s likely to serve the same purpose for ever more people as its user base grows and people start feeling left out if they’re not on it. Take a look at Owen Thomas’s wonderful essay on how he used social networking to lose weight, making important distinctions between various different networks:

When I went to the gym, I also checked in on Foursquare, announcing my location to friends and eventually winning the rank of “mayor” of my local gym. When I completed my food and exercise diary, the computer informed my Facebook friends; when I lost weight, it broadcast the news to the world on Twitter…

I post my exercise calories and announce the completion of my daily food diary on Facebook, while limiting Twitter posts to weight-loss milestones. I share the details only with other MyFitnessPal users.

Or, more powerfully still, listen to Louisa Lim’s story on how microblogging is reuniting families of abducted children in China.

Twitter has already, to a very large degree, supplanted blogging for millions of people; even people like me who cling loyally to the old-school blog format tend to find ourselves doing ever more of our job on Twitter. Twitter is the ultimate democratization of the commons: never has it been easier to publish material online, for all the world to see and respond to. And at the same time it’s also intensely social: it’s fantastic at strengthening bonds between individuals. I’ve befriended people I never knew before thanks to Twitter, and at the opposite end of the spectrum I’ve learned a substantial amount about my wife just from the material she posts on her Twitter account. (Go follow her! She’s great!)

How exactly will crucial social infrastructure get monetized in the future? Nobody knows for sure — but everybody knows that it’s not simply going to happen by scaling up current-day revenues from promoted tweets and the like. Twitter’s on track to make $100 million this year without even breaking a sweat, but the one thing all of its investors understand is that priority number one for the company is to become an indispensable service for millions of people around the world.

Twitter has a couple of hundred million dollars of cash in the bank: it’s not like it’s running out of money. And the chances are that as Twitter succeeds in cementing itself into the way that people live their lives each day, it will be bombarded with opportunities to monetize its position. In the history of humanity, everybody who owns the means by which people communicate and socialize with each other has been very rich and powerful. That might be less true going forwards than it was in the past, but it’s unlikely to disappear entirely.

On top of that, the putative $8 billion to $10 billion valuation is for the company as a whole: it surely includes a substantial control premium. If Google and Facebook are fighting over Twitter, a large part of its value to each company is that the other one won’t own it.

Twitter is a highly speculative investment, of course, and in fact only a very select group of carefully-qualified and extremely rich investors can invest in the company at all. Everybody putting money into the company right now is well aware that they’re taking a calculated risk: in order to capture the potential upside, they’re willing to accept a lot of downside as well.

The news yesterday from Andreessen Horowitz that it has bought an $80 million stake in the company is particularly interesting, because the shareholding was acquired on the secondary market. The idea behind VC firms like Andreessen Horowitz is that they provide expertise and guidance along with their money, and that they generate alpha by acting as real owners, rather than simply as passive shareholders. But in this case, their stake is much more speculative.

Why would Andreessen Horowitz invest this way? Kara Swisher I think hints at the answer:

Sources said that the firm made the move because it is already deeply invested in other key companies in the social space, including gaming giant Zynga, location-focused Foursquare, local discounting phenom Groupon and general social networking behemoth Facebook.

The idea here, I think, is that it’s hard to pick individual winners in this space, even if you’re convinced that the space itself is going to be extremely valuable. The last thing that Andreessen Horowitz wants, after making an enormous bet on social media, is to find that it isn’t invested in one of the handful of companies which will generate massive returns. And so it’s spreading its money around all the possible winners, trying to buy every ticket in the lottery.

Looked at this way, the valuation of Twitter makes sense even if it will probably go down. That’s the way of lottery tickets: their value is nearly always higher than their payout. And people looking to buy into Twitter at a $5 billion or $10 billion valuation aren’t doing so because they’ve discounted a bunch of predictable cashflows and decided that the present value is that ginormous. Instead, the investment is more in the form of a hedge. Twitter just might turn out to be one of the most important and valuable companies in the world. And if it does, then everybody will have wanted to get in around now. If you have that opportunity, it’s a hard one to turn down.

Comments
13 comments so far | RSS Comments RSS

Whay is the value of the Twitter user vs Facebook & Google

but also considering the 12% users demographics.

Food for thoughts!

Wxynot

Posted by Wxynot | Report as abusive
 

What is the value of the Twitter user vs Facebook & Google user.

But also considering the 12% users demographics.

Food for thoughts!

Wxynot

Posted by Wxynot | Report as abusive
 

Much as I might like to believe you, Felix, this simply feels too much like a dozen years ago, when we made up ways to value companies that had nothing to do with revenue, profit, and growth potential. You’ve given us no reason to believe that this time it’s different, except that you and some like-minded people use Twitter as an extended party line (remember that term?). Sorry, I think that reasoning is woefully inadequate.

You’ve also given us plenty of reason to believe that this is a valuation bubble, by telling us that know one knows how it will be monetized in the future, but that it will at some point be bombarded with opportunities.

Internet startups fooled us 10-15 years ago into thinking the same thing. It’s okay to be fooled once. But until you come up with a much better line of reasoning, you’re pitching that same snake oil all over again.

Posted by Curmudgeon | Report as abusive
 

I am sceptical about the value of all this, but there is no need to give my opinion much credence because I am older and not terrribly social. I find Facebook tedious and Twitter meaningless, and while I know many people who are virtually living their lives through social media now, I know more who really cant be bothered.

There is a potential danger to things like Twitter in that they increase society’s already excessive inclinations toward the immediate and the superficial. When I first started to use Twitter (before growing bored and irritated with it) it reminded me of the type of people featured in the book “The Smartest Guys in the Room” about Enron. Part of the story was about how much emphasis was put on deals and not on any follow through after the deals. The dealmakers made a great story and they continued to build the story, but nobody bothered to build the company. All that was important was what was immediate and upfront. The mundane work which was the real value of the company was not valued at all.

I saw the same thing at another institution. A bunch of brilliant people built a massive social network built upon a house of cards of immediate and persistent interaction. They achieved what they thought was their goal but when they got there they did not know what to do. It was not that they did not have the ability to do it, it was that all that mattered to them was the promise, not the delivery. This is nothing new in human history, just the means of making the promises changed.

Things like Twitter might be of value to clever, quick and social types like Felix Salmon, but let’s not think it is going to reshape all human interaction.

Posted by wpw | Report as abusive
 

@Cumudgeon
I see a lot of sense in your arguments but I feel it only right to remind you that a companies revenue, profit and growth potential are only indicators of performance rather than the “key data” that enables investors to be able to make an informed decision about what value to place on a company.

Firstly, Twitter has deals in place with both Google and Bing in respect of search. Although not huge they provide a revenue baseline. Both Google and Bing have priced up the data in Twitter and sought to pay for it and guess what the next deal will be more expensive than the last.

Secondly, Twitter has plenty of advertising potential. Regardless of user numbers and percentages of internet users (for the record both are growing – rapidly), it is likely that the relevance of twitter as an advertising channel is enormous.

Thirdly, Twitter as a resource (the potential for data solutions). Twitter has rather rudimentary first generation search tools but as the technology matures this will become much more granulated. The question that arises of course is how much will media companies, researchers, marketers and other users of data pay for this targetted services.

Of these three potential uses only two have been monetised and only since last April so to see that revenue of $45m as an early year one figure you can see how exciting the future looks. As an investor you can look at the raw numbers or realise that all of these is trending upwards and the next figure you see – say next April (or even at IPO) places the stock out of reach and way beyond the $10bn figure.

@wpw and @cudmudgeon
Both of you mention Black Box but I think its entirely transparent how twitter is seeking to increase its revenues. There is no black box or raptors here.

Posted by Iheke | Report as abusive
 

@Cumudgeon
I see a lot of sense in your arguments but I feel it only right to remind you that a companies revenue, profit and growth potential are only indicators of performance rather than the “key data” that enables investors to be able to make an informed decision about what value to place on a company.

Firstly, Twitter has deals in place with both Google and Bing in respect of search. Although not huge they provide a revenue baseline. Both Google and Bing have priced up the data in Twitter and sought to pay for it and guess what the next deal will be more expensive than the last.

Secondly, Twitter has plenty of advertising potential. Regardless of user numbers and percentages of internet users (for the record both are growing – rapidly), it is likely that the relevance of twitter as an advertising channel is enormous.

Thirdly, Twitter as a resource (the potential for data solutions). Twitter has rather rudimentary first generation search tools but as the technology matures this will become much more granulated. The question that arises of course is how much will media companies, researchers, marketers and other users of data pay for this targetted services.

Of these three potential uses only two have been monetised and only since last April so to see that revenue of $45m as an early year one figure you can see how exciting the future looks. As an investor you can look at the raw numbers or realise that all of these is trending upwards and the next figure you see – say next April (or even at IPO) places the stock out of reach and way beyond the $10bn figure.

@wpw and @cudmudgeon
Both of you mention Black Box but I think its entirely transparent how twitter is seeking to increase its revenues. There is no black box or raptors here.

Posted by Iheke | Report as abusive
 

@curmudgeon and @Iheke

I have to agree with curmudgeon on this one. Revenue and profit are how your measure investments. Alot of people got burnt in the dot.com bubble when they realized pageviews and mindshare can’t pay dividends to shareholders. How will Twitter monetize? I don’t see adds being as effective for them because a lot of people using third party apps that just leach off the Twitter network. Citing a valuation comparing the market share of one company trading at 50+ times revenues to another trading at 50+ is another relic of the dot.com days.

Posted by TurtleBay | Report as abusive
 

To anyone willing to bid Facebook, twitter, open table, or any company up to 100 times earnings or 50 times reveune… take a look at yahoo…

It’s a 20 billion dollar company today.

It was a 40 billion dollar company in 2006

It was a 200 billion dollar company in 2000

For Twitter to be worth 10 billion dollars someone needs to explain how they will be earning 500 million in profits within 24 months… anyone care to take a stab at that?

Myspace… enought said.

Posted by y2kurtus | Report as abusive
 

Mindshare is notoriously fickle… I’ve been reading this blog for a year and a half now, longer than most of my online activities. If Felix keeps it new, keeps it interesting, I might participate for another year or three, but past experience suggests that I almost certainly won’t be here in a decade.

The fads of yesterday are rarely the fads of today, and the entrenched companies today are if anything LESS likely to reinvent themselves to become the hot companies tomorrow. Go back a dozen years and we knew that the future of the Internet belonged to some combination of AOL and Yahoo (unless Microsoft managed to break their hold). What share do they have today? (Not counting Microsoft’s Windows/Office franchises.)

Posted by TFF | Report as abusive
 

@TFF and others – It’s not that I’m not willing to be convinced that Facebook is worth $50 billion or more, or Twitter $10 billion. It’s that Felix mails in his justification. Saying that someone will figure out how to make money off of these concepts in the future sounds an awful lot like the worst excesses of the boom. And yes, ultimately these technologies do have to make money. I fear I expect better analysis from Felix, and am not getting it.

Posted by Curmudgeon | Report as abusive
 

I agree with Curmudgeon, TurtleBay and others. Valuing Twitter at x/5 because Facebook is valued at x is no way to make a valuation. Let’s not forget that social network users are notoriously fickle, and change ship as soon as something better comes along – and something better usually does.

As soon as Twitter (or Facebook) make too many changes to earn the money they are valued at, they will most likely lose large swathes of disgruntled users who are being used as the basis for the bubble valuations.

IF statements can be useful, but not in this context: it’s just too big an IF. The valuations can only be met IF they can work out how to monetise their setup, and IF they can keep their users and IF something better doesn’t come along.

Posted by FifthDecade | Report as abusive
 

The valuation of almost every company is based on the amount of profit that speculators expect the company will earn. Obviously, twitter has not earned anywhere near an amount to justify a $10B valuation, but enough people (including some overrated venture capitalists) believe it will grow enough to justify that appraisal. I’m unfortunately with Curmudgeon here (I say unfortunately because my wife calls me a curmudgeon, so I hate to agree with anyone who uses that as his name), as I really don’t see how so many dot-coms, which will be dependent on a finite pool of advertisers, will generate the profits so many people expect.

During that dotcom bubble, people drove up the prices of companies with no revenue or business model, because they expected they would eventually figure out a business model that would generate revenue. A decade or so later, it is obvious that advertising is the business model to generate revenue, but the value of advertisements is inversely proportional to the industry’s capacity for advertisements, which appears to approach infinity. The more that popular websites are created, the more space there will be for ads, which will drive down the price of ads and deflate those business models and profit expectations. And twitter is even worse off than most websites, as a majority of its users rely on 140 character tweets – not an ideal vehicle for advertisements.

I think companies like twitter and facebook will prove to be a valuable tool for society, but not in the way that most people see them. They will be great vehicles for re-distribution of wealth.

Posted by KenG_CA | Report as abusive
 

@TurtleBay: Many companies, including Apple, don’t pay a dividend. Because of this, people buy stock in Apple or some other non-dividend paying stock because they expect the value of the company to increase in the future, and at a high enough rate to compensate for the lack of income (ignoring the tax impact).

The price for a stock of mature companies is usually (but not always) based on recent earnings. If Apple’s profits grew at, say, 4%, its stock price would plunge, but are all stock movements rational? What happened in 2008 to cut the value of Apple in half (especially considering its record earnings during that period)?

So the question of Twitter’s valuation is not what it is earning today or even next year, but how quickly it’s valuation will grow over, say, the next 5-10 years. But no one can project that. If I were to invest in Twitter, for example, I might agree to buy it at a $1B valuation but not a $10B valuation.

What makes Twitter attractive at $1B is that in 5 years it could be valued at $20B or $0. Even if it had a 2/3 chance of failing in the next 5 years and a 1/3 chance of major growth, it would still be an easy buy. At a $10B valuation, it’s not so easy but still results in a projected return of 6%. What is the right number? I have no idea and that’s why the range in its valuation is so large. The valuation has to account for risk in some way.

The major problem facing Twitter is the ease of entry into its market. So far, with the help of corporate america, the entertainment industry and the media, Twitter gets a lot of free publicity. While a lot of people don’t know what the point of Twitter is, most people have at least heard of it while they couldn’t name a single competitor.

Yahoo’s problem is somewhat different as it hasn’t kept pace with its competitors, which include Google and Microsoft. I think we can ignore the valuations from 2000 as they didn’t include any sort of rational benchmarks. Will Facebook be able to fend off competition from Google?

Interesting times to say the least, but it is (in my opinion) in no way similar to the dot com era of 2000. Back then, changing the name of a company to include a dot com could increase its valuation by over 50%.

Posted by unmasked | Report as abusive
 

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