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Umar Saeed
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I’m a Chartered Accountant with a Master’s degree in financial accounting. I currently work for the Ontario government. Formerly, I was VP of Operations at Citco Fund Services, the largest hedge fund administrator in the world. Throughout my career I have provided an eclectic range of... More
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  • How to value a social network - Facebook, Twitter and LinkedIn

    From the film Social Network (2010), Mark Zuckerberg expresses his discontent with the idea of banner ads cluttering up the Facebook network to his business-minded partner:

     

    Mark Zuckerberg: Cause The Facebook is cool and if we start installing pop-ups for Mountain Dew it's not gonna be cool...

     

    Eduardo Saverin: Well I wasn't thinking Mountain Dew, but at some point, and I'm talking as the business end of the company, the site...

     

    Mark Zuckerberg: We don't even know what it is yet. We don't know what it can be. We don't what it will be. We know that it is cool. That is a priceless asset I'm not giving up.

     

    That is a fundamental reason that Facebook surpassed MySpace as the worlds leading social network in 2008. To make money, MySpace saturated its pages with banner ads. It wasn’t pretty. Facebook offered a clean alternative and people liked the experience better.

     

    Twitter, a remarkably different kind of social network, also remains more concerned about being cool and pleasing its users, as opposed to generate revenues and turning a profit. LinkedIn, having gone public first, is charging users fees for premium access, generally considered uncool among social networks. LinkedIn’s approach contrasts the mindset of the other “Web 2.0” companies. Facebook and Twitter have required tremendous faith on the part of private investors as demonstrating profitability is not their primary concern.

     

    Naturally, the investment community is skeptical of this approach. Everyone recalls how the old wave of technology companies tempted the investment community in exactly this way. They were told that traditional financial metrics were insufficient in valuing these companies. While investors have every right to be skeptical, to ignore the sheer power of social networks and dismiss them as being part of a bubble is to ignore a valuable intangible factor: the network effect.  The greater the network effect, the more indispensible it is to corporations that want to penetrate the network.

     

    At the same time, enhancing profitability through membership fees, blatantly selling personal information or pervasive direct advertising opens the doors for new social networks to replace the old ones. Social networks have to be cool in order for people to use them and corporations must depend on the information that they produce.

     

    Not all social networks are worth the risk. Unlike LinkedIn, Facebook and Twitter are more valuable because they understand and are committed to making money in a roundabout way. While revenues and profit are necessary, the way in which they are collected has to preserve the organic nature of the social network. It simply won’t work any other way.

     

    Facebook:

     

    To skeptics, the effectiveness of ads on Facebook is already disconcerting. A whitepaper issued by Webtrends indicates a diminishing click-through rate for ads on Facebook. In addition, Facebook’s click-through rates are a fraction of companies such as Google. 

     

    This isn’t surprising. If you’re having dinner with your friends talking about a trip to Toronto, you’re still going to be annoyed by some guy who interrupts your dinner to tell you about great flight deals to Toronto. It’s not cool. You’ll stop dining there if the ads get in your face. This only supports the notion that conventional advertising ideas won’t work on Facebook, but it doesn’t diminish the need for advertisers to have a thriving Facebook.

     

    To fully understand the value of Facebook to advertisers, it’s important to understand something called Memetics*.  This concept is instrumental in explaining brand advertising. The idea is to saturate your mental space with ads, because over time, you will recognize that brand and are more likely to buy it.

     

    As of now, advertisers don’t have to pay for the most valuable marketing happening on Facebook. People voluntarily share commercials on Facebook, making the Old Spice guy an icon. They voluntarily endorse brand pages, information that is relayed to friends through the network. This means a great deal of brand marketing doesn’t appear on advertising expenditures for firms.  The fact that people are personally endorsing brands is priceless to advertisers. That is what makes the social network indispensible to them, and why they will ultimately have to pay to keep Facebook alive and well.

     

    Twitter:

     

    Initially, Twitter was the most puzzling social network when it came to deciphering its usefulness. Now, it appears to have unlimited dimensions of use compared to any other social network. It is old news that hedge funds are using Twitter to assess market sentiment regarding specific stocks in order to profit from it, but that is only one way of mining millions of tweets for information in a real time fashion. Companies are building the technological infrastructure to be able to mine this data more effectively.

     

    Twitter is impersonal and simple, making it inviting and dynamic. Regardless of the subject, Twitter is positioning itself to provide the raw data representing human sentiment. It takes a poll without asking people to take a poll. For those that know how to exploit it, Twitter provides an information advantage. To corporations that are building the technological infrastructure to capitalize on this information, Twitter is becoming indispensible.

     

    LinkedIn:

     

    LinkedIn has much less potential than Twitter and Facebook. Simply put, there’s nothing cool about it. It is trying to be the Facebook of the business world. Unlike Facebook, people don’t spend countless hours on the website. It’s as valuable as an interactive Rolodex.
     

    There aren’t many indirect benefits stemming from the network, which limits its future growth. It isn’t indispensible to corporations, which limits the fees it can charge. Many Seeking Alpha contributors have already demonstrated how it has been overvalued since its IPO. Using fundamental analysis in this case is more appropriate, because there aren’t a myriad of ways in which LinkedIn can potentially make money. Its function is well defined and limited.

     

    Finding Value:

     

    So it appears that the social networking companies worth valuing are impossible to value. They continue to demonstrate their relevance to members and establish themselves as necessities to a variety of social information users, but have yet to draw clear lines as to how they will make profits.

     

    Most financial information remains private and when it does leak to the public, it underwhelms. Probably most disconcerting is how the argument of growth potential as value echoes the investment mistakes made a decade ago.

     

    There are some positive signs, however. The last several years has seen a shift towards Internet advertising from other media.  Facebook and Twitter stand to benefit from that.

     

    Private markets are not efficient, but they do indicate that investors privy to the books and records of Facebook and Twitter have enough faith to continue pouring money into these ventures. Admittedly, this isn’t the best indicator of value as the IPO in-and-of-itself often assures private investors a profit, regardless of how outrageous their valuations may be.

     

    By taking these private transactions and dividing them by the number of users on each social network, Facebook’s value is over $150/user, LinkedIn over $100/user while Twitter is only $40/user (despite having more users than LinkedIn).  Such crude metrics make things comparable, but if you’re wrong about one, you’re going to be wrong about all of them – by a lot. At this stage, numbers provide no comfort. The reality is valuing a social network is more of an art than science.

     

    Indeed, social networks are a different kind of animal. Facebook and Twitter remain patient as users become more vested in using them and corporations become more dependent in the information they provide. As they wait, the networks are growing in size and in the ways in which they are used. While the business model appears convoluted, power has always had predictable relationship with dependency. You hold power over those that depend on you.

     

    It’s important to remember that not every single stock in the last technology bubble was a bust. The most resilient ideas made it through and larger media corporations paid great premiums to purchase and control them. Given that LinkedIn, the company with the weakest network effect of the three, still trades at a handsome premium a month after its IPO, one can only imagine the prices that Twitter and Facebook will command upon their IPOs.

     

    There will be no fundamental valuation that will justify the price of Facebook or Twitter shares when they go public. But for those who have the appetite for the risk, setting aside capital to purchase shares may be worth it. Assess a social network’s value by determining how much other corporations will depend on its existence. Judge a social network’s resiliency by its commitment to staying cool.

    __________________

    *Memetics: 

    The term Memetics was coined by Richard Dawkins in the final chapter of his book The Selfish Gene, where he suggested that ideas (“memes”) may evolve in the same way as genes. The implications of the theory is that ideas, thoughts, opinions spread through propagation and exposure, and have little to do with logic or reason.

     

    There are philosophical problems with the theory. For example, how do you reduce an idea down to a single meme? Ideas don’t simplify themselves in the same way as physical matter. However, philosophical inconsistencies don’t diminish the explanatory value of the theory.

     

    For example, at one point the scientific community believed Atoms were the smallest units of matter. When the electron was discovered, the theory changed but that didn’t diminish value of Atoms in explaining the construction of matter. Ultimately, using Atoms to explain physical matter is still valid, but not complete. Memes can be thought of in a similar way to explain ideas, thoughts, beliefs and how these ideas are propagated from one mental space to another.

     



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
    Jun 24 12:10 PM | Link | Comment!
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