Latepost Facebook Buys Whatsapp For $19 Billion: Value In Addition To Pricing Perspectives

This week, I was at the Tuck School of Business at Dartmouth, talking nigh the departure betwixt toll as well as value. I built the presentation around ii points that I receive got made inward my posts before. The showtime is that in that location are ii dissimilar processes at operate inward markets. There is the pricing process, where the toll of an property (stock, bond or existent estate) is prepare yesteryear demand as well as supply, amongst all the factors (rational, irrational or only behavioral) that larn amongst this process. The other is the value procedure where nosotros travail to attach a value to an property based upon its fundamentals: cash flows, growth as well as risk. For shorthand, I volition telephone telephone those who play the pricing game “traders” as well as those who play the value game “investors”, amongst no moral judgments attached to either. The 2d is that spell in that location is absolutely cypher incorrect or shameful nigh beingness either an investor  (No, you lot are non a stodgy, boring, stuck-in-the-mud erstwhile fogey!!) or a trader (No, you lot are non a shallow, brusk term speculator!!), it tin give notice locomote unsafe to mean value that you lot tin give notice command or fifty-fifty explicate how the other side works. When you lot are wearing your investor cape, you lot tin give notice locomote mystified yesteryear what traders exercise as well as react to, as well as if you lot are inward your trader mode, you lot are only equally in all probability to locomote bamboozled yesteryear the idea processes of investors. So, at the risk of ending upwards amongst a split personality, allow me examine looking at Facebook’s acquisition of Whatsapp for $19 billion, amongst $15 billion coming from Facebook stock as well as $4 billion from cash, using both perspectives.

The Investor/Value View

I volition start wearing my value cap, to a greater extent than oft than non because I experience to a greater extent than comfortable inward it as well as partly because I sympathise it better. Looking for fundamentals to justify the toll paid but I realized really chop-chop that this would non only locomote futile but frustrating as well as hither is why. To justify a $19 billion value for a companionship inward equity markets today, you lot would postulate that companionship to generate nigh $1.5 billion inward after-tax income inward steady state. 

Value of equity = $19 billion

Implied required render on equity, given how stocks were priced on 1/1/14 = 8.00% (a 5% equity risk premium on plow over of a 3% risk gratis rate)

Steady soil earnings necessary to justify value = $ nineteen billion *.08 = $1.52 billion

Steady soil pre-tax earnings needed to justify value, using an effective taxation charge per unit of measurement of 30%= $1.52 billion/(1-.30) = $2.17 billion

That would interpret into pre-tax income of nigh $2.2 billion as well as it is a lowball approximate of interruption fifty-fifty earnings, since the interruption fifty-fifty break volition increase, the longer you lot receive got to hold off for steady soil as well as the to a greater extent than risk in that location is inward the occupation concern model. Using a 10% required render (reflecting the higher risk) as well as edifice inward a waiting menstruum of five years before the income gets delivered increases the break-even income to $4.371 billion. You can examine the spreadsheet amongst your inputs, if you lot as well as so desire, to run into what your break-even earnings approximate volition be.

There are 3 pathways to delivering these break-even earnings:

1. If the companionship continues its electrical flow occupation concern model of allowing people to examine the app for gratis inward the showtime twelvemonth as well as accuse them a dollar a twelvemonth after that (99 cents) as well as has null operating costs (completely unrealistic, I know), you lot would postulate nigh 2.5 billion people using the app on a continuing basis.  
2. It is possible that the app is as well as so proficient that you lot could accuse to a greater extent than per twelvemonth as well as non lose customer. At their existing user base of operations of 450 million, that would interpret into nigh $5/year  per user, if you lot receive got no costs, as well as more, if you lot receive got costs (which you lot clearly will).
3. The value may locomote inward the shape of advertising revenues from Whatsapp’s users but that volition locomote tricky. On the abode page for the app, hither is what the app’s developers say nigh advertising:

While they may non locomote legally jump yesteryear this statement, it volition locomote awkward to walk it dorsum as well as start sending text ads. However, in that location is a dorsum door that Facebook may locomote able to user, if they tin give notice depict Whatsapp’s users (who tend to locomote younger) into the Facebook ecosystem as well as advertise to them there. Whatever the model, though, you lot would yet receive got to generate at to the lowest degree $2.2 billion inward after-tax income from advertising to Whatsapp users to interruption even.

As an investor, the fact that a pregnant portion of Whatsapp's client is teenagers is terrifying equally a occupation concern proposition. While it is unfair to generalize based on anecdotal evidence, equally the manlike individual rear of iv children, ii of whom used to locomote teenagers as well as ii of whom are inward the total throes of the illness (with symptoms ranging from extreme self-centeredness to volatile mood swings), it seems to me that the only grouping that is less dependable (and predictable) than teenagers is a grouping of teenagers who text a lot.

At this stage, if you lot are an investor, you lot receive got ii choices. The showtime as well as less damaging 1 is to select that social media investing is non your game as well as displace on to other parts of the market, where you lot tin give notice notice investments that you lot tin give notice justify amongst fundamentals. The 2d is to larn from frustration (at beingness unable to explicate the price) to righteous anger or indignation nigh bubbles, irrationality as well as brusk term traders to trading on that anger (selling short). I would strongly recommend that you lot non larn downwards this path, since it volition non only locomote damaging to your physical wellness (it is a certainly burn means to ulcers as well as heart attacks) but it may locomote fifty-fifty to a greater extent than as well as so for your fiscal health. While you lot may locomote correct nigh the value inward the long term, the pricing procedure rules inward the nigh term. 

The Trader (Pricing) View

Wearing my trading hat, though, the Facebook acquisition for Whatsapp may non only brand consummate sense, but it may truly locomote viewed equally a positive. To sympathise why, I had to alter my mindset from thinking nigh fundamentals (earnings/cashflows, growth as well as risk) to focusing on what the marketplace seat is basing its toll on. To notice that “pricing” variable, I looked at the marketplace seat prices of social media company, multiple measures of their success/activity as well as tried to dorsum out the drivers of both toll differences as well as toll movements.

These companies receive got dissimilar occupation concern models as well as may fifty-fifty locomote inward dissimilar businesses but remember that the pricing game may non locomote nigh what you lot as well as I (as investors) mean value makes feel but what traders tending about. Though the ii (what makes feel as well as what markets focus on) may sometimes converge, they don’t receive got to, at to the lowest degree for the moment. My simplistic travail at making feel of marketplace seat prices was to facial expression at the correlation betwixt the market's assessment of corporate values as well as each of the measures for which I had data:

Based on this correlation matrix, hither are the conclusions I would draw:

1. Number of users is the dominant driver: The key variable inward explaining differences inward value across companies is the break of users. While the value side of you lot may locomote telling you lot that you lot cannot pay dividends or purchase dorsum stock amongst users (you postulate cash flows), cry upwards that the pricing game is non nigh what you lot or I mean value makes feel but what traders tending about. This is reinforced yesteryear marketplace seat reactions to earnings announcements, amongst Zillow seeing its stock toll climb 12% when it reported earnings on Feb 14, 2014, primarily on the intelligence that they added to a greater extent than users than expected as well as Twitter seeing its stock toll drib 25% terminal week, in 1 lawsuit again primarily on intelligence that the user base of operations grew less than expected.
2. User appointment matters: The value per user increases amongst user engagement. Put different, social media companies that receive got users who remain on their sites longer are worth to a greater extent than than companies where users don’t pass equally much time. While making comparisons across companies is difficult, since each companionship oft has its ain "measure" of engagement, in that location is bear witness that markets tending nigh this statistic. For instance, some other argue Twitter was punished after its terminal study was that investors believed that the "timeline views per average user" as well as the "revenues per one 1000 timeline views" reported the companionship were lower than they had anticipated.
3. Predictable revenues are priced higher than to a greater extent than diffuse revenues: Some of the companies on this listing derive revenues exclusively from advertising, some from a mix of advertising as well as subscriptions as well as some from only subscriptions. In fact, some similar Zynga brand their revenues from retailing (in game purchases). While the sample is also modest to depict rigid conclusions, the value per user of $577 attached to Netflix's users suggests that the marketplace seat values predictable subscription revenues to a greater extent than than uncertain advertising or retail revenue.  
4. Making coin is a secondary concern (at to the lowest degree for the moment): Markets (and investors) are non completely off kilter. There is a correlation betwixt how much a companionship generates inward revenues as well as its value, as well as fifty-fifty 1 betwixt how much coin it makes (EBITDA, cyberspace income) as well as value. However, they are less related to value than the break of users.

So, what's next?
Following inward the footsteps of my favorite baseball game full general manager, Billy Beane, its fourth dimension to play some Moneyball, where nosotros allow the information drive our actions, rather than our intellects. Here is what I select out of these numbers:

1.  If you lot are an investor, halt trying to explicate toll movements on social media companies, using traditional metrics – revenues, operating margins as well as risk. You volition only drive yourself into a frenzy. More important, don’t assume that your rational analysis volition create upwards one's hear where the toll is going side yesteryear side as well as deed on it as well as merchandise on that assumption. In other words, don’t sell short, expecting marketplace seat vindication for your valuation skills. It won’t come upwards inward the brusk term, may non come upwards inward the long term as well as you lot may locomote bankrupt before you lot are right.
2. If you lot are a trader, play the pricing game as well as halt deluding yourself into believing that this is nigh fundamentals. Rather than tell me stories nigh hereafter earnings at Facebook/Twitter/Linkedin, brand your buy/sell recommendation based on the break of users as well as their intensity, since that it what investors are pricing inward correct now.
3. If you lot are a companionship as well as you lot wishing to play the pricing game, I mean value that the key is to notice that "pricing variable" that matters as well as examine to deliver the best results you lot tin give notice on that variable.

Returning to the Facebook/Whatsapp deal, it seems to me that Facebook is playing the pricing game, as well as that recognizing that this is a marketplace seat that rewards you lot for having a greater break of to a greater extent than involved users, they receive got gone after a companionship (Whatsapp) that delivers on both dimensions. Here is a really simplistic means to run into how the bargain tin give notice play out. Facebook is currently beingness valued at $170 billion, at nigh $130/user, given their existing user base of operations of 1.25 billion. If the Whatsapp acquisition increases that user base of operations yesteryear 160 1000000 (I know that Whatsapp has 450 1000000 users, but since its revenue options are express equally a standalone app, the value suggestion hither is inward incremental Facebook users), as well as the marketplace seat continues to toll each user at $130, you lot volition generate an increment inward marketplace seat value of $20.8 billion, higher than the toll paid. Are in that location lots of "ifs" inward this deal? Sure, but it does simplify the explanation. 

Are in that location dangers inward this deal? Of course! First, it is possible (and mayhap fifty-fifty probable) that the marketplace seat is over estimating the value of users at social media companies across the board. However, Facebook has buffered the blowback from this occupation yesteryear paying for the mass of the bargain amongst its ain shares. Thus, if it turns out that a twelvemonth or ii from instantly that reality brings social media companies dorsum downwards to earth, Facebook would receive got overpaid for Whatsapp but the shares it used on the overpayment were also over priced. Second, equally social media companies displace upwards the life cycle, the variable(s) that fifty-fifty traders user to toll companies volition alter from break of users/user intensity to revenues, earnings as well as cash flows. When that happens, in that location volition locomote a repricing of social media companies, amongst those that were most successful inward turning users into revenues/earnings beingness priced higher. This, after all, is what happened inward an before iteration amongst dot com companies that went from beingness priced based on website visitors (analogous to break of users) to beingness priced based on how long those visitors looked at your website (paralleling user intensity) to how much they generated inward revenues before settling into earnings. The occupation for companies (and investors) is that these transitions occur unpredictably as well as that markets tin give notice shift abruptly from focusing on 1 variable to another. For Facebook, the path to success amongst this bargain is hence simple, albeit non easy. Start yesteryear trying to attract Whatsapp users to the Facebook ecosystem, as well as promise as well as pray that the market's focus stays on the break of users for the nigh term. Follow upwards yesteryear trying to monetize these users, amongst advertising revenue beingness the obvious forepart halt but mayhap other sources equally well.

Closing Thoughts

My experience amongst markets has been that no 1 has a monopoly on virtue as well as proficient feel as well as that the hubris that leads to absolute conviction is an invitation for a marketplace seat take-down. To investors who persuasion deals similar the Whatsapp acquisition equally bear witness of irrational exuberance, cry upwards that in that location are traders who are laughing their means to the bank, amongst the profits that they receive got collected from their social media investments. Similarly, for traders who persuasion fundamentals as well as valuation equally games played yesteryear eggheads as well as academics,  recognize that mood as well as momentum may locomote the dominant factors driving social media companies correct now, but markets are fickle as well as fundamentals volition affair (sooner or later).

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