A couple of months back, Facebook shook the world with their billion dollar Instagram acquisition, days before going public. As if that didn’t cause enough furore, Facebook’s stocks tanked soon after going public, inviting sharp criticisms from all ends. It sounds too much like the .com bubble of the late ’90’s, the last time the early world of web apps messed up our economy.
Some people even started predicting doom and the end of the world as we know it. Okay, I made that up. But I can’t quite make peace with the fact that Instagram, a company which had only been around for a year and a half now, and made zero profit, is worth a billion dollars.
Outrageous, one might say! But knowing Zuckerberg’s working style and Facebook’s history, I believe there must be some reason behind this seemingly irrational move. In this article, we’ll try to understand how product valuation works, what is an economic bubble, and more importantly, why Instagram.
Before digging too much deeper, it’s essential to have a basic idea of a “bubble”. A bubble is a “trade in high volumes at prices that are considerably at variance with intrinsic values”, to quote Wikipedia. Essentially, a bubble happens when the price of a product has been inflated artificially to meet the seller’s needs.
Let’s assume Jon Doe is a fruit vendor, a greedy one at that. He purchases a box of apples for $50 from the market. Usually vendors keep a profit margin of 15-20%, and use that to set their price. But our Jon is so greedy that he wants all the money for himself and decides to sell it at $100. Seeing this other vendors will follow suit and charge the same price. This is called Artificial Inflation or even a bubble.
To make more profit, our greedy Jon Doe buys more apple and stocks them. But when the customer realises that a fruit vendor has taken him for a ride, he’ll never go back to that shop again. Jon Doe knows that apples are perishable and can’t be stocked for long. He has to sell off his stock or face a huge loss. All he can do now is to minimize the loss, and sell the product at a throw-away price. This is called as market correction or in this case, the bubble burst.
Actually, things are not so different in the real world. Brokers create an artificial hype around a certain stock and when many people go and buy that stock, it creates an artificial demand. As always, price rallies with demand and as people see a bullish trend they buy more stock. But this extra value is artificial and not the real value of the stock. It’s inevitable for a market correction, and when that happens, stocks plummet, as people try to reduce their losses by selling off their stock. This invokes a sharp decline in the stock market, and ultimately a market crash, as it happened during the dot-com bubble.
Determining the Value of a Product
Deciding a value of a company or a product is one of the most challenging tasks. There are many intrinsic and extrinsic factors to consider. For an investor, all that matters is the ability of his investment to mint money. On the other hand, for an acquirer, it is the business value that comes along.
Photoshop is an indispensable tool for pros, but for a casual user the price is way too steep. The reach of Photoshop is rather limited (when compared to its free alternatives) and yet it forms a major chunk of Adobe’s income. On the other hand GIMP is free and a pretty solid alternative to Photoshop, but its revenue is nil. If I’m looking to buy/invest on a product that will bring me millions of dollars, the obvious choice would be Photoshop. But for an Adobe rival trying to build a commercial alternative for Photoshop, it would make sense to commercialize GIMP and steal its user base.
As with any technical product there is a steep cost involved with its maintenance. That also needs to be taken into account before evaluating the product. Typically we’d draw a graph with a cost to business value ratio. If you’re interested in learning more about valuations, Software Insider has a wonderful post, for you.
Now, the Billion Dollar Question: Why Instagram?
Before jumping to conclusions, let’s try to understand what made Instagram what it was. Instagram is a photo-sharing app for iOS and Android devices. The sheer fact that it has 30 million users worldwide in itself should talk about its awesomeness, so I’m not going to bore you with that.
As lovable as it is, Instagram has not made a single penny till date. Yes, you heard me. They, like Facebook in their second year, were relying on investor help to meet their expenses. If it doesn’t have a solid business model, why bother buying it? Could it be because of their strong user base? Nope! I’m pretty sure that 99%, if not all, of Instagram’s users would’ve a Facebook account already. No good there.
Facebook might have ruled the web, but the world has come a long way since the iPhone. Smartphones and tablets have invaded our lives in many ways than we would have ever imagined, and recent studies have shown that Facebook, despite its best engineers, is yet to take off on the mobile fore. Some have even predicted that this would be the battle where Facebook dies. Now with Instagram under its belt, Facebook has a strong foot in the mobile race.
Another thing is until now Instagram was an indirect threat to Facebook. Instagram was more like a personal social network where people used to share stuff with only those mattered. And Instagram is really simple to use. With Pinterest growing ever more rapidly, it was just about time that Facebook did something to keep them alive in the game of simpler, photo-centric social networking
All these factors would’ve played in Zuckerberg’s mind before making this move.(And yes, just Zuckerberg. The board of directors were never involved.)
But wait: Where’d Facebook Get the Money?
Facebook has acquired more than 6 startups since the Instagram acquisition in April. But how does a free service get so much cash? Where is all the money from? Actually, Facebook makes more money than half the businesses on the planet put together. Let’s find out how.
Advertising forms a major chunk of Facebook’s revenue. Facebook offers a highly customized and sphisticated advertising service for businesses. Since your ads are shown to the most relevant people, with over 1/7th of the world’s population at your reach, it’s not surprising that many marketing folks are rallying behind Zuckerberg.
Facebook Credits is Facebook’s internal payment system, used for purchasing games and apps inside the social network. Today, it makes around 15% the social giant’s revnue, but it’s set to grow could perhaps eventually compete with Paypal.
Facebook was initially founded in 2004 and it took 5 sweet years for them to profit of any sort. They merely survived on investments until then. Emarketer has projected Facebook to earn $4bn in revenues this year. That’s a lot of money, but just to put things into perspective, it’s a little above $4 per user while Google makes over $30 per user. Now, don’t get me wrong. I don’t think Facebook is useless; it’s just that they’re not living up to their current potential, and could potentially be raking in much more money. But even with that, they still have more than plenty of cash laying around.
The Next Bubble is Here
No, don’t be silly. Is a billion dollars for a photo app outrageous, even if you have billions of dollars laying around? Yes, by all means. Will this have a huge impact? Nah! Let me elaborate.
In all fairness, you cannot blame Zuckerberg alone for this ambiguity. Instagram was valuated at $500 million bucks, just a few weeks before its acquisition. Even still, that would make the company worth $16.60/user, a seemingly impossible figure since Instagram had to date made $0 in revenue. But, as we’ve already seen, the cost of a product and it’s value are two different things. Instagram’s founders would’ve spend, at most, $50-60 million to create the app. Even if I give them a profit margin of 400%, that just comes up to $240 million. But, the value it adds to Facebook is enormous, while it would worth $0 to Rolls-Royce.
Basically, Facebook simply decided that Instagram was worth what it was to them. If it takes $1 per Facebook user to buy out an app they saw as a chief competitor, then by all means, they should do it.
With the delay due to the ongoing FTA investigation, it would seem that Facebook has made a stupid decision. But I see this as a very well executed business strategy, which will sure yield better results on the longer run. Whether Facebook paid too much to Instagram is irrelevant. All that matters now is who’s going to win this war between the tech giants. For now, Facebook appears to be on the winning side, thanks in part to their willingness to open their wallets.
Valuing companies and trying to justify stock decisions is so complicated that even the mathematicians get confused. The metrics used to valuate a product are dubious at best, and it requires a lot of effort to overcome these challenges. Until then we’d have to fight our way through these half-cooked calculations. The good thing is, one outsized valuation shouldn’t throw the entire economy into a tailspin.
What’s your take on this deal? Do you think it’ll change Facebook’s fortune, or the fortunes of other startups waiting to get bought out or go public? We’d like to hear your thoughts. Do join us in the discussion below.