Recently, in a conversation with another investor, I referred to a company’s management as being “extremely honest.” I was corrected, that honesty is binary and cannot be described with an adjective — a person is either honest or not.
The same applies to the word insane — you cannot be insane a little. Insane is, however, the word I would use to describe the valuation that Facebook (FB) paid for WhatsApp. You see, beyond a certain point at which the boundaries of reason have been thoroughly breached, quantifying the valuation paid for WhatsApp is like putting an adjective in front of infinity.
A couple of years ago, Facebook paid $1 billion for online photo-sharing service Instagram. Everyone (including present company) thought that valuation was extremely insane, since Instagram had little to no revenue. I was wrong; now that purchase just looks insane. When a business has no earnings and little potential for significant earnings, the line between reasonable and insane becomes nebulous.
Facebook paid $1 billion for about 50 million Instagram users in 2012, so maybe the correct price tag for nine times as many WhatsApp users (450 million) should be nine times that for Instagram, or $9 billion. See, I just figured it out: The $19 billion price tag for WhatsApp is only two times plus $1 billion insane, whereas at $4.5 billion, WhatsApp would have been only one-half insane. (Maybe the Instagram price tag should be the new standard insanity quotient: Facebook shelled out $20 million per million pairs of eyeballs.)
There are at least two problems with price-per-eyeball valuations. First, not all eyeballs can be monetized in the same way — revenue and profit per user may be very different. Second, today’s user is tomorrow’s ex-user. Using WhatsApp text messaging might have made sense in the U.S., for instance, when text messages were not free. At the beginning of February, however, AT&T most likely started a trend by giving away text messaging with every mobile line service. It is just a matter of time before this will take hold globally; it’s happening in Europe already.
If you have a cell phone, you have text messaging, so if your provider starts offering free texting, your cost to switch from WhatsApp to your carrier is zero. So do you think there will be 1 billion or even 10 million WhatsApp users in two years? I have no idea, but neither number seems far out on the tail of the probability spectrum.
But let’s be honest. The $19 billion that Facebook CEO Mark Zuckerberg is paying for WhatsApp was only partially real money (cash). A big chunk of the WhatsApp price was paid in Facebook stock — Monopoly money. After all, Facebook stock trades at 20 times revenue.
Here is a paradox that can only occur in the wild, weird, wacky (WWW) world of investing: The less money you make, the higher your valuation and the less insane and dilutive (priced out of this world) acquisitions look.
In fact, after a certain point, if the price you pay is high enough, insanity starts to be confused with genius. It is almost like a contemporary painting. If you stare at it long enough, you will start doubting yourself and your so-called rational mind. Perhaps you are a simpleton who has not attained the empyrean heights of the brilliant artist, who comprehended things that you — a mere mortal — did not even have grounds to suspect.
And maybe young Zuck can pull $19 billion of cash flows out of WhatsApp over the next 20 years. There may be a multitude of hidden synergies between the few dozen WhatsApp staffers and the Facebook multitudes. Or maybe Zuck can cut costs by laying off all 19 WhatsApp engineers who just cost him $1 billion a pop. Or maybe he should integrate WhatsApp into Facebook so a grandfather who is big into Facebook can text his granddaughter who has moved on to another social network. If you stare at this acquisition long enough, your imagination sort of runs away with you. But maybe we’ve seen this movie before, back in the ’90s, and this time is not different.
I am concerned about this acquisition, not because it may end up being the biggest and fastest write-off of goodwill in human history — I’ll let Facebook shareholders worry about that — but because it just raised the valuation plank for every itty-bitty start-up in Silicon Valley. I can just see how the last three slides in all these fledgling companies’ PowerPoint presentations — the ones that talk about valuations — are being reworked, and price-to-infinity is being doubled or quadrupled.
I am concerned about the impact WhatsApp will have on the stock market valuation. Tesla Motors (TSLA) and Netflix (NFLX) just became deep-value stocks, too (especially on the price-to-user metric). But I am even more concerned that tech companies, of which we own plenty, will start paying nosebleed prices for start-ups that come to the table with little more than eyeballs and promises.
About the author:
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).