Facebook buys Whatsapp for $19 billion: Value and Pricing Perspectives
From Aswath Damodaran’s Musings on Markets Blog
Thursday, February 20, 2014
http://aswathdamodaran.blogspot.com/2014/02/facebook-buys-whatsapp-for-19-billion.html
This week, I was at the Tuck School of Business at Dartmouth, talking about the difference between price
and value. I built the presentation around two points that I have made in my posts before. The first is that
there are two different processes at work in markets. There is the pricing process, where the price of an
asset (stock, bond or real estate) is set by demand and supply, with all the factors (rational, irrational or
just behavioral) that go with this process. The other is the value process where we attempt to attach a
value to an asset based upon its fundamentals: cash flows, growth and risk. For shorthand, I will call
those who play the pricing game “traders” and those who play the value game “investors”, with no moral
judgments attached to either. The second is that while there is absolutely nothing wrong or shameful
about being either an investor (No, you are not a stodgy, boring, stuck-in-the-mud old fogey!!) or a trader
(No, you are not a shallow, short term speculator!!), it can be dangerous to think that you can control or
even explain how the other side works. When you are wearing your investor cape, you can be mystified
by what traders do and react to, and if you are in your trader mode, you are just as likely to be
bamboozled by the thought processes of investors. So, at the risk of ending up with a split personality, let
me try looking at Facebook’s acquisition of Whatsapp for $19 billion, with $15 billion coming from
Facebook stock and $4 billion from cash, using both perspectives.
The Investor/Value View
I will start wearing my value cap, mostly because I feel more comfortable in it and partly because I
understand it better. Looking for fundamentals to justify the price paid but I realized very quickly that this
would not only be futile but frustrating and here is why. To justify a $19 billion value for a company in
equity markets today, you would need that company to generate about $1.5 billion in after-tax income in
steady state.
Value of equity = $19 billion
Implied required return on equity, given how stocks were priced on 1/1/14 = 8.00% (a 5% equity risk
premium on top of a 3% risk free rate)
Steady state earnings necessary to justify value = $ 19 billion *.08 = $1.52 billion
Steady state pre-tax earnings needed to justify value, using an effective tax rate of 30%= $1.52 billion/(1.30) = $2.17 billion
That would translate into pre-tax income of about $2.2 billion and it is a lowball estimate of break-even
earnings, since the break even number will increase, the longer you have to wait for steady state and the
more risk there is in the business model. Using a 10% required return (reflecting the higher risk) and
building in a waiting period of 5 years before the income gets delivered increases the break-even income
to $4.371 billion. You can try the spreadsheet with your inputs, if you so desire, to see what your breakeven earnings estimate will be.
There are three pathways to delivering these break-even earnings:
1. If the company continues its current business model of allowing people to try the app for free in
the first year and charge them a dollar a year after that (99 cents) and has zero operating costs
(completely unrealistic, I know), you would need about 2.5 billion people using the app on a
continuing basis.
2. It is possible that the app is so good that you could charge more per year and not lose customer.
At their existing user base of 450 million, that would translate into about $5/year per user, if you
have no costs, and more, if you have costs (which you clearly will).
3. The value may be in the form of advertising revenues from Whatsapp’s users but that will be
tricky. On the home page for the app, here is what the app’s developers say about advertising:
While they may not be legally bound by this statement, it will be awkward to walk it back and start sending
text ads. However, there is a back door that Facebook may be able to user, if they can draw Whatsapp’s
users (who tend to be younger) into the Facebook ecosystem and advertise to them there. Whatever the
model, though, you would still have to generate at least $2.2 billion in after-tax income from advertising to
Whatsapp users to break even.
As an investor, the fact that a significant portion of Whatsapp's customer is teenagers is terrifying as a
business proposition. While it is unfair to generalize based on anecdotal evidence, as the father of four
children, two of whom used to be teenagers and two of whom are in the full throes of the disease (with
symptoms ranging from extreme self-centeredness to volatile mood swings), it seems to me that the only
group that is less dependable (and predictable) than teenagers is a group of teenagers who text a lot.
At this stage, if you are an investor, you have two choices. The first and less damaging one is to accept
that social media investing is not your game and move on to other parts of the market, where you can find
investments that you can justify with fundamentals. The second is to go from frustration (at being unable
to explain the price) to righteous anger or indignation about bubbles, irrationality and short term traders to
trading on that anger (selling short). I would strongly recommend that you not go down this path, since it
will not only be damaging to your physical health (it is a sure fire way to ulcers and heart attacks) but it
may be even more so for your financial health. While you may be right about the value in the long term,
the pricing process rules in the near term.
The Trader (Pricing) View
Wearing my trading hat, though, the Facebook acquisition for Whatsapp may not only make complete
sense, but it may actually be viewed as a positive. To understand why, I had to change my mindset from
thinking about fundamentals (earnings/cashflows, growth and risk) to focusing on what the market is
basing its price on. To find that “pricing” variable, I looked at the market prices of social media company,
multiple measures of their success/activity and tried to back out the drivers of both price differences and
price movements.
These companies have different business models and may even be in different businesses but remember
that the pricing game may not be about what you and I (as investors) think makes sense but what traders
care about. Though the two (what makes sense and what markets focus on) may sometimes converge,
they don’t have to, at least for the moment. My simplistic attempt at making sense of market prices was to
look at the correlation between the market's assessment of corporate values and each of the measures
for which I had data:
Based on this correlation matrix, here are the conclusions I would draw:
1. Number of users is the dominant driver: The key variable in explaining differences in value across
companies is the number of users. While the value side of you may be telling you that you cannot
pay dividends or buy back stock with users (you need cash flows), remember that the pricing
game is not about what you or I think makes sense but what traders care about. This is reinforced
by market reactions to earnings announcements, with Zillow seeing its stock price climb 12%
when it reported earnings on February 14, 2014, primarily on the news that they added more
users than expected and Twitter seeing its stock price drop 25% last week, again primarily on
news that the user base grew less than expected.
2. User engagement matters: The value per user increases with user engagement. Put different,
social media companies that have users who stay on their sites longer are worth more than
companies where users don’t spend as much time. While making comparisons across companies
is difficult, since each company often has its own "measure" of engagement, there is evidence
that markets care about this statistic. For instance, another reason Twitter was punished after its
last report was that investors believed that the "timeline views per average user" and the
"revenues per 1000 timeline views" reported the company were lower than they had anticipated.
3. Predictable revenues are priced higher than more diffuse revenues: Some of the companies on
this list derive revenues entirely from advertising, some from a mix of advertising and
subscriptions and some from just subscriptions. In fact, some like Zynga make their revenues
from retailing (in game purchases). While the sample is too small to draw strong conclusions, the
value per user of $577 attached to Netflix's users suggests that the market values predictable
subscription revenues more than uncertain advertising or retail revenue.
4. Making money is a secondary concern (at least for the moment): Markets (and investors) are not
completely off kilter. There is a correlation between how much a company generates in revenues
and its value, and even one between how much money it makes (EBITDA, net income) and
value. However, they are less related to value than the number of users.
So, what's next?
Following in the footsteps of my favorite baseball general manager, Billy Beane, it’s time to play some
Moneyball, where we let the data drive our actions, rather than our intellects. Here is what I take out of
these numbers:
1. If you are an investor, stop trying to explain price movements on social media companies, using
traditional metrics – revenues, operating margins and risk. You will only drive yourself into a
frenzy. More important, don’t assume that your rational analysis will determine where the price is
going next and act on it and trade on that assumption. In other words, don’t sell short, expecting
market vindication for your valuation skills. It won’t come in the short term, may not come in the
long term and you may be bankrupt before you are right.
2. If you are a trader, play the pricing game and stop deluding yourself into believing that this is
about fundamentals. Rather than tell me stories about future earnings at
Facebook/Twitter/Linkedin, make your buy/sell recommendation based on the number of users
and their intensity, since that it what investors are pricing in right now.
3. If you are a company and you want to play the pricing game, I think that the key is to find that
"pricing variable" that matters and try to deliver the best results you can on that variable.
Returning to the Facebook/Whatsapp deal, it seems to me that Facebook is playing the pricing game, and
that recognizing that this is a market that rewards you for having a greater number of more involved
users, they have gone after a company (Whatsapp) that delivers on both dimensions. Here is a very
simplistic way to see how the deal can play out. Facebook is currently being valued at $170 billion, at
about $130/user, given their existing user base of 1.25 billion. If the Whatsapp acquisition increases that
user base by 160 million (I know that Whatsapp has 450 million users, but since its revenue options are
limited as a standalone app, the value proposition here is in incremental Facebook users), and the market
continues to price each user at $130, you will generate an increase in market value of $20.8 billion, higher
than the price paid. Are there lots of "ifs" in this deal? Sure, but it does simplify the explanation.
Are there dangers in this deal? Of course! First, it is possible (and perhaps even probable) that the
market is over estimating the value of users at social media companies across the board. However,
Facebook has buffered the blowback from this problem by paying for the bulk of the deal with its own
shares. Thus, if it turns out that a year or two from now that reality brings social media companies back
down to earth, Facebook would have overpaid for Whatsapp but the shares it used on the overpayment
were also overpriced. Second, as social media companies move up the life cycle, the variable(s) that
even traders user to price companies will change from number of users/user intensity to revenues,
earnings and cash flows. When that happens, there will be a repricing of social media companies, with
those that were most successful in turning users into revenues/earnings being priced higher. This, after
all, is what happened in an earlier iteration with dot com companies that went from being priced based on
website visitors (analogous to number of users) to being priced based on how long those visitors looked
at your website (paralleling user intensity) to how much they generated in revenues before settling into
earnings. The problem for companies (and investors) is that these transitions happen unpredictably and
that markets can shift abruptly from focusing on one variable to another. For Facebook, the path to
success with this deal is therefore simple, albeit not easy. Start by trying to attract Whatsapp users to the
Facebook ecosystem, and hope and pray that the market's focus stays on the number of users for the
near term. Follow up by trying to monetize these users, with advertising revenue being the obvious front
end but perhaps other sources as well.
Closing Thoughts
My experience with markets has been that no one has a monopoly on virtue and good sense and that the
hubris that leads to absolute conviction is an invitation for a market take-down. To investors who view
deals like the Whatsapp acquisition as evidence of irrational exuberance, remember that there are traders
who are laughing their way to the bank, with the profits that they have collected from their social media
investments. Similarly, for traders who view fundamentals and valuation as games played by eggheads
and academics, recognize that mood and momentum may be the dominant factors driving social media
companies right now, but markets are fickle and fundamentals will matter (sooner or later).