A few days ago, I came across an interesting post by Ashwath Damodaran on the $19 billion Facebook-Whatsapp deal. For those who aren’t familiar with him, Ashwath Damodaran is a Professor of Finance at the Stern School of Business and is one of the world’s leading experts on valuation. First off, I have tremendous respect for his work and I could never hope to match his knowledge about the world of finance. That said, I do understand asymmetric competition and this post truly shows how futile traditional valuation methods can be (especially discounted cash flow) when valuing acquisitions that pose such a threat to an incumbent.
Let me start with an (overly) simplistic explanation of discounted cash flow (DCF) valuation for readers with a non-finance background. A DCF analysis begins with a 3-5 year forecast of the company’s cash flows (based on certain assumptions) and a “terminal value” at the end of this period. This terminal value is either based on an assumption of steady state growth of 4-10% or a revenue or earnings multiple. To get to the current value of projected cash flows, these figures are then discounted by the “cost of capital” or opportunity cost, i.e. the return one could expect if the same funds were put into an alternative investment opportunity with a similar risk profile (e.g.: alternative acquisition/investment, stock buyback, etc.).
This methodology suffers from two problems — 1) Realistic cash flow forecasting requires extremely good business model comprehension and industry knowledge, and 2) It suffers from a “status quo bias”, i.e. the cost of doing nothing is ignored. Let’s take a deeper look at these problems:
Business Model Comprehension
There are three pathways to delivering these break-even earnings:
- 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.
- 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)
- The value may be in the form of advertising revenues from Whatsapp’s users but that will be tricky.
Now, this may be a good way to value Whatsapp as a standalone entity. Because of their conservative business model, their intrinsic value is unlikely to even cross $1 billion. The problem here is that he assumes there are just two ways to monetize Whatsapp even after the Facebook deal – 1) Subscription (the current, subpar model), and 2) Advertising (unviable for a messaging app).
As I explained in my previous post, it is abundantly clear that neither is being considered. Alternative monetization models (distribution platform for digital commerce, direct marketing channel for brands) have already been attempted and proven by Whatsapp competitors like LINE, KakaoTalk and WeChat. How successful have they been? LINE, one of Whatsapp’s biggest competitors, is readying an IPO that could value it at more than $10 billion. Here’s a snapshot of LINE’s financial performance:
In less than 3 years, LINE’s annual (2013) revenues reached ~$340 million, more than double the $153 million that Facebook generated at the same point in its lifecycle (2007). In Q4 2013, LINE’s annual revenue run rate reached roughly $480 million, far more than Facebook’s $272 million full-year revenue in 2008. This clearly shows that the scale and monetization potential of mobile services is unlike anything we’ve seen before.
The Cost of Doing Nothing
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.
In closing, let me leave you with this thought — Assuming it was viable, imagine what BlackBerry would look like today if they bought Apple in 2008 and let them run independently. While that analogy is far from perfect, it does get my point across.
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