Jul 8, 2012

How did Zuckerberg value Instagram?

I wondered how Facebook came up with $1B figure for Instagram.  For example, do you value Instagram based on its revenues? Or how do you get $1B from number of users Instagram had?

A few weeks before Facebook announced its acquisition of Instagram, I wrote a blog about what problem instagram solves, and concluded that there is huge value in delivering abstract stuff like beauty. Specifically, I wrote:

"Increasingly, products with the highest value offering will be those that allow people to experience beauty, meaning, transformation, values which are not forefront when more mundane problems persist. But, as people increasingly cover the 'basic needs', demand for such abstract items will rise."

This made me wonder about the valuation logic in Silicon Valley. How does a brilliant entrepreneur and hacker like Mark Zuckerberg (or Twitter's Jack Dorsey) think about valuing assets that they acquire?

I thought back to some common methods for valuing stuff in the business world.

1. Discounted cash flows (DCF) - discounts future cash streams
2. Comparables - uses similar deals as benchmark
3. Options - applies some fancy math to financial instruments ... and assumes normal distribution
4. Customer lifetime value (CLV) - tries to value the customers
5. Gut

1. DCF - From what I understand, the Wall Street-types love using something called discounted cash flows method to value an asset. Asset is anything that will make you money today or later. In short, discounted cash flows values an asset by all the money that asset might bring you today and in the future, and then "discounts" the value of all that money to adjust for inflation. (Inflation - you know, a 12 oz Coke used to be 50 cents, but is now a $1 at a vending machine.)

So, if you use discounted cash flows, Instagram value is $0. Why? Because they weren't really generating cash flows.

2. Comparables - this isn't a bad way to get a baseline. But, what other deal was like Instagram? Has Instagram been sold and traded before? Nope.

3. Options - this usually applies to trade of commodities and financial assets (remember the movie Trading Places?). No help here.

4. CLV - okay, this one is a bit more promising. (This model works well when subscription is involved - like Netflix or newspapers.) I tried to imagine Zuckerberg doing the math in his head. Let's say Instagram had about 40M users at the time of acquisition. $1,000M / 40M users = $25 / user. 
(For comparison, here's a Quora answer on the lifetime value of a Netflix customer.)

But, then think about the fact that once acquired, Instagram has access to Facebook's user base (let's round up and say it's 1 billion).  Let's do the math again. $1B / 1B users = $1 per user. A $1 per person! Do you think you could squeeze out $1 over the lifetime of a Facebook-Instagram user if you were Zuck? Do cats meow?  

Image from techi.com - 4/10/12 post

5. Gut - okay, there's not much science here.  Clearly, none of the above methods are going to give you a true answer.  I'm beginning to learn that there is a healthy amount of going by the gut in Silicon Valley.  Give it a try.  Next time you have to make a decision, try the back of the napkin, but also listen to your gut!

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