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Facebook purchase of Instagram bound to flop

Staff Columnist

Published: Friday, April 20, 2012

Updated: Friday, August 23, 2013 17:08

Facebook founder Mark Zuckerberg caught much attention last week when he announced via his Facebook page that he had bought Instagram, a smartphone app allowing users to apply retro filters to pictures and share them. The sale itself wasn’t so spectacular; rather it was the price Zuckerberg was willing to pay - $1 billion - that turned heads. This is a staggering amount to pay for a company that had a whopping 13 employees (just a single employee one year ago) and zero revenue to date. In perspective, Facebook could have opted to buy out the entirety of the New York Times at its current market cap and have money to spare. Started by a 28-year old with no formal programming education who claimed to have only taken eight weeks to build the app, the sale has quickly been put forward as the value of social media increases mobile and technocentric world. But I contend the social media is overvalued. Excitement about the future is clouding people’s judgment of reality.

Instagram isn’t really a new concept: sharing photos over the internet is as old as the internet itself. Applying filters to photos on-the-fly, albeit less advanced ones, (think almost) preceded smartphones. Combining those two ideas isn’t so profound. However novelty has gained traction, only to an extent. For comparison, OMGPOP, the company behind the popular virtual charades smartphone app, Draw Something, was purchased last month for $180 million. On its sale date, the game was yielding 14.6 million daily users, roughly 60 percent of its 22.4 monthly users, and was earning about $250 thousand per day. Instagram had only a small fraction of Draw Something’s daily users (1.7 million on its sale date) and these users were far less dedicated to the app (only 23 percent of monthly users being daily users) while earning the company no money. Yet somehow, while having not even one-eight the daily users, Facebook paid almost six times the price - a highly inflated valuation.

Facebook itself has been valued at highly inflated levels as well. In January 2011, Goldman Sachs gave Facebook a $50 billion valuation, at about 500 million users, for a value of about $100 per user. Meanwhile, revenues were only $4 per user and profits only $1 per user (that’s a 25 percent profit margin and a 100:1 price/earnings ratio). Now, with Facebook’s initial public offering (IPO) less than a month away, it has capped at around $100 billion on secondary markets, and roughly maintaining those same margins. In comparison, Google had a P/E of about 120:1 at IPO but grew to south of 20:1 today. In order for Facebook to make those gains, they will have to grow five-fold over the next several years. This will either have to be a five-fold increase in users (4.25 billion - about two-thirds the world’s population, including infants and impoverished), a five-fold increase in ad revenue per person (five times the amount of ads!), or a combination of both. But the prospects of Facebook being able to attain these growth numbers becomes even more difficult because there are a limited number of people in the developed world who are premium users in ad markets.

Clearly, these large sums are based on expected growths, rather than actual earnings - but these expected growths are pretty absurd. Furthermore, no social media site has been able to show it can maintain the earnings people are expecting. RenRen, regarded as the Facebook of China, went public a year ago but dropped in half since its IPO, rather than gained.

The problem for social media appears to be that most people are unwilling to pay for it. This has forced sites that focus on social media to earn revenue primarily through advertisements. But a website can only put so many ads on a page and have them yield so much of a response. Betting extraordinarily high sums on social media with nothing to base its staying power or earning potential on is even more misguided than pouring money into “established” sites. Social media is exciting and new at the moment but as Dylan Grice explains as the lottery ticket effect, “we’re hardwired to overvalue excitement and undervalue boredom.” People are overvaluing excitement here. 

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