Why Facebook Paid Billions for Break-Even Online Businesses

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In a conversation a short while ago, I asked James Price from JPA Business (a business advisory, valuation and broker firm) to explain the incredible valuations of WhatsApp and Instagram and how Facebook was able to justify multi-billion dollar price points for break-even businesses. He shares his response here.

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Enter James…

What’s the story?

Some of you may have heard that Facebook, the world’s most successful and prevalent social media platform, has paid an extraordinary amount of money for two relatively young, online businesses. Those businesses are WhatsApp, which is a messaging, video and photo sharing mobile application, and Instagram, a popular mobile-based photo sharing site.

Facebook shelled out $19 billion for WhatsApp in February this year, after paying $1 billion for Instagram in April 2012. These are both businesses that currently would not be reporting positive earnings – at best they’re breaking even.

How did this happen?

To understand why Facebook valued these businesses so highly, we need to recognise that, when conducting a valuation, a business’s health factors are divided into two key categories:

The strategic framework, and
The financial and business performance of the business.

Facebook valued WhatsApp at $19 billion, not because of its financial performance, but because the acquisition gave them a strategic advantage – it gave them a quality online database in a market they were targeting.

Facebook’s strategic acquisitions

When assessing the value of an online business some of the most important strategic health factors and issues include:

Size and quality of database;
Online presence and quality of online interaction, and
How others in the online space are interacting with customers and audiences, including their point of difference.

Over the past few years Facebook has become concerned about the loss of users and potential users aged in their teens and early 20s, because that demographic tends to be more interested in mobile technologies than PCs.

At the same time mobile-based applications, like WhatsApp and Instagram, have developed very large user bases, specifically targeting this same audience. For instance, in February this year WhatsApp had a reported user base of 450 million people. Instagram, when it was sold to Facebook back in April 2012, had a user base of 33 million – it’s now reported to have a user base of 150 million.

But it’s not just the big numbers.

As well as having large databases these applications have ‘quality’ users – people in the demographic Facebook wanted to secure: the tweens, teens and early 20s. These are people Facebook saw as strategically important for their future – they also saw competitors grabbing these users’ attention and behaviour.

Facebook was prepared to step in and pay an enormous sum of money for these businesses because it put a high value on specific ‘strategic health factors’, i.e. their database and quality of online interaction. Put another way, it was an aggressive move to remove a competitor that threatened Facebook’s core business.

Financial business health factors important, too

Facebook wasn’t too fussed that, at the time of purchase, their new acquisitions weren’t making a profit. What they were more interested in was stemming the tide of loss of a particular age group of customers and strategically positioning themselves with applications to attract those customers.

However, don’t for one minute think Facebook didn’t assess what the potential value would be – in a financial sense – from buying those businesses. Just like a discounted cash flow analysis, that value assessment was based on future revenues and earnings, the growth trajectory of those earnings and the risk of achieving positive earnings in the future.

Revenue potential from online businesses

If you look at the financial aspects when valuing an online business, there are usually three levels of revenue generation:

Advertising revenue;
Transaction revenue (i.e. products and services sold), and
Subscription-based services.

Typically online businesses will look at revenue per user on a daily, monthly or 12-monthly basis to assess how active the user is and whether the business is enhancing their revenue per user over their cost base.

As valuers, we also look at the actual earnings – the business maintainable earnings (BME) – even though some don’t consider BME relevant when valuing online businesses.

Often, when valuing a traditional small or middle-sized business, the valuation involves first looking back at how the business has performed over the last three years, and then sketching out future projections, usually only for indicative purposes as a health factor.

Online business valuation is more about looking at how the business may perform or is projected to perform in the next one to 10 years, given the user base, user activity, demographic, the relevance of content, it’s ranking in search engines and so on.

WhatsApp is growing at one million users a day and in 12 months time they’re projected, by some commentators, to have one billion users. After 12 months of using WhatsApp, users pay a subscription fee of 99 cents per annum. That means Facebook’s revenues from one billion users will be about one billion dollars per year, apart from future growth in the user base.

In Facebook’s eyes, there are future profits to be made, even if they don’t know exactly what they are and there is a risk and return equation around them.

So while strategic factors were critical in Facebook’s purchase of WhatsApp and Instagram, financials were still important and they had a positive view about future earnings.

$19 billion – what a bargain!

It’s interesting to look at relative valuations of Facebook, WhatsApp and Instagram at the user level (i.e. what the valuation of each equates to on a $/user basis – see graph above).

Facebook has 1.28 billion users and is estimated to be trading at a market valuation of approximately $117/user. The WhatsApp purchase for $19 billion equates to $42/user, and the 2012 Instagram purchase for $1 billion equated to $30/user at the time.

So maybe Facebook got a good deal! History will tell.

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About Toby Jenkins

Toby Jenkins is co-author of Web Marketing That Works. He also released 33 free marketing templates, is CEO of Bluewire Media and co-hosts an iTunes podcast and has written for Fairfax Media, ProBlogger, Jeff Bullas and many other blogs. Toby is an Athens Olympian.