With the New York Stock Exchange running a test drive to brace itself for the much-awaited Twitter Initial Public Offering (IPO), it is worthwhile examining some of the characteristics of Twitter to guesstimate the value of the IPO.
Twitter, intends to sell 70 million shares at between $17 and $20 each, and will be holding the biggest Internet IPO since Facebook, raising about $1.6 billion with a total valuation pegged at about $11 billion. Twitter shares are expected to be traded from November 7. However, this valuation is much less than that of Facebook that opened its IPO last year at $38 per share at a market value of $104 billion.
Twitter, much like Facebook, is a Group Forming Network (GFN), consisting of groups of users who are connected to each other, tweeting and re-tweeting the 140-character feeds over the internet. Much like any other network such as telecom, Twitter has direct network externality effect that increases value both for the network owner as well as users connected to the network, as the number of users in the network increases. The billion dollar question is: is the value of the network (i.e. Twitter) proportional to n (the number of Twitter users), or square/exponential in n. A number of researchers looked at this problem in detail: (i) Sarnoffs Law is more conservative in estimating value that varies linearly with n and found to be true in the case of television and cable broadcasting networks; (ii) Robert Metcalf, the inventor of Ethernet, is widely-credited with Metcalfs Law that states that value is proportional to square the number of users, i.e., n2; (iii) Reed however proposed that in a GFN, the value could be exponential as many sub-networks can be created as in the case of Facebook and Twitter; (iv) and finally, a conservative estimate by Odlyzko and Tilly who argued that not all connections between users and sub-groups are equally important, and hence, the value is much less. For those technically inclined, they proved that it is in the order of nlog(n). In other words, increasing the number of users from 10 to 20, the value of the network only doubles, i.e., 10 to 20, as per Sarnoff; quadruples, i.e., 100 to 400, as per Metcalf; while it will be only slightly more than twice as much, i.e. 10 to 26, as per Odlyzko and Tilly estimate. The accompanying chart illustrates how the value of the network grows in terms of the user base (n), as per the above different laws.
Twitter, that has a base of about 215 million active users, can be valued at anywhere between $215 millionas per (i) and $ 1.7 billionas per (iv), to astronomically high values as per (ii) and (iii). Targeting $1.6 billion at IPO is incidentally very much closer to the nlog(n) estimation! However, valuation of a GFN firm is never that simple as pointed out in an article by Professor Michael Cusumano of the MIT Sloan School that appeared in the communications of the ACM soon after Facebook IPO.
What makes the valuation of Twitter interesting is that it is still a fledgling firm with the number of active users doubling every year and expected to reach 1 billion by 2015, a figure Facebook almost had when it went public in 2012. Twitter had nearly 100% growth in sales revenue over last year and its $11 billion valuation is about 31-times its revenue of about $350 million. Much the same as that of Facebook that had 88% sales growth and a valuation of about 28-times. The gross margin of Twitter is about 65% which is at least 10 percentage points lower than that of its peer GFNs such as Facebook and LinkedIn. At employee strength of less than 1,000, the sales/person for Twitter is about $350,000, same in the likes of LinkedIn, much less than that of Facebook or Google.
What should be of utmost concern for prospective investors is operating losses that Twitter is making that jumped to $64.6 million from $21.6 million a year earlier. This indicates the huge impact of sales, general and administrative expenses as well as research and development expenses that contribute to about 35% of revenue for Twitter. Facebooks operating profit was an astonishing 47%, even better than that of Microsoft and Google. While the high R&D spending is a signal for future innovative offerings from Twitter, its financials are inferior compared to Facebook at the time of IPO.
Now, the all-important question is given the projected growth in the user base, can Twitter be a gem of GFN, and hence, be lot more value-adding to its potential shareholders. Though there is no universal law governing the above, the distribution of value of users as they get added to networks such as Twitter tends to be convergent, and hence, the valuation hits a finite ceiling post which it becomes insensitive to size of the network. What this means is that when the number of Facebook users grows from 1 billion to 2 billion, the additional 1 billion do not bring much value to Facebook. Hence, the mindset of Wall Street compared to that of Silicon Valley and the resultant crash of Facebook share prices post the IPO and corresponding de-valuation corrections.
Hence, pegging the valuation of Twitter to the projected 1 billion users is rather risky as the convergence might happen earlier. One major reason is that people still find it difficult to comprehend the technology of tweeting with its limitations on number of characters, and abbreviations for basic functions such as hashtags and RTs unlike the easy-to-use Facebook. By conservatively pegging its valuation, Twitter might, after all, be right!
The authors are with Sasken Communication Technologies.
Views are personal