Can Twitter Justify Its $11 Billion Valuation?
A lot of entrepreneurs are probably watching the excitement over the approaching initial public offering of Twitter and wondering if they can get a similar valuation for their companies.
After all, your company may be tech-focused and growing fast--especially if you're on the Inc. 500--and, unlike Twitter, you may be profitable.
The short answer: Don't bank on it.
Twitter is an anomaly whose value has been somewhat manipulated by investment bankers, a frothy stock market that's favoring social media stocks and a sort of desperate investor longing for a return to the good old days of the first dotcom boom.
Still, the pricing legerdemain surrounding the Twitter offering could prove an instructive lesson for small-business owners seeking insight on how to value their own businesses--a task usually accomplished by examining free cash flow. So let's look at some of the available data and see if we can get ourselves to a realistic estimate of Twitter's value.
The challenge, of course, is defining "realistic." If you see Twitter as the next Google, you'll be using one set of assumptions and calculations. If you think Twitter is a media company--like Yahoo or the Huffington Post--you'll use completely different assumptions and end up at a different valuation. Call it a technology company, and you wind up in someplace entirely different. Remember that Google--for all intents a category of one--was profitable for three years before it went public.
No Profits. So What's it Worth?
Twitter has set the range for its offering at between $17 and $20 a share. If it prices at the low end of that range, the company would be worth about $11.1 billion.
Figuring out whether the company is "really" worth that much is complicated greatly by the fact that twitter is not profitable. Most public-company stocks are valued by their price-to-earnings, or P/E ratio, but Twitter has no earnings.
It does have fast-growing revenue: According to its filings with the U.S. Securities and Exchange Commission, Twitter had $317 million in revenue in 2012, nearly three times its 2011 revenue. For the six months ended June 30, 2013 Twitter reported $253 million in revenue, about double its revenue compared to the same time period a year earlier.
Nearly 90 percent of that revenue came from advertising. As of June 30, Twitter had $418 million in debt. So where do we go from there?
1. Price-to-sales ratio
In the absence of profits, we can look at Twitter's price-to-sales ratio, and compare that to comparable public companies.
If you divide Twitter's $11 billion valuation by the amount of its last full year of sales, you get a price-to-sales ratio of 35. That number comes down to 24.5 if you use the more recent trailing 12-month revenues of $448 million.
That's quite high compared to Facebook, whose price-to-sales ratio is 21. Amazon, which has never been profitable, has a price-to-sales ratio of 2.5, and Google's is about six.
You don't even have to compare Twitter's price-to-sales multiple to other companies. You can use entire industries. Multiples for media and multimedia companies range from about eight to 10, says David Zilberman, a partner at San Francisco's Comcast Ventures. Using those multiples, you'd get a valuation, on the high end, of about $4.5 billion. If you were to consider Twitter a software company, you'd have to use a lower multiple, of three to four times sales, and end up with a valuation of less than $2 billion.
2. Growth rate
Another way to sort out Twitter's value is to project out its annual compound growth rate out five years or more, and then try to back out the company's present value. To do this, we enlisted the help of New York's Capstone Valuation Services.
Let's start with Twitter's trailing 12-month revenues of $448 million, and accept digital-marketing company eMarketer's projection that Twitter's annual revenues will reach $1 billion by 2014. That gives us a compound annual growth rate of 67 percent.
By 2019, growth at that same rate would give Twitter $13 billion in annual revenue.
Time to go to the back of the envelope: By taking a 50 percent discount for operational expenses, and imagining a 20 percent annual return, you'd get a $32.5 billion valuation for the company in six years. Using a 20 percent discount rate, Twitter would be worth about $10 billion today.
But if your eyebrows aren't raised by now, maybe they should be. Think about the assumptions made by those calculations.
For one thing, we're assuming Twitter maintains its 67 percent compound annual growth rate. For a large company, that's not too realistic. Signs of growth petering off in the future are suggested in the S-1, although they are not yet apparent in revenue numbers. Twitter says it has about 200 million active users, but concedes international markets account for 77% of active users while contributing only 25 percent of revenue.
The value also assumes that operating expenses are only 50 percent of sales. Currently, Twitter's expenses, which include marketing and research and development, exceed revenue by more than 100 percent.
Lastly, and perhaps the most important part of the equation, this formula assumes a 20 percent return to investors. While that's a modest return for a high-flying tech stock, at a certain point, Twitter would hit a wall trying to satisfy investors and contain its costs.
3. Revenue per customer
Zilberman points out that the stickiness of customers, and the cost to acquire them, are critical in attempts to value unprofitable companies. In the case of Salesforce.com, Zilberman says, each customer is like a mini-annuity providing a dedicated revenue stream each month, making it easier to calculate the company's value. Unfortunately, more complete company metrics about customers are noticeably absent from Twitter's S-1.
Still, investors and the market are likely to give Twitter a pass for at least a couple of years, Zilberman says. After that, they'll want to see results. "Twitter will get this initial pop, and then once they report a few quarters and if they are not demonstrating an ability to keep customers up, or revenue per customer at certain level, they will be penalized."