Guess Which Social Network Is Overpriced

Matthew C. Klein writes for Bloomberg View about the economy and financial markets. He previously wrote for the Economist magazine and its economics blog, Free Exchange.
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Will boredom burst what looks like a bubble in social-media company valuations? It sure seems like it's possible.

As for whether there is a bubble, a new survey of Bloomberg subscribers found that 82 percent of traders, analysts and investors think there is. Here's the conundrum: Each company's valuation only makes sense if you assume that it will emerge as the dominant player. Of course, that's impossible.

Social networks are only valuable if they have lots of users who regularly interact with each other. For the most part, the owners of those networks extract that value by selling ads. (Financial Times blogger Izabella Kaminska has a novel proposalwhere users could pay for the privilege of participation in exchange for equity.) The value of any of these networks is capped by the total amount of time people spend on them.

Attention, however, is a finite resource. Consider Facebook, the biggest social-media company. It has a market value of about $116 billion despite bringing in less than $2 billion of annual profits. That's ludicrous unless the company can rapidly increase earnings by capturing even more people's attention. But how?

The company already has 728 million daily active users, including what seems like everyone in the developed world under the age of 50. About 73 percent of the people who have joined in the past two years live in poorer countries. On average, those users generate only about 15 percent of the revenue the company gets from U.S. and Canadian users. (European users are in the middle.)

Even worse for Facebook is the danger that people maintain their accounts but shift their limited attention to other platforms. This concern might explain Facebook's attempt to start ane-mailservice and its acquisition of Instagram. Those efforts may have helped, but they haven't changed the fundamental challenge. I still use Facebook to find friends' birthdays, but most of my time now is spent on Twitter. To the extent that my actions create value for either network, Twitter has gained at the expense of Facebook in a near-zero-sum game.

Twitter has yet to make any profits at all, notwithstanding thefevered experimentationof the company's designers and the exhortations of Saudi PrinceAlwaleed bin Talal. Furthermore, Twitter's $24 billion market value probably can't coexist forever with Facebook's. Twitter will need to expand itspenetration rate -- only about 11 percent of Internet users in rich countries -- to make money. Some, or a lot of that growth, will have to come at Facebook's expense.

Or maybe another service will destroy them both. Snapchat, the "pre-revenue" ephemeral messaging service, rebuffed Facebook's $3 billion all-cash acquisition offer because its founders thought they could do better on their own. Henry Blodget, the founder of Business Insider and a former technology analyst at Merrill Lynch, says they seem to believe the service can "reach 'web scale' (vast) and become a dominant global messaging platform." If Snapchat succeeds in this objective it would cripple both Twitter's and Facebook's ability to grow, if not displace them.

Right now every service is being valued as if it will be the industry's dominant company. Maybe one will succeed and crush all others, but it's just as likely that the sector will remain fragmented. In that case, many of the extant businesses are worth a lot less than the markets think.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.