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How Much Would You Pay for Snapchat?

Justin Fox is a Bloomberg View columnist. He was the editorial director of Harvard Business Review and wrote for Time, Fortune and American Banker. He is the author of “The Myth of the Rational Market.”
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What is Snapchat worth? Well, if the purveyor of disappearing photos and videos succeeds in attracting a new funding round of $500 million, and gets those new investors to settle for 2.6 percent of the company, it will be worth $19 billion -- just like Xiaomi and Uber, two startups with even higher valuations, are worth $45 billion and $41 billion, respectively.

It’s as simple as that. Investors are free people. If they’re willing to pay that much, that’s what the company is worth, right?

There are those who don’t think so. Aswath Damodaran, a New York University finance professor, writes near the beginning of his “Little Book of Valuation”:

I know there are those who argue that value is in the eye of the beholder, and that any price can be justified if there are other investors who perceive an investment to be worth that amount. That is patently absurd. Perceptions may be all that matter when the asset is a painting or a sculpture, but you buy financial assets for the cash flows that you expect to receive.

If you’re expecting other investors to buy that asset from you, though, isn’t that a cash flow that you expect to receive? Not by the reckoning of Damodaran and others who speak of “intrinsic value.”  They mean cash that flows from the business itself, not from financial markets. It’s no coincidence that the two great gurus of the intrinsic valuation of stocks, Benjamin Graham and John Burr Williams, wrote their masterpieces (“Security Analysis” and “The Theory of Investment Value”) in the 1930s, when financial markets more or less shut down. A stock was worth what you could get out of it in a world where there were no other stock market investors.

Graham’s focus was on a company’s assets and what they could fetch in a sale. Did it have cash, or machines or real estate that some non-financial buyer would be willing to buy? Then it was worth something. By this standard Snapchat is probably worth a few hundred million dollars -- the cash it still has lying around from previous investment rounds (it just raised $485 million in December) plus a few laptops and desks. Its value lies almost entirely in the money it hopes to make in the future. Williams calculated this with his dividend discount model, into which he fed an estimate of a company’s future dividends, then discounted them using a net present value formula. Because companies now give cash to investors via share buybacks as well as dividends, and sometimes hold onto cash for tax and other reasons, such models these days are usually built around free cash flow (the money a company COULD pay out via dividends and other means) rather than dividends.

Snapchat has no free cash flow at this point. Until recently it had no revenue, although that’s changing as the company begins to charge $750,000 apiece for ads that disappear in a day. Still, it isn't unreasonable to think it will make money in the future. Let’s say that moment comes in five years, the company generates $100 million in free cash flow that year, and this number goes up 25 percent a year for 20 years after that. That would give it a free cash flow of $8.7 billion a year in 2040 -- more than Disney in 2014, less than Google. Figure that the growth stops then, and plug in a discount rate of 5.6 percent, which according to the latest Credit Suisse Global Investment Returns Yearbook is the median discount rate for U.S. industrial and service companies since 1976, and you get (or at least I got) a valuation of $51 billion. So Snapchat’s a bargain!

Actually, though, that discount rate seems awfully low for a company with business prospects as uncertain as Snapchat’s. How about we double it, to 11.2 percent? That brings the value down to $10 billion. And what if cash flow growth is 20 percent a year instead of 25 percent? That brings free cash flow in 2040 down to $3.2 billion, a bit less than Facebook’s now, and Snapchat’s present value to $5.1 billion.

All these cash flow estimates are pulled out of thin air, of course -- my Bloomberg View colleague Katie Benner thinks MySpace (last valued, when News Corp. sold it in 2011, at about $35 million) may be a better reference case for Snapchat than Facebook or Disney. I went through the exercise mainly to illustrate how hard it is to pin an intrinsic value on a company as immature as Snapchat. Last June Damodaran did a much more involved intrinsic valuation of Uber, then valued in its latest funding round at $17 billion, and landed at $5.9 billion. Venture capitalist Bill Gurley (an Uber investor and board member, and thus biased, but also a generally level-headed guy) objected that Damodaran’s estimates of the total available market for taxi and limo services and Uber’s likely share of it were way too low. Who’s right? Who knows? But for the moment Gurley is, because in December a new round of investors came in and valued Uber at $41 billion.

Even Damodaran acknowledges that market values count. Despite his bold talk of perceptions not mattering, he teaches relative valuation (using price/earnings ratios and such) alongside the intrinsic kind, and relative valuation amounts to figuring out what other investors are willing to pay for similar stuff. Facebook paid $22 billion last year for messenging service WhatsApp, which has about 400 million active users. Snapchat has at least 100 million active users, possibly many more, and seems to have more potential ways to make money off of them than WhatsApp does. Relatively speaking, $19 billion doesn’t seem too crazy.

Unless, of course, Facebook was crazy to pay $22 billion for WhatsApp. Last night on Bloomberg TV, Paul Kedrosky speculated that the main force behind Snapchat’s valuation is professional investors’ “fear of missing out” on what has become marquee name.  Having Snapchat in your portfolio makes it easier for you to go out and raise more money. It looks good. Sort of like a painting or a sculpture.

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

To contact the author on this story:
Justin Fox at justinfox@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net