Justifying Twitter’s Valuation

Posted on 10/02/2011

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The news that Twitter is currently in talks to do a deal that the would value the company at $8-10bn has got many commentators questioning whether or not we are witnessing another 1990’s-like silly-season as valuations once again reach bubble levels.  In my view, while the exact valuations are still debatable, the issue of whether or not such business es are highly valuable is beyond question.  This is because the web 2.0 businesses have a product that is almost free to create and distribute but commands a large and committed audience.  This represents a huge opportunity to the advertising industry.

I think the best way to think about Twitter is as an entertainment company or content producer.  Twitter essentially has a continuous live user-generated TV show with 175m viewers (users).  At present, the business is operating like the BBC with no advertisements getting in the way of the programming.  The BBC has millions of viewers and is currently funded by a licence fee, but what would an acquirer pay for the BBC on the assumption that the licence fee was to stop and the new company would be able to show advertisements?  It wouldn’t be worth zero on the basis that current advertising income was zero.  A competent CEO would feel confident about selling advertising to fit around and within the programming.

The US commercial TV business has output which is approximately 30% adverts and 70% programming (based on my assumption that the episodes of West Wing that I have on DVD are 42 minutes long and are shown in a hour-long slot).  For Twitter to insert ads into the stream at this ratio would probably be suicide, but I suspect selling targeted adverts that fill 5-15% of users’ streams would be a viable business model for Twitter.  Users wanting to opt-out of adverts could be charged a fee for premium usage, say $5/month.  If 10% of the 175m users took-up the premium service then that would be a $1.05bn/year in revenues.  Assuming the rest of the users are worth only $10/year to advertisers, then this would generate a further $1.58bn of revenue.  This would take total annual revenue to $2.62bn.

If Twitter was able to operate with a net profit margin similar to that of Google (30%) then this would mean annual profits of approximately $800m, something that could be achived in just a few years if management are able to execute successfully.  Therefore, a valuation of $8-10bn, or 10-12.5x a viable future earnings number does not look particularly far-fetched, particularly given the sharp growth in user numbers.

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Posted in: My Thoughts