Social networks – when discounted cash flow valuations are ignored

The extraordinarily high prices being achieved in social network flotations are flying in the face of discounted cash flow valuations and raise the question as to whether another tech bubble is imminent.

Just last week, Renren, the Chinese social network with 31 million users, floated on Nasdaq with a valuation of $6.7bn or roughly 80 times its annual sales. In order to justify this valuation using DCF, sales will need to near double next year, then increase by a further 60 per cent, the 40 per cent before settling at around 6 per cent annual growth. That’s a lot of faith in a company’s future performance.

It’s the social networks with very high active user numbers that are achieving the high valuations, irrespective of whether they’re currently or making much profit – or even forecasting significant profits.

LinkedIn has an indicative valuation of $3bn to $3.3bn, which will value the business at 13 times 2010 sales. Not bad for a company that states in its prospectus: “We expect our revenue growth rate to decline and, as our costs increase, we may not be able to generate sufficient revenue to sustain our profitability in the long term.”

Facebook, with its 600 million users, is valued at $65bn or 32 times its 2010 sales.

High-user social networks are being bought partly because of their strategic potential and to prevent competitors from dominating.

Microsoft’s purchase of Skype this week was influenced by its concern that if Google beat them to the purchase, it would quickly strengthen the search giant’s position in the operating systems arena and enterprise market.

The purchase price of $8.5bn is equivalent to 10 times last year’s revenues ($860m) at Skype, which has always struggled to make any money and recording a loss of $7m in 2010. It has to be noted however that Skype’s revenue growth rate has far outstripped Microsoft’s over the past five years.

If Microsoft succeeds in turning Skype into a business-grade offering, it has huge potential customer bases that will lap up the service, either on its own or integrated into Microsoft’s own products. There is much value in the Skype brand, which is often used as a common verb, and its purchase will hardly make a dent in Microsoft’s cash reserves.

Investors might be as well to remember the massive writedowns that occurred with AOL’s purchase of Bebo, bought for $850 million in 2008 and sold for just $10 million in 2010. Or News Corp’s purchase of MySpace for $580m in 2005 – the business is currently up for sale for around $50m.

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