Internet companies have been the darling names on wall-street for more than two decades. Traders and investors alike have bet money on these stocks, with contrasting results. Some strike it rich, while others lose their fortune. So how do we pick the right names to invest in from this highly lucrative sector? Here is what experience suggests.
Internet companies rarely fit traditional valuation models, such as the dividend discount model, discounted cash flow model or multiples based valuation. This is due to various factors, a major one being lack of profits and in some cases even a lack of revenue. For example, Twitter does not have any profits to speak of, but is currently valued at $26 billion. The same can be said for WhatsApp, which has no significant revenue, but was valued at $19 billion in its recent acquisition. Most of these valuations depend on expected growth and are highly speculative in nature. However, this anticipated growth can be explosive and may not fit into estimates from traditional models, which rely on historical performance to a large extent.
Internet Valuations are Largely Driven by Non-Financial Metrics
Whether right or wrong, internet companies’ valuations are often driven by metrics like unique users and pageviews, which are difficult to express in monetary terms. Hence, ascertaining the true value of these companies becomes that much tougher. For example, the WhatsApp valuation was centered on its huge user base.
If internet companies were only valued on rules of traditional investment strategies, like value investing, this might lead to missing out on some really good investment opportunities. We need to use a mix of financial and non-financial criteria to find winners from the internet sector.
How to Value Internet Companies
Metrics like the number of unique visitors and number of pageviews are essential to track the growth of an online company. However, these by themselves are insufficient to financially value internet companies. To determine value, an investor must first look into the operating model of the company. Then, examine the monetization and engagement levels of a platform which can be estimated using specific metrics.
Operating Models Used by Internet Companies
Online operating models are typically one of two types; subscription revenue based and advertising revenue based. LinkedIn Premium service is a good example of subscription service. Advertising based operating models will typically have a service or software product offered for free usage online, and the company then generates revenue from advertising to their users. For example, Facebook and Twitter largely derive their revenue from advertising embedded in their free services.
Monetization and Engagement Metrics
Monetization strategy for effectively monetizing an online platform is extremely important to value an internet company. The effectiveness of a monetization strategy is measured by metrics like revenue per user. For companies with an advertising based revenue model, important monetization metrics also include cost per click, cost per mille (thousand) and the engagement rate, which is measured by metrics like click through rate and time spent on page. Now take a deeper look into each of these metrics.
Revenue per user: This is the total revenue derived from a platform, divided by the total number of unique users on the specific platform. It can be further classified as subscription revenue per user and advertising revenue per user.
Cost per click (CPC): This is the average cost per click charged to an advertiser for a user clicking on a sponsored advertisement.
Cost per mille (CPM): This is the average cost per thousand impressions served (displayed) on an online platform, paid by the advertiser to the owner of a website, regardless of whether the user clicks on the advertisement or not.
Click through rate (CTR): This is the percentage of advertisements displayed on an online platform which were clicked on by users. It is derived from the following formula: Advertisements clicked on a platform/Total number of advertisement impressions served on the platform.
Average time spent: This is the average time spent by every user on an online platform. This is derived from a ratio of total time spent on an online platform over a certain period and the average number of users during the same period.
These numbers, as relevant, are reported by most internet companies on a periodical basis along with their financials. Hence, an investor must look at these metrics to gauge their impact on the financial performance of a company in order to make well informed investment decisions.
We can understand these metrics and their relevance to valuations using examples from Google, Facebook and Twitter. Why are we choosing these three companies? Well, Google is by far the most successful online company with its cash machine in the form of its search engine. Facebook is another huge online platform with its billion plus audience and strong monetization improvements over the last few quarters, making it a success compared to most online platforms. Twitter, on the other hand, is relatively small and young compared to the first two, and with the recent slowdown in its user growth, its monetization strategy is under sharp focus. However, all three of these online companies derive a bulk of their revenues from online advertising, making them comparable.
The revenue of these online companies is a direct function of the number of visitors coming to their site, and the money they make per user by advertising to them. Let’s first take a look at the user base numbers for each of these companies.
Facebook (1.32 billion) and Google search (1.17 billion monthly searchers), with over a billion visitors every month are far ahead of Twitter’s current base of 271 million monthly active users. Hence, Twitter has a long way to go before it can achieve a similar scale as Facebook or Google. We look at searchers of Google as this is the total addressable advertising market for Google. Let’s now take a look at the monetization levels on each of these platforms.
We see that Facebook and Google are far bigger than Twitter in terms of scale. Also on the monetization front, Google is in a league of its own with average ad revenue per user of $46.95 (over the last twelve months) as compared to $6.90 for Facebook and $3.23 for Twitter. As an investor evaluating the three companies, we arrive at the following conclusions:
- Twitter has room for the highest growth, followed by Facebook and Google, whether on the user base front or monetization per user metrics.
- Google understands its users better than its competitors, which leads to better targeting of ads, reflected in its runaway Ad revenue per user. Remember, we literally tell Google what we are looking for when we search; that helps Google to target relevant ads to us.
We can now use the above information to value the three companies. Take a look at the current valuation multiples of the three companies displayed in the table below:
LTM PE ratio
LTM PS ratio
Looking at the current valuations of the three companies, we can conclude that Twitter valuations are entirely based on future earnings growth, in the absence of any history of profitability and earnings. Facebook also enjoys a valuation based on future potential with a track record of growing monetization levels and profit margins for the last few quarters. Google, on the other hand, has a history of solid profit margins and steady cash flows, though with slower current growth as compared to the other two. Valuations of Google are tied to its current financial performance with little premium for potential value.
We can classify these three stocks in the order of decreasing risk as follows:
- Twitter: Most risky as valuations are supported by potential that is unproven in its short history.
- Facebook: More risky than Google and less risky than Twitter, as potential valuation is supported by a strong but short history of earnings growth and solid revenue growth.
- Google: Least risky of the three, with valuations driven by current performance rather than future potential.
The Bottom Line
Investors examining internet technology stocks should assess their risk profile and decide which stock(s) they would want to add to their portfolio. Though the sector is definitely one of the most rewarding ones, picking the wrong names will drain your wealth before you realize what happened.
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