Posted on January 10, 2014 by David Laidlaw

In mid-November, photo messaging service Snapchat turned down a $3 billion all cash offer from Facebook. The rejection was greeted with amusement—how could a company without any revenue (much less earnings) be worth $3 billion? The founders believe Snapchat could be worth much more. Facebook generates almost $7 billion in revenue and trades for $140 Billion or 20X sales. At a 20X multiple, Snapchat would only need $150 million in revenue to get to $3 billion. And more photos are shared on Snapchat than on Facebook!

Snapchat plans to make money by (surprise, surprise) selling ads mixed in with snaps every now and then. The company can expand its services and have 3rd parties develop apps in order to increase its scale (it’s currently estimated to be in the 10s of millions of users) to ultimately become a platform by which users access the Internet, similar to Facebook. Facebook has 1.2 billion users for comparison. This scale leads to revenue and skyhigh valuations (and maybe even profits). Essentially, Snapchat wants to become Facebook 2.0. But wait, wasn’t Facebook just Myspace 2.0—now valued at well less than 20x revenue? And where does Twitter fit into this universe, or smaller services such as WhatsApp?

The problem with the valuations starts with the comparison to Facebook. This assumes Facebook is accurately valued. In order to justify its current stock price, Facebook needs to hit analysts’ estimates calling for revenue growth of almost 30% through 2018. And then it needs to keep growing while still generating cash. When doing a cash flow valuation, we project revenue and income for 10 years and then assume a steady discount and growth rate past 10 years. As long as the discount rate is higher than the growth rate, this series sums to a whole number- its terminal value. Using a cash flow model for Facebook, to get its $140 billion market cap, almost 80% comes from the terminal value. In other words, our model predicts that by investing in Facebook, you are assuming it will be a profitable and growing business well past 10 years.

There are signs that Facebook will not be a growing and profitable business in 5 years, much less 10. During their last conference call, Facebook disclosed a decrease in daily users among younger teenagers (i.e. Snapchat’s target users). Facebook already tried to combat this through the purchase of Instagram in August 2012 yet still felt a need to buy Snapchat. Users may leave because they are bombarded with ads or because it’s just not cool anymore. The cool factor is seemingly what’s happening to Facebook (yuck, my parents use Facebook) and the ad bombardment was likely a large part of Myspace’s downfall.

But the biggest threat to Facebook is that Snapchat was willing to turn down $3 billion. The market has decided to reward companies for the potential of creating a platform to attract scale and ad dollars. This has enabled companies to give away their products for free and while this is good for the consumer, it lowers the barriers to entry for competitors. More competition means us fickle consumes can walk away once the company tries to monetize its users. This means serious long-term risk for the company, i.e. risk to its terminal value. And now we’re back to wondering how the revenue-lacking Snapchat could turn down $3 billion.