Thursday, 3 May 2012

Is Instagram Worth 1 Billion… only to Facebook

I ended my last post with the comment “at Facebook's estimated $100 billion valuation, there is a lot of room to pay a lot of money.”  What this speaks to is the notion of accretive acquisitions.   Companies want their acquisitions to be accretive because of a somewhat flawed notion that if you buy a company at a lower multiple of earnings than your own, then the valuation of the acquirer will get a lift as the combined earnings continue to benefit from the acquirer’s multiple (it is flawed because this ignores the impact of the target’s risk profile).
As a quick example: if the acquirer trades at 20 times net income of $10M (i.e. an enterprise value of $200M) and the target is purchased at 10 times net income of $1M (a price of $10M), then the combined enterprise generates $11 million (excluding possible cost savings from the combination) and, with the same multiple of 20, the enterprise value is now $220M. 
Most acquisitions are accretive, however in the case of Instagram, whether it was profitable or not probably wouldn’t have had much impact.  The metric that is driving Facebook’s valuation right now is not net income but user base and user growth, and on this front, Instagram generated over 30 million users in its first two years of operations.  Facebook has more than 800 million daily active users and it is worth approximately $100 billion, so approximately $125 per user. When you apply this metric to Instagram (30M times $125), then Instagram would be worth $3.75 billion.
I noted in my last post that reasons for Facebook wanting to acquire Instagram could include: to improve its mobile revenues (of which it had none), to eat Twitter’s lunch, to eliminate a potential future competitor, and basically to maintain its growth and market value momentum.  Now you can see the last point is well validated. This example illustrates the “value-to-the-buyer” which is not the amount buyers want to pay unless they are forced to in a competitive bidding environment.  In the end no other company had the room in the value-to-the-buyer to compete with Facebook.
To conclude, the typical valuation metric is a multiple of net income or free cashflow but in some cases it can be revenues or market penetration or subscriber growth.  In any case, most acquisitions are accretive with respect to the relevant valuation metric and in all cases the price is less than the value to the buyer.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

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