I must admit, in the past I was highly skeptical of staggering acquisitions like WhatsApp, which sold for $19 billion. I did not believe that a company such as WhatsApp, with almost no revenues and an unclear business model, would be able to monetize and provide that amount of value in a million years. To be perfectly honest, I still am a bit skeptical, but I am now more willing to accept these insanely pricey acquisitions. My thinking on this topic has changed fairly recently, as I've been trying to think outside of my traditional business education, and understand this new wave of valuations.
I'm not the only one who is trying to understand valuations in high growth industries. Here is what Jeff Liu and Jim Reinhart write in a report for EY:
Clearly, traditional valuation metrics based on multiples of current earnings or revenues don’t accurately reflect the future expectations that the valuations imply in recent large transformative transactions. Consider the $19 billion price tag placed on WhatsApp, which reportedly generated only about $20 million in 2013 revenue — a multiple of 950x revenue! In fact, applying traditional valuation approaches may cause companies to overlook acquisitions that can transform their business by propelling growth in new markets or industries.
This whole time, I was looking at these acquisitions through my traditional accounting and finance education, which preaches metrics like book value, net income, and simple year over year growth. While these are still solid metrics to gauge most businesses by, they begin to break down for unprofitable companies that are experiencing rapid growth, which defines most social media startups. The truth is, there is no fundamental metric that can precisely predict the future growth, profitability, and success of companies in this industry. Social media, startups, the other companies that we associate with Silicon Valley all fall into an extremely young industry that has not been studied in enough detail yet. Everything in this business is an estimate, at best. And while new metrics to value these companies have emerged, they are not battle-tested enough to spend billions of dollars based on their results. I bet a large part of the WhatsApp purchase was Zuckerberg's gut.