Asset Valuation in a Winner-Take-All Economy

Pondering the $1 billion valuation of Instagram, Tim Fernholz and Dylan Lathrop end up concluding that “[v]aluing a company is ultimately a very subjective process; it’s not just a matter of guessing at future revenues, but also at the state of an entire industry that’s rapidly changing.”

I would say it’s a very difficult process but not necessarily a subjective one. The problem is winner-take-all economics and network effects. The social networking space isn’t like the auto industry, in which you can have a whole bunch of successful firms. It’s not as if Facebook is doing extraordinarily well but Friendster is also a big success. No. The fact that Mark Zuckerberg’s product was somewhat superior and somewhat better-timed than the alternatives meant that he has the whole market for this kind of service even though lots of people had roughly similar services at roughly the same time. So when you’re evaluating a company, you’re not trying to decide whether it’s really an $800 million company or a $900 million or a $1.1 billion company. What you’re doing is choosing between it being a $10 billion company and it being a $0 company. Because you’re talking about feast or famine scenarios, you end up with very small variations in probability leading to wildly different conclusions. Saying “I think there’s a 11 percent chance Zuckerberg is going to make this work” is not a very different assessment of the universe from saying “I think there’s an 10 percent chance Zuckerberg is going to make this work.” But those claims have radically different implications for the appropriate valuation of Facebook circa 2007.