Did Facebook Underpay for Instagram?

April 19, 2012

On the surface, Facebook’s agreement to buy Instagram seems completely absurd. Companies with approximately zero revenues aren’t supposed to sell for a billion dollars. Founders aren’t supposed to make $725k per day over two years and then cash out. 13 employees aren’t supposed to be able to support a 40 million user social media empire. My first thought was to write another crotchety blog about bubble valuations and suspect business models.

But then a funny thing happened. I made a few assumptions, ran the numbers, and I think I like it.

Here’s my math on Facebook’s Instagram Acquisition:

A. Users: 50 Million.

Coming into April, Instagram had about 30 million users. That number grew to 40 million in just 10 days after the company launched its Android app. Assuming there’s considerably still growth from Android users yet to come, I think it’s safe to say they’ll hit 50 million in the next couple of months.

B. Revenues Per User: $1.20 Per Year.

According to Facebook’s S-1, the company makes a billion dollars on 875 million active monthly users, or about $1.20 per user per year. Let’s assume, as Mark Zuckerberg probably does, that they’ll be able to monetize Instagram’s users similarly, and profit a dollar per year on each user.

C. Valuation Multiple: 50x Earnings.

Facebook’s expected market cap of $100b is 100x its one billion in earnings. Not to say this is reasonable or unreasonable, but it’s the going rate on social media, and this is what you’d expect to pay for an acquisition in a competitive market. We’ll give Instagram half of that multiple, which might even be overly conservative given its level of growth.

Multiply A x B x C, and you get 2.8 billion dollars.

Hold on a second, did Facebook just underpay forInstagram by $1.8 billion?

For that to be true, one critical assumption has to come to fruition: Facebook has to monetize users of Instagram at the same rate they monetize their own users. I don’t mean to trivialize this challenge, but I don’t think it’s unrealistic, either. At $4 in revenue per user per year, I’ve always thought Facebook underachieves badly on this front, considering how much time users spend on their website. Could the Instagram user base stomach $4 per year in advertisements without stunting its growth? Facebook seems to think so, and I don’t disagree with them.

So while I can’t say I’d spend $1 billion of my own hard-earned cash on Instagram stock, I at least understand Facebook’s reasoning. To take it one step further, given some pretty achievable assumptions about how Facebook plans to monetize the investment, it could even end up being a bargain.

Did I actually just defend a billion dollar deal for a company with no revenues? Get me to the hospital, I must be having a mild stroke.

Behavioral Data Analyst

Nick is a Behavioral Data Analyst at <a href="https://www.betterment.com/">Betterment</a>. Previously he analyzed OpenView portfolio companies and their target markets to help them focus on opportunities for profitable growth.