In recent years, there has been a shift in how companies, particularly in the tech and social media sectors, are valued. Traditional metrics like total revenues and cash flows are still important, but for companies such as Uber, Facebook, and Netflix, the focus often begins with their users or subscribers. While we maintain that long-term value ultimately derives from cash flows, the path to achieving those cash flows increasingly hinges on user acquisition and engagement.
This trend is even more pronounced in pricing, where many investors now evaluate social media companies based on user numbers rather than conventional multiples of revenue or earnings. However, this shift brings challenges, particularly in valuation and pricing practices. For example, Facebook’s vast user base—exceeding 2 billion by the end of 2017—and its detailed data on user preferences attract advertisers eager to pay for targeted ads. This has driven a robust online advertising revenue stream with high operating margins, exceeding 50% in 2017.
In contrast, younger companies like X and Snap often boast significant user growth but struggle to generate comparable revenues or profits. They argue that profitability will come with time, though this remains to be seen.
The reliance on user growth is not limited to social media. Netflix, for example, emphasizes subscriber growth in its earnings reports, with over 100 million subscribers by the end of 2017. Similarly, Amazon has leveraged its Amazon Prime subscription model, which had 100 million members by the same year, to drive growth and create value across its retail and entertainment divisions. Even traditional software companies like Microsoft and Adobe have shifted to subscription-based models, with offerings like Office 365 and Creative Cloud replacing one-time software sales.
For investors and analysts evaluating these companies, there are three approaches to consider:
Stick with conventional aggregated models, capturing the benefits of user growth through revenue and operating margin forecasts, while accounting for the costs of user acquisition as reinvestment.
Estimate the value of individual users or subscribers based on intrinsic valuation principles or standard pricing methods, and aggregate these values to assess the company as a whole.
Combine the two approaches, using conventional forecasting methods while explicitly linking projections to user numbers, factoring in acquisition costs and expected user value.
Each approach has its merits, and employing multiple perspectives can provide a more comprehensive understanding of these evolving business models.
