Is Twitter’s Valuation Justified?

There has been a surge in the valuations of social networking companies. In a recent investment deal Facebook, which is estimated to have sales of nearly $2 billion in 2010, was valued at $65 billion. And in a recent auction of Twitter’s shares, investors valued the company at $7.7 billion. Twitter, which kicked off its monetization last year, is estimated to have generated just $45 million in revenue in 2010. Are such high valuations justified?
Twitter’s microblogging service has become a popular real-time communication tool for politicians, businesses, and celebrities. It has nearly 200 million registered accounts. Twitter got serious about making money only last year and has three ad services: Promoted Trends, Promoted Tweets, and Promoted Accounts.

Following its recent monetization efforts, Twitter has raised $200 million in December that valued the company at $3.7 billion. Last month, Netscape co-founder Marc Andreessen’s venture capital unit invested $80 million in Twitter.

The Wall Street Journal last month reported that executives at Facebook and Google have explored acquiring Twitter for $8 billion to $10 billion. The report says the talks have gone nowhere, and Twitter says it is committed to building a large, independent company. Twitter has been hiring engineers and increasing its workforce to more than 350, up from 100 in January 2010. Twitter has also been building an executive team, appointing Dick Costolo, a former Google executive, as CEO last year.

Mathew Ingram on GigaOM, while pointing out that the report could be a marketing effort by Twitter, evaluates the theoretic possibility of Google or Facebook acquiring Twitter. He says Twitter would fit in with Facebook’s recent rollout of real-time commenting following its acquisition of FriendFeed in 2009. But he also says that

“the biggest problem for Facebook is the valuation — the company doesn’t have the cash to buy something for $8-$10 billion, and to this point the social network has done primarily small cash deals.”

Google, on the other hand, has the cash, and it would get a massive boost in terms of real-time social communication. But Twitter could lose its momentum under Google’s wing.

Industry research firm eMarketer expects Twitter to generate about $150 million this year. However, Twitter’s valuation is based not on its current revenue but on its future revenue potential. Social networking sites like Facebook and Twitter link millions of users across the world and offer huge potential for advertising.

According to eMarketer, advertising spending on social networking sites in the U.S. is expected to increase 20% over the year from $1.4 billion in 2009 to $1.68 billion in 2010. Another report from Borrell Associates says that social network ad spending is expected to increase to $10 billion in 2013, $12 billion by 2014, and $14 billion by 2015.

While Facebook is the leading social networking site and accounts for 62% of Internet users, Twitter accounts for 12% Internet users. On that basis, Felix Salmon on Reuters says Twitter’s valuation makes pretty good sense:

If Twitter is 20% the size of Facebook, and Facebook is worth $50 billion, then Twitter can be worth $10 billion.

But even Facebook’s valuation is high and Twitter is way overvalued. Twitter’s revenue story has just started, and even if its monetization models succeed, the revenue level will not be able to justify a $10 billion valuation.

There are allegations going around that Kleiner Perkins, which invested in Twitter in December at a $3.7 billion valuation, has already sold some of the stock at a $7.8 billion valuation. Michael Arrington on TechCrunch clarifies that Kleiner Perkins decided to reduce its investment from $150 million to $130 million, and the $20 million stock was bought by Insight Venture Partners at the same valuation. But even so, the fact that Kleiner Perkins decided to reduce its investment in Twitter indicates that it is an overhyped stock that doesn’t deserve the kind of valuation it has been receiving.