There’s a lot of talk about Facebook and Groupon being valued at $70 billion and $15 billion respectively, and there is a common wisdom from booming real-estate industries that says that the best properties almost always look too expensive initially. But let’s get back to basics. The value of an item in a free market is defined as the price someone is willing to pay for that item. In the case of real estate, a house being worth $400k means that someone is going to pay (or take out a mortgage for) $400k to buy the house.
In valuating companies however, the valuation is entirely based on investment for a fraction of a company. That valuation is extrapolated based on the partial purchase. For example, if an investor decides to pay $1 million for 20% of a company, then that company is said to be “valued” at $1 million / 0.20 = $5 million. As someone with a basic understanding of economics would know, not everyone is willing to pay the same price for an item. Hence, the investor who invested $1 million for 20% of the company might be the person who is willing to pay the most for that company (presumably he’s the most excited about it), and he may not want to pay that price for the next 20%. In fact, it might be that no one is willing to pay more than $500k for 20%, and if everyone else only wants to pay $500k for 4 parts of 20%, then the total value of the company is worth $1 million + 4*$500k = $3 million, not $5 million.
The investor is of course looking for a return on that investment and would therefore expect that someone else is willing to pay a higher price in the future. This is usually based on growth. If a company is growing very fast, then it’s expected that the company will be worth a lot more in the future. Therefore, the premium price they paid today is based on the expected future price of the company, the present value is lower, much lower for a high growth company like Facebook.
I’m not saying that Facebook won’t be worth $70 billion some time in the future, but until you find enough people willing to pay that price for every share of the company, it’s not currently worth $70 billion.
Update: Here’s a list of companies worth less than the current facebook valuation: http://larrycheng.com/2011/01/12/the-companies-worth-less-than-facebook/, and a comment on HN that relates to what I’ve said here:
It’s important to note that stock valuations are derived from the expected future profitability of a company. Stock is a claim on future profits. Compared to a company like Halliburton, who has to build billion-dollar oil rigs before they make any profit, a technology company like Facebook is a lot more lucrative and thus its stock can inflate quickly if the profits expand faster than costs. And generally technology costs go down over time while profits increase exponentially. So you have a powder-keg scenario in Facebook if, and only if, they find a profitable business model based on their enormous userbase. And they better find that business model or the stock will crash like it’s the year 2000.
