In a post on valuing social media companies, Aswath Damodaran, properly warns not to be misled by the fallacy of aggregation (http://aswathdamodaran.blogspot.com/2013/10/when-pieces-dont-add-up-micro-dreams.html). More specifically, with regard to these companies relying on advertising as a source of revenue he notes that the total advertising revenues of the companies cannot exceed total online advertising. His calculations suggest that the valuations of social media companies are inconsistent with this constraint – implied total advertising revenues of even a relatively small sample of companies exceeds total projected on-line advertising expenditure.
With respect to a host of the newer social media companies such as Snapchat, Pinterest, WhatsApp and no doubt numerous of companies of which I am unaware, I think he significantly understates the extent of the overvaluation. There is a second aggregation issue that Damodaran does not account for – namely that advertising will ultimately be correlated with consumption. There is little point in advertising products to people who will not or cannot buy them.
It turns out that the dramatic growth new social media is driven by people ages 12 to 22 or even younger. This is not surprising. Research in biology suggests that there are evolutionary reasons why the “sexing” of the brain in adolescence produces an intense focus on social interaction and sort. Social media are now the method of choice for that interaction instead of passing notes in class or gathering in the corridors. The social media services that are currently seen as cool have a dramatic spikes in usage, but there a good reasons why in all but a few unique cases that popularity will never be monetized. They include, most prominently, the following.
1. Young social media users account for a small fraction of total consumption. Eventually, advertisers will realize you can’t sell washer-dryers or home remodeling services to teenagers.
2. Point one might not be a problem if the audience were loyal users who became committed to a service for years or decades, but just the reverse is true. Young people are adverse to what the previous generation found cool. Novelty is a virtue in and of itself.
3. Possible solutions to point two are switching costs and barriers to entry, but neither works for most social media companies. The cost of producing new applications is within the resources of small startups. The current hot media companies are examples. The switching costs, if they are even costs, are small as well. To young people trying new things is novel and fun so there may be switching “benefits”.
4. The foregoing points also rule out charging for service. What could be more uncool than paying for something that the latest and greatest start-up is offering for free.
The bottom line is that for social media companies that rely on the young the problem is not that they have yet to monetize their operations, it is that they never will. The path to profits is not through “cool” but through necessity. At one time, Amazon and Google were cool innovations used mostly by the young. Now they are both necessities used by everyone. That is why the companies are so valuable. But few sexy new social media companies are likely to make that transition to necessity so investors should “be afraid, be very afraid.”