Will Twitter shares fly? How to assess the stock

Staff Writer
Columbus CEO

(c) 2013, The Washington Post.

Twitter moved forward with the most-hyped stock offering of the year, and investor demand was off the charts. After initially planning to sell shares for $17 to $20 each, Twitter sold at $26 each, which valued the company at up to $26 billion.

Not bad for a firm that had only $317 million in revenue last year and has never earned a profit.

So what went into this valuation, and does it make any sense?

First, Twitter does have the characteristics of businesses that can become wildly profitable. It relies on network effects: Twitter is more useful to everyone the more people use it. That is to say, the fact that Katy Perry and President Barack Obama and your third-grade teacher all have Twitter accounts makes it more likely that you will have an account, if only to follow them. The fact that you have an account and follow people makes it more valuable to the celebrities and advertisers who want to count you as a follower, and to your friends and acquaintances.

Those network effects act as an economic moat that could protect Twitter from competition. Anybody can start a new microblogging service and try to undercut Twitter with advertisers. But while it may be easy to replicate the service itself, getting the critical mass of 232 million active users that Twitter has is not. (If you think launching a social media network from scratch and scaling up is easy, just ask the people who brought you Google Plus.)

The best thing from investors' point of view is that Twitter, like Facebook, is able to build a large audience with little expenditure. Its users are creating the content, and Twitter just has to keep the servers running, make sure the interface is welcoming and try to avoid Fail Whales.

Twitter and Facebook command big chunks of their users' time and attention — attention that they can sell advertising against — without the messy and expensive responsibilities of creating any content themselves. Newspapers have a big roomful of people paid to write articles they hope you will click on; a TV network has to spend millions creating shows that it hopes you will watch.

Twitter and Facebook not only don't have those burdens but they have the added benefit of knowing exactly who their users are and where they are. So the advertisements they display are more precisely customized for each user.

So that's the bullish case: Strong network effects, great economies of scale, sky is the limit.

Here's the bearish case: All that might be true, but the company hasn't shown that it can extract meaningful revenue (and profit) from those users. And the business of running a social network has proven astoundingly fickle, so there is little assurance that Twitter will still be a thing a few years from now. (See: MySpace, which Rupert Murdoch bought for $580 million in 2005 — and sold seven years later for $35 million.)

On the first point, the company has been hard at work figuring out how to package "sponsored tweets" and other techniques to deliver advertisements to users in ways that don't drive them nuts and may actually be useful. But it is still early in that process. Through the first nine months of this year, it has brought in revenue of only $1.93 per active user.

In other words, if you're buying Twitter stock, you're betting that the company will rapidly find the secret sauce of serving up more ads to its users. The company will have to figure out how to serve up ads that get a good enough response from users that advertisers will pay high rates, and yet don't detract from the experience of using Twitter enough to cause users to revolt.

At a $26 billion valuation, the company is worth about as much as giant, well-established, profitable companies like Marriott International, Campbell Soup and ConAgra Foods. It is a good buy if, and only if, you feel confident you can see the future of social media, and it comes in 140 character increments.

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Irwin writes the Econ Agenda column for The Washington Post and is the economics editor of Wonkblog, The Post's site for policy news and analysis