When a Network Effect Like Snapchat's Are Overvalued

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When determining the value of certain companies and their competitive advantages, the number of users or customers is often highlighted. These are called network effects -- the more users who take part, the more valuable that service becomes for everyone.

However, somewhere in the shift from traditional industries to high-tech start-ups, the exact value of a network has gained more than the value it can actually create.

Tangible versus ephemeral
Whereas the network effects of interchangeable parts for all sorts of machinery are clear and tangible, the value of advertising to Facebook's (NASDAQ: FB  ) network are still a bit unclear. For example, back in October, a Forrester survey ranked Facebook at the bottom of advertising effectiveness behind LinkedIn (NYSE: LNKD  )  and Twitter. Whereas a marketplace like eBay obviously gains from more sellers and buyers of physical products, smartphone application Snapchat's user base amounting to a $3 billion valuation may not make much sense.

Weak networks
As the ease of floating in-between and among these networks increases, the value of network effects should fall. This has yet to happen, as valuations speak to the belief of a strong network lock-in. While joining the Microsoft Office network meant that a user had to pay a non-zero amount, joining Snapchat has little cost beyond a few taps on a smartphone. And while that's great for quickly building a user base, it creates a weak network effect in comparison to one with more initial cost.

This idea of weak network effects should be applied to most online social networks, especially ones that provide a free service. Now that we don't even need to sit down at a computer to join a network, or fill out any form, or pay anything, the value of each user should be minuscule.

Monetizing weak networks
That's not to say that these companies can't make money and easily monetize through advertising. Facebook's income statement is a testament to the amount advertisers are willing to pay to access these networks. In the last quarter, advertising brought in $1.8 billion of Facebook's income, 89% of its total for the quarter. However, when a company like Snapchat springs up and sports nothing but a small tweak to previously offered services like Instagram, one should remember the outcome of past fads. The barriers to entry for making a service go viral are minimal. And while Beanie Babies at least had a profit margin to reap while they were popular, Snapchat has little more than server costs.

The lesson
When looking at a company that uses network effects to support its value, make sure they actually reap value from their network. LinkedIn is a great example. While it offers plenty of its service for free, it also sells premium subscriptions that brought in $80 million last quarter and hiring solutions that brought in $225 million. This is in addition to its advertising revenue -- what most other social networks solely depend on -- of $88 million. And once a company buys into its network to find employees, and that becomes the standard way for a company to find talent, it becomes a much stronger lock-in effect.

Beware of weak social networks. They can spring up as easily as they can fall apart.

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Dan Newman

Writing for the Fool since 2011. Interested in technology, the future of society, and how both overlap.

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