When a Network Effect Like Snapchat's Are Overvalued

What's the difference between a LinkedIn and Snapchat user? One is a bit more permanent.

Jan 6, 2014 at 10:30AM

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.

Investing picks in strong networks
Strong network effects can lead to fantastic returns. And, such a quality is only one to look for to match Motley Fool co-founder David Gardner's 100-bagger stock pick wins. You can uncover his scientific approach to crushing the market and his carefully chosen 6 picks for ultimate growth instantly, because he's making this premium report free for you today. Click here now for access.

Fool contributor Dan Newman owns shares of eBay. The Motley Fool recommends eBay, Facebook, LinkedIn, and Twitter. The Motley Fool owns shares of eBay, Facebook, and LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.

Compare Brokers