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Why Investors Are Paying a Premium for Snap

By Adam Levy – May 31, 2017 at 7:00PM

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The company is valued at nearly twice the market cap of Twitter.

Snap (SNAP 11.52%) made its IPO at the beginning of March, and it's had quite a volatile ride on the public market. Investors that bought shares after the stock opened for trading on its first day have likely lost money as shares now trade around $21. But even that price tag represents a huge premium compared to Snap's peers.

Snap's price-to-sales ratio is around 49 on a trailing-12-month basis. Even with sales expected to grow to $1 billion this year, it's trading at 25 times forward sales estimates. By comparison, Facebook (META 28.12%) trades for 14 times sales and 11 times forward estimates. Twitter (TWTR) trades for just 5 times sales.

Looking at it another way, Snap's market cap of $25 billion is nearly twice as much as Twitter's $13 billion market cap.

Why are investors willing to pay so much more for a dollar of revenue from Snap than Facebook or Twitter, especially considering it's not even close to profitable?

A model wearing Spectacles

Image source: Snap.

A huge runway for growth

Snap just started monetizing Snapchat at the end of 2014. It didn't develop a real ad platform until 2015. As such, it's still growing rapidly. Analysts expect revenue to more than double this year, and then nearly double again next year. Facebook is still growing revenue fairly quickly, but it's expected to slow to about 40% this year and 28% next year. Meanwhile, Twitter is experiencing a revenue decline this year.

Analysts see several major revenue drivers from Snapchat. Most importantly is its average revenue per user. Last quarter, Snap generated $0.90 per user. In North America, it made twice its global average, $1.81 per user. Still, that's well short of the revenue generated by Facebook and Twitter.

What's more, Snapchat gets better engagement than Twitter. The average user spent more than 30 minutes per day using the app last quarter. So, there should be plenty of room to increase the number of ads users see.

Snap can also grow revenue by increasing its user count, although user growth has slowed significantly since the middle of last year, when Facebook started copying the main Stories feature of Snapchat. Another opportunity remains in Spectacles, its wearable camera built into a pair of sunglasses. The device generated about $8 million in revenue last quarter.

Is Snap really worth paying a premium for?

Snap looks like it will grow extremely quickly over the next couple years as it ramps its advertising business, but Snap reminds me more of Twitter than Facebook.

It's focusing first on big-brand advertisers, and its success with small businesses is yet to be seen. The company opened up its advertising API to allow businesses to target ads more easily earlier this year, and it just launched a new self-serve ad buying platform this month. Both could help Snapchat attract smaller ad buyers.

While Snapchat's engagement is impressive, the amount of ad inventory it can theoretically sell is less so. There aren't as many natural spaces to place ads compared to Facebook or Twitter. What's more, the native ads in Snapchat typically require sizable budgets to create (full-screen video, custom face lenses and geofilters, etc.). It'll be hard for Snapchat to attract a lot of advertisers, like Facebook does.

Twitter found it difficult to penetrate the small business market with a product very similar to Facebook ads. The company still generates the majority of its ad revenue from direct sales to big brands. And when engagement growth slowed, ad revenue started to fall off. The company posted its second straight quarter of year-over-year ad revenue declines in the first quarter.

Snapchat may face a similar fate as Twitter, where it sees a cap on its revenue. While it's growing quickly now, investors are betting it will keep growing well into the future with the price they're paying.

Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Facebook and Twitter. The Motley Fool has a disclosure policy.

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