Is Snapchat Worth $3 Billion?

The following article is exclusive content from The Motley Fool. While this is typically paid content, we are bringing it to you free because we think it is especially pertinent to your ability to invest wisely. The photo-sharing application, Snapchat, recently rejected a $3 billion buyout offer from social media giant Facebook (NASDAQ: FB). Below you will hear from one of our newsletter analysts about Snapchat's value to Facebook and why they believe that they are worth much more.

Is Snapchat worth $3 billion? Evan Spiegel, founder of photo-sharing social phenomenon Snapchat, turned down Facebook's  buyout offer so he must think so. The financial media and technocrats have no shortage of opinion either, with most taking the other side of Spiegel's bet, claiming that a $3 billion valuation for a company with zero revenue is absurd. As for me? I don't know and don't care -- but I do care about the strategic and financial implications for Facebook.

Is Snapchat worth $3 billion...to Facebook?"

As a Facebook shareholder, this is the critical question to be asking, and I think the answer is "heck yes."

For those who say yes along with me, the common refrain is that young people prefer Snapchat and that Facebook can't afford to have young people disengage from its service. Strategically, Facebook needs to retain younger users, and it needs to acknowledge that its users don't want all communications immortalized and logged for posterity (thank you, Timeline). I agree with this assessment, but it doesn't go far enough in explaining why that price tag is justified.

For that, we need to look at Facebook's competitive advantage and its valuation.

Facebook's competitive advantage resides in the proprietary data its users upload which it parses, packages, and makes available to advertisers for hyper-targeted selling opportunities. That data must be inputted by users, which tells us that Facebook needs (a) users and (b) engagement. What drives users and engagement, primarily, is other users and engagement (and probably boredom and ease of use, too) -- classic network effects that create a winner-take-all environment. If this is, in fact, how Facebook's business will drive sustained excess profits, it needs to take strategic actions to keep its user base, grow its user base, and heighten their engagement. These strategic actions are key to Facebook protecting its moat and continuing to earn excess profits.

The reason Snapchat is important to Facebook has to do with the fact that, in order to earn excess profits for an extended period of time (decades, not merely years), it needs to attract and retain each successive generation of socialites to ensure its user data, and therefore ad fodder and profit stream, continues to mount. When Facebook begins to suspect it may have missed a cohort, it needs to fix the problem ... which in many cases will probably mean multi-billion dollar offers to companies with zero revenue or profits. For the moment, Facebook has unlimited access to money, but it has limited opportunities to secure users.

We shouldn't be distracted by the "zero revenue and profit" rhetoric -- it doesn't matter. What matters is that the user base acquired or retained extends Facebook's competitive advantages (and therefore its excess profits) for a few more years, which is easily worth tens of billions. In a winner-take-all environment, Facebook can't miss a generation or the network strength is compromised and could crumble.

Will Facebook be OK?

If we assume Snapchat is out of the picture, will Facebook be OK? I think so, provided that Snapchat isn't able to use its app as a platform to encroach on the Facebook's perma-sharing turf. However, it does highlight that Facebook may have turned its attention to far from user-centric innovation for the moment. The bulk of the company's innovation lately has centered around the business aspects of Facebook -- building out its advertising exchange and creating novel measurement and return on investment tools for advertisers. To be fair, these pressures were likely brought on by Facebook now being a public company. Eventually, and soon, the user will need to move back to the center of the company's focus, and with Zuckerberg at the helm, I'm betting on it.