It was only a couple years ago when people said $1 billion was way too much for Facebook (NASDAQ:FB) to pay for Instagram. Since then, Facebook has made several more billion dollar acquisitions, including paying $19 billion for WhatsApp. Last fall, the company reportedly offered to pay $3 billion for Snapchat and was turned down. Many didn't understand why.
It seems Snapchat is getting the last laugh, however, as its most recent round of funding valued the company at $10 billion. While it's a far cry from Facebook's $200 billion valuation, it's fairly close to the market cap of Twitter, which stands around $30 billion. More interesting, it's more than twice the value of mobile game maker King Digital (NYSE:KING).
There's big money in mobile games, and Snapchat still generates $0 in revenue. King Digital is even turning a significant profit. So, why is Snapchat worth so much more than the most noteworthy mobile game maker?
Utility vs. entertainment
While Snapchat seems like a novelty act at first, it turns out to be quite a handy communication tool. It makes sharing pictures and videos with friends extremely easy -- easier than most other messaging apps. To a certain degree, Snapchat is indispensable to its users.
Mobile games, on the other hand, often rise and fall in popularity quickly. Even games with strong staying power find themselves usurped by the next big fad within months. For one company to consistently create new engaging and overwhelmingly popular games is practically impossible.
Candy Crush Saga is already slipping from its throne. The game is now the 19th most popular free game in the Apple App Store. In the second quarter, the apps gross bookings declined $70 million sequentially, leading to a $30 million decline in King's overall gross bookings. Management expects that number to decline more significantly in the third quarter.
King hasn't been able to generate a strong follow up to Candy Crush, and once it does -- if it does -- it will need to generate another ... and another ...
Snapchat, as a utility, can simply focus on drawing more users to its flagship product. It doesn't have to keep creating novelties in order to stop users from flocking to a competitor. New features are introduced to improve the utility of the app, which makes it more attractive to a wider audience with the addition of stronger engagement from existing users.
The network effect
What Snapchat really has going for it, however, is that it's a social network at its core. It sends you alerts that your friends want to connect with you, which are much more powerful alerts than a game shouting, "play me, play me."
This network effect increases adoption at an exponential rate, and it keeps even casual users engaged with the app on a consistent basis.
There's a long history of social networks consistently increasing their active user base. Facebook's monthly average user, or MAU, metric has never declined. After it acquired Instagram, the photo sharing network saw its user base grow from 30 million to 200 million over just two years. Since Facebook bought WhatsApp, it's grown from 450 million user to 600 million users, and it had previously doubled its user base in the 12 months before the purchase agreement.
The network effect applies to Snapchat too. The app reportedly has over 100 million active users, which is more than three times the number of users it reportedly had when Facebook offered the owners $3 billion for it in November. Moreover, about two-thirds of those users open the app daily. Snapchat benefits from the fact that one user sharing content often forces another user to open the app to see it -- the network effect in action.
While 67 million users is only half of King's 138 million daily active users in the second quarter, Snapchat is heading in the right direction while King is not. Daily users declined by 5 million sequentially for King -- there's no network effect.
Still not that expensive
On a cost-per-user basis, Snapchat isn't very expensive. At about $100 per user, both Facebook and Twitter cost more. If you look at its potential for growth compared to King or Zynga -- both of which are struggling to grow revenue -- it makes perfect sense why Snapchat is worth more than them.
Adam Levy has no position in any stocks mentioned. The Motley Fool recommends Facebook. The Motley Fool owns shares of Facebook. 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.