Thursday, January 24, 2008

Web 2.0: Bubble?

I was reading a note about Zillow's new round of funding (WSJ link, paid) a couple months ago, and their post-money valuation, at $350 million, seemed a little high to me. I didn't have time to do the math, but I returned to it today to do some back-of-the-envelope math. I wanted to use a more analytical approach to to a gut check on whether here's any truth to the b-word being bandied around about Web2.0.

Zillow's business model is advertising-based, and they're allegedly profitable. They're a fairly well-known brand in the home valuation arena, but are they really worth $350 million?

Let's do the math together.

Here's how I'm figuring it: The nearest comparable is a public, ad-supported, web-based business. There aren't any that I can directly compare with in the industry, but I decided to use Google as a baseline. Treating Google as purely advertising-driven isn't strictly true; Google also sells products like the Google Search Appliance, extra drvive space for Google apps, Google Premium Apps for small businesses, etc. However, since the majority of their revenue still comes from advertising, this should give us a ballpark estimate, if nothing else.

Here are the rough metrics on average stay and visits/month:

Let's assume the value to advertisers is roughly the number of visits times the length of stay, and for argument let's assume Zillow's ads are worth the same as Google.

Site Average stay (mins) Visits (million) Valuation Metric (Stay * Visits) Valuation ($M)

Zillow 525 3.3 1,732.5 550

Google 405 1400 567,000 180,000

This gives us a valuation of $550M for Zillow. Factor in a discount for startup risk (if you can make the same return on Zillow as you can make on Google, most rational investors would choose Google) and lack of liquidity (for the VC investment), and $350M isn't looking completely outlandish after all, even though this back-of-the envelope calculation assumes away a number of factors.

Some of the simplifying assumptions that could skew this one way or the other, once accounted for, are:

  • Google sells products like Google Mini/Appliance, etc. Some of Google's revenue also comes from AdSense. Since Google doesn't publish revenue/profit breakdowns, the true share of valuation that comes from on-site advertising is indeterminate.
  • We're also implicitly assuming similar cost structures even though I'd expect Google's long-run cost structure to be more favorable than Zillow's, partly because of scale and partly because Zillow has to buy a lot of its data.
  • Advertising value at Google and Zillow isn't the same. People spend less time on Google by nature, but they visit often and get lots of excellent targeted advertising. On the other hand, the average value of products sold through Zillow (mortgages, brokerage services, etc.) is expected to be higher than the average value of products or services sold through Google.
  • Google's and Zillow's prospects are assumed to be equally bright, so there's no growth premium on either site. While Google is an older firm and can't grow at the same rate as a startup, it is still priced as a growth stock, and with good reason - it has the potential to grow into many new market segments. Not so much with Zillow.
So, unless you believe that Google's valuation is way overblown (which you may, depending on how pessimistic you are about GOOG's growth potential) Web 2.0 startup valuation, as proxied by $350M for Zillow, doesn't seem completely outlandish.

I have to admit that surprised me.

No comments: