Twitter could end up being really profitable. But it’s a super risky stock.

November 4, 2013

Twitter is moving forward with the most hyped stock offering of the year this week, and investor demand appears to be off the charts. After initially planning to sell shares for $17 to $20 each, the company now expects them to go for $23 to $25 each, which will value the company at up to $13.6 billion.

Not bad for a firm that had only $317 million in revenue last year and has never earned a profit.

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So what is going into this valuation, and does it make any sense? Here are the concepts that anybody thinking of investing in Twitter needs to understand.

First, Twitter does have the characteristics of businesses that can become wildly profitable. It relies very much on network effects: Twitter is more useful to everyone the more people use it. That is to say, the fact that Katy Perry and Barack Obama and your third grade teacher now all have Twitter accounts make it more likely that you will want to have an account, if only to follow them. The fact that you have an account and follow people makes it more valuable to the celebrities and advertisers who want to count you among their followers and to your friends and acquaintances.

Those network effects act as an economic moat that could protect Twitter from competition. Anybody can start a new microblogging service and try to undercut Twitter with advertisers. But while it may be easy to replicate the service itself, getting the critical mass of 232 million active users Twitter already has is not. (If you think launching a social media network from scratch and getting mass usage is easy, just ask the people who brought you Google Plus.)

The best thing from investors’ point of view is that Twitter, like Facebook, is able to keep building a large audience with very little expenditure. Its users are creating the content, and Twitter just has to keep the servers running and make sure the interface is welcoming and try to avoid Fail Whales.

Twitter and Facebook command big chunks of their users’ time and attention — attention that they can sell advertising against — without the messy and expensive responsibilities of creating any content themselves. At The Washington Post, we have a big roomful of people paid to write articles we hope you will click on; a TV network has to spend millions creating shows that they hope you will watch.

Twitter and Facebook not only don’t have those burdens of producing content, but they have the added benefit of knowing exactly who their users are, and where they are. So the advertisements they do display are more precisely customized for what that particular user is interested in.

So that’s the bullish case for Twitter: Strong network effects, great economies of scale, sky is the limit.

Here’s the bearish case: All that might be true, but the company hasn’t shown it can extract meaningful revenue (and profits) from those users. And the business of running a social network has proven astoundingly fickle, so there is little assurance Twitter will still be a thing a few years from now.

On the first point, the company has been hard at work figuring out how to package “sponsored tweets” and other techniques to deliver advertisements to users in ways that don’t drive them nuts and may actually be useful. But it is still very early in that process. Through the first nine months of this year, it has brought in revenue of only $1.93 per active user.

In other words, if you’re buying Twitter stock, you’re betting that the company will rapidly figure out the secret sauce of serving up more ads to its users. The company will have to figure out how to serve up ads that get a good enough response from users that advertisers will pay high rates for, and yet don’t detract from the experience of using Twitter enough to cause users to revolt.

They could do it. Think of how rapidly Google has managed to make ads tied to search results the dominant driver of its enormous business, or how seamlessly it has gotten us used to ads tied to YouTube videos. At the same time, a decade ago it was not at all certain that Google would be able to figure that all out, and the same is true of Twitter today.

But the biggest threat to Twitter’s longer-term value is the faddishness of social media. People are fickle, especially the younger people who are heavy users of Twitter. Ask anyone who used Friendster or MySpace in what seems like a distant past (or ask Rupert Murdoch, who paid $580 million for MySpace in 2005 — and sold it seven years later for $35 million).

If you pay $25 a share for Twitter, you’re essentially saying that you are confident the company will master these challenges and become a cash cow, spinning off huge earnings thanks to its unique hold on users. At a $13.6 billion valuation, the company would be worth about as much as giant, well-established, profitable companies like Marriott International, Campbell Soup Co., and ConAgra Foods. It is a good buy if and only if you feel confident that you can see the future of social media, and it comes in 140 character increments.

Want to know more? Here's Lydia DePillis on the five most fascinating things you'll find in Twitter's IPO registration.

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Sarah Kliff · November 4, 2013