Investors love Twitter. Really, really love it.
Just a week ago the company had expected to issue shares for $17 to $20 each. Earlier this week, it upped that to a $26 initial public offering. And in trading Thursday, Twitter saw its stock hit as high as $50 a share before settling at $46 to $47 in mid-afternoon. At that price, the value of the company stands at around $26 billion -- for a money-losing company that had only $317 million in revenue last year and $422 million in the first nine months of 2013.
By contrast, WellPoint Inc., a health insurer with about the same market capitalization, had $69 billion in revenue last year, or 217 times as much.
At first glance, it might seem insane. Investors are paying dearly for a company with relatively minuscule revenue that is still losing money. It's clear that Twitter could one day earn vast amounts of money from its popular social network. But it has not at all proven that it will be able to pull that off and become a lasting money-maker.
But what if investors were so enthusiastic about Twitter shares not in spite of its relatively low revenue, but because of it?
Here's an analogy. In the mid-2000s, I was reporting on commercial real estate in Washington. It was a unique time in which investor sentiment was particularly favorable to office buildings in Washington, D.C. A developer once explained to me an odd quirk of how investors in those buildings were viewing things.
It was better to sell an office building empty, with no leases signed, he explained. That way, buyers would build models projecting the rents they would be able to get for the office space -- and whoever was most bullish on office rents in Washington would be willing to pay the most, and thus win the auction. That defies normal financial analysis, which says that it is more valuable to buy something where you know exactly what kind of cash it will spin off.
But in times when pervasive optimism prevails, speculative possibility can be more valuable than a sure thing. It particularly holds true when there is a limited amount of supply of something on the market (whether that is empty office buildings in downtown D.C. in 2004 or Twitter shares on Thursday morning, at the IPO's debut).
What does that have to do with Twitter? The company is relatively early in the process of turning its huge audience into revenue. It faces a delicate balancing act of trying to sell advertisers the right to slip commercial messages into peoples' Twitter streams often enough to make the kind of money that would justify a $26 billion valuation -- but not in ways that degrade their service so much that people stop using it.
It is a tricky balance, and it is no sure thing that the company will succeed. Nor is there any certainty over what its revenues and earnings will look like in a best-case scenario. When investors are valuing not the current earnings of a company but its future potential, the range of possibilities is exceptionally wide.
Because the company is just beginning to monetize its user base, investors can pencil in whatever optimistic expectations they wish. They can see what they want to see. And with finite supply (only 69 million Twitter shares are floating int he market, 12 percent of its 545 million total), it is those with the rosiest view of the company's prospects who appear to be setting the price. Short sellers could ultimately bring them back to earth, but it could take time for those who want to bet against Twitter to fully enter the market.
Over time, this will resolve itself one of three ways. Perhaps the company will turn out to be a smashing success, growing so flush in users, revenue and earnings that the optimists' projections are justified and everybody is happy. Or perhaps those numbers will disappoint and the great rise in sales and earnings that is currently priced in never materializes, bringing Twitter's share price back to earth over a period of many years as it becomes easier to value the company.
A third possibility is that the adjustment happens sooner rather than later, as pessimists start to bet against the company by shorting its stock and more supply enters the market as insiders start to cash out, increasing the volume of shares trading on the open market. In other words, in a few months we may not know yet whether Twitter has a bright financial future. But we will have a better handle on what a fair market price is for its stock.
If Twitter had waited a couple more years to go public, the success or failure of its revenue strategy would have been clearer, and, for good or ill, its share price would more precisely reflect its business prospects. By moving early, before its business has matured, the company has let investors bet on possibility rather than reality.