On the face of it, Microsoft’s decision to pay $26.2bn (£18.5bn) for the social media company could seem excessive but the company will have completed detailed cost modelling exercises and have a plan in place for realising value from its investment.
Clearly the valuation in this case is not based on turnover and profits. Most of the value tied up in the deal is a nod to LinkedIn’s data sets. This data is not just comprehensive it is also up-to-date and requires no cleansing. From a user perspective, the nature of some of this data is immediately apparent.
LinkedIn knows where we work now, where we have worked in the past, and, depending on our recent search history, where we might be heading next. Based on information about which professional groups we have joined, LinkedIn can also deduce our areas of specialism and expertise.
Once analysed, such big data has significant commercial value, which Microsoft is obviously intending to leverage. In particular, there is speculation already that Microsoft could be planning to use it to help identify sales leads, start conversations and close deals.
The worry now is the impact this valuation could have on the deal market as a whole. If anything positive came out of the recent economic downturn from a corporate finance perspective, it was that vendor expectations became more realistic. Tech companies in particular were forced to acknowledge that business valuations must be based on concrete financial information and profit-making potential. Could this transaction encourage tech companies to start pursuing aspirational valuations once again?
Far from being a start-up venture, it is important to remember that LinkedIn is a successful, income-generating business, which is operating a platform used by millions of users. This platform has gained recognition as a valuable resource for third party users who would wish to access its data or use its services to reach a targeted audience of business people.
While it is not unusual for tech companies to attract high valuations that are not supported by their current earnings, they must stand up to close scrutiny. Any business valuation will be arrived at based on a number of considerations including the sector it is trading in, its earnings potential and its actual earnings. For high-growth tech businesses, a discounted cash flow model, which takes account of future earnings potential, is considered reliable in most cases.
Instead of getting carried away by headline deal values, tech companies should concentrate on developing their business plan and adding value to their data sets. This is where the real value lies.