The latest news today is reporting the takeover of Instagram by Facebook for a nice round sum of $1 billion.

This is the first major takeover undertaken by Facebook.

It comes just before the flotation of Facebook’s own shares on the stock exchange, expected to be sometime in May or June 2012, although a firm IPO date has not been announced yet.

Is this a smart acquisition by Facebook or have they lost their minds?

And even it is a smart acquisition, is $1 billion a fair price for Instagram?

As a share investor, this question of fair value for a company and its shares is one you will face every time you buy and sell shares for your own portfolio.

So let’s take a look at this “investment transaction” right now to see what it reveals and what we can learn…

What Is Instagram?

I’ll be honest with you now – I’ve never heard of Instagram!

I like to think that I know a bit about technology and I have a lot of gadgets including an iPad and an iPhone and I know what iOS is.

I love apps and I have far too many on my iOS devices.

But I’ve still never heard of Instagram.

So when I heard the news today, I had to go looking on the Internet to find out what Instagram was.

I discovered that Instagram is a company that produces an app for iOS devices such as the iPhone and iPad.

As of last week, early April 2012, Instagram also produces its app for the Google Android mobile operating system too.

The app allows you to apply a filter to any photographs taken with your mobile device, to make them look better and then post them easily onto social networks such as Facebook, Twitter and Flickr.

How Does Instagram Make Money?

Er…it doesn’t!

No I’ve not gone mad or lost my marbles or started smoking dope or anything similar.

Instagram does not make any money.  Full stop.

Not only does it not make any profits, but it does not generate any revenue/income either.

That is because the Instagram app that it “sells” for iPhone, iPad and Android mobile devices is FREE.

Instagram is therefore a loss making company, spending investors money on developing apps to touch up and share photos, which it then gives away to the likes of you and me!

That’s all very generous of them isn’t it?

So is Instagram a business or a charity?

What Is Fair Value For Instagram?

Valuing a company like Instagram is not quite as straight-forward as you might think.

As I explained in my article on Valuation Methods, there are 3 main ways of valuing a company.

Before you read any more, it is worth watching the short video from my article which I have reproduced below:

I have previously applied these 3 valuation methods to the Facebook IPO itself.

That was difficult enough.

But with Instagram, applying these methods is about as useful as a chocolate teapot!

Net Asset Valuation Method

To use this method, we need to know the net asset value of Instagram.

Instagram is not a public company and has only been in business since October 2010 so its accounts are not readily available.

In any case, like Facebook, it is likely to be a low asset company.

Producing apps does not require lots of infrastructure, plant and machinery or inventory.

Not producing any income also means that it won’t have any debtors either.

So any assets it does have are likely to be cash and investments only and thus the NAV method would underestimate the value of the business.

Price To Earnings Comparison Method

Given that Instagram made zero in revenues and zero in earnings, this PE Ratio method will yield a value for Instagram of ZERO!

Discounted Cash Flow Method

Similarly, revenues, profits and cash flows of zero implies a DCF Valuation of ZERO too!

But the DCF method is often used to value start-up scenarios such as this, which have lots of potential and not much of a track record.

So does Instagram and Facebook have plans to monetize the business in future?

If it does and if we knew what those numbers were, we could use the DCF method to turn those estimated future cash flows into a value for the business.

As those numbers have not been published, we would have to make up our own.

To do this, we need to forecast the future revenues, profit margins, profits, cash flows, capital expenditure, borrowing levels, and so on.

For the reasons I mentioned in my valuation methods article, I’m not going to attempt this method here as it is far too complicated and we would have to make far too many assumptions due to the scant financial information available.

However, it is worth considering some of the information we do have and considering the possible scenarios.

What Are Facebook’s Plans For Instagram?

Facebook has said that it plans to leave Instagram as a standalone app but increase its ties with Facebook.

What does this mean?

Instagram was beginning to become more of a social networking app than a photo app and this may explain why Facebook is interested in it.

Instagram is just getting going with 25 million users compared to Facebook’s 847 million.

Instagram has lots of competitors doing similar photo jiggery-pokery but seems to have got itself noticed because of its rapid rise in user numbers.

Facebook’s move could therefore be a way of saving money on the development of its own photo application which it was previously working on.

Or it could be a defensive move to take out a fast rising competitor.

Only time will tell what Facebook’s plans are for Instagram and so attempting to estimate the future revenues of the business are nigh on impossible.

So Is Instagram A Good Buy?

Is a company with only 13 employees, no sales revenues, no profits and a single FREE product in a competitive marketplace of highly fickle users worth $1 billion?

Well, put like that…err…

If you had a billion dollars going spare, would you spend it on this company?

I’m pretty sure I wouldn’t!

Admittedly, I’m not Mark Zuckerberg and I don’t have a billion dollars burning a hole in my pocket.

But then I’ve got something that Mark Zuckerberg has not got!

Like many other investors of my age and experience, I’ve seen and experienced all this nonsense before during the Dotcom boom at the end of the last millennium.

I’ve therefore got the grey hair, the emotional scars, the memories and the experience that Mark Zuckerberg has not got.

Sure, he’s got advisers, but they are all too keen to take his money and tell him what a great, insightful decision he is making.

And the problem he will have, like most ‘great leaders’, is that his closest advisers will not want to tell him the truth.

Just in case they lose favor with him and they then drop out of his inner circle.

Behavioral psychologists call this phenomena Group Think and it can destroy companies and great leaders.

Has Mark Zuckerberg Lost His Marbles?

Or is he busy lapping up the praise of his ‘yes men’ whilst he drinks his own bath water and believes his own ‘publicity’?

Whether he is or not, it is rare for acquisitions of this type to turn into good, sound investments.

Google’s acquisition of YouTube for $1.65 billion in 2006 is only just starting to pay back properly six years later and looks like one of the better ones.

Newscorp’s acquisition of Myspace faired less well turning a $580 million social network leader into a $35 million has-been in six years.

Similarly, AOL turned its $850 million acquisition of Bebo into a $10 million company flop in just over two years.

Instagram may go the same way but I expect it will become lost in the Facebook empire and fully integrated at some stage.

My guess is that the promise of keeping it as an independent company is a condition of purchase imposed on Facebook by the Instagram founders.

I can’t believe that Facebook is now entering the app market and certainly not with FREE apps, unless it plans to develop and market a pro version of the app.

My instinct tells me that this is a panic purchase by Facebook at a ridiculous valuation.

But hey, what do I know?

Let me know your views by leaving me a comment below or posting on my Facebook page here.

Now there’s an irony for you!

Keep smiling,

Adrian