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Last November, a couple of econophysicists at the Swiss Federal Institute of Technology in Zurich took a close look at the share price of Facebook, the social networking company that is valued at anywhere between $65 billion and $100 billion.

That, they said, is crazy given the amount of money Facebook can reasonably squeeze out its 750 million users. They calculated that a more realistic valuation would be between $15 and $30 billion, based on Facebook being able to extract about $1 profit per user and under the assumption of modest growth in the next few years.

We’ll find out in the near future whether anybody has taken any notice of Peter Cauwels and Didier Sornette when Facebook’s IPO finally takes place later this year. It is widely expected to be one of the largest in history.

Today, Cauwels, Sornette and a colleague, Zalan Forro, take aim at another social networking company currently valued at eye-watering levels. This time, these guys ask whether the social gaming company Zynga is overvalued with a market capitalisation of around $8 billion.

The strange thing about the company’s value before it went public a few months ago, is that while plenty of numbers were bandied around, nobody offered any reasoning for their valuation. Some analysts said  Zynga could be worth as much as $14 billion, a number that might as well have have been plucked out of the ether and may well have been.

Cauwels, Sornette and Forro have decided to inject some method into this madness by calculating a reasonable value for Zynga based on thee scenarios–a base value, high growth and super high growth.

The point out that valuing Zynga is much more complicated than valuing Facebook  or other companies because its success is intimately related to the popularity of individual games and so cannot be easily modelled by a single function. Instead, they look at the company’s likely rate of innovation–the rate at which it produces popular new games. 

They conclude that a base valuation of Zynga is $3.4 billion and say that even under the assumption of super high growth, it cannot reasonably be valued at more than $4.8 billion. 

“On the basis of this result, we can claim with confidence that, at its IPO and ever since, Zynga has been overvalued,” say Cauwels, Sornette and Forro, adding that even their calculations are optimistic.

The bigger picture, of course, is that the entire market for social networking companies is experiencing a bubble, probably sustained by the greater fool theory of market behaviour: “I’m a fool for paying so much but I know there’s a greater fool out there who will pay more”. 

We all know how that ends. The question at the back of many fools’ minds will be this: will the end come before or after the Facebook IPO?

Ref: arxiv.org/abs/1204.0350: When Games Meet Reality: Is Zynga Overvalued?

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