Instagram could be one of the best deals of the last decade

The news that Citigroup now thinks Instagram could be worth as much as $35 billion likely caused some mouths to fall open last week, and the list of those who found themselves agape probably included co-founder Kevin Systrom and Twitter CEO Dick Costolo, although for very different reasons. Whether Citigroup has the actual number right or not is impossible to say — but what is clear is that the Instagram acquisition could be one of the smartest things that Facebook has ever done, and one of the best deals of the past decade.

The reason why Kevin Systrom might be shaking his head a little at the valuation is that such a huge number implies he might have sold the company too soon, something that Silicon Valley founders and their financial backers often worry about after the fact. Of course, it’s difficult to say whether Instagram would ever have gotten there if it had remained an independent company and not had Facebook’s marketing power behind it.

As for Dick Costolo, he’s likely remembering when Twitter tried to buy Instagram — and, according to some reports, had a deal ready to go — only to have Mark Zuckerberg swoop in and yank the company out of his grasp with a much higher offer. Now Instagram not only has more users than Twitter (although Twitter co-founder Evan Williams said recently that he doesn’t care about those figures) but it is now worth more too, at least theoretically.

Photo sharing = ads

Getting to $35 billion requires you to do some mental gymnastics of the kind that Wall Street analysts are pretty accustomed to — you take the 300 million users that Instagram says it has, then estimate what each one could generate in terms of advertising revenue, then look at what proportion of Facebook’s overall revenue that represents, then apply the same multiple that Facebook’s stock has and bingo: eventually you get $35 billion.

Om Malik — Founder, Gigaom Speaker: Kevin Systrom — Co-Founder and CEO, Instagram

Om Malik with Instagram founder and CEO Kevin Systrom

So Citigroup analyst Mark May previously argued that Instagram was worth about $19 billion based on this arithmetic, but now he says its almost twice as much. Why? Because he thinks that Instagram’s advertising — with companies like Adidas, GE and Lexus — is going so well that the company could bring in far more revenue than he expected. In fact, he estimates that Instagram’s revenue will be close to $3 billion next year, or about three times what Facebook paid for the company.

Even if you disagree with the $35 billion price tag that Citigroup has come up with, it’s hard not to argue that Mark Zuckerberg got a hell of a deal when he bought Instagram for only $1 billion, even though that sounded like an awful lot of money at the time (of course, that was before Facebook paid an even more mind-boggling $19 billion for WhatsApp). Is it the best deal of the past decade? I think it’s right up there.

Better than YouTube?

It’s not just that Facebook paid $1 billion for something that might now be worth $35 billion, although that is pretty incredible in itself. It’s that by buying Instagram, Mark Zuckerberg was able to tap into something that had the potential to disrupt Facebook in the worst kind of way: a photo-sharing app that not only was growing like a weed, but appealed to younger users — the very same user base that was becoming increasingly disenchanted with Facebook proper.

Facebook’s purchase looks even smarter because of what it did after the acquisition, which is virtually nothing — in other words, it left Instagram alone to function more or less as it had before. I come across younger fans all the time who don’t even know that Facebook owns Instagram, and that’s probably for the best. This is a classic example of Zuckerberg’s willingness to disrupt himself and his business at the drop of a hat, often by spending billions (WhatsApp is another great example).

The only acquisition I can think of that comes close to Facebook’s purchase of Instagram is Google buying YouTube: just as it was in Instagram’s case, most analysts thought the $1.65 billion price tag for the video-sharing site was insane — especially given the potential copyright issues. This year, YouTube is estimated to be worth about $40 billion to Google, which is right in the same ballpark as Instagram, if you believe Citigroup’s numbers. And Google did the same thing with YouTube as Facebook did with Instagram — namely, mostly left it alone. There’s a lesson in there somewhere.