A few weeks ago, Microsoft made a $240 million investment in Facebook for a 1.6% stake.  That puts Facebook’s valuation at $15 billion versus sales of approximately $150 million.

That’s a breathtaking 100-times revenues valuation.  By conventional logic, that’s a nearly impossible valuation to justify.

But that pre-supposes that valuation is inherently a logical process.

Of course, you can whip out your MBA textbooks and read up on how a company’s valuation is SUPPOSED to be a discounted cash flow, blah, blah, blah…

Yes, it is supposed to work that way… but in reality, valuation is driven by something far more powerful than logic — human nature.

You see, Facebook’s valuation, triggered by the Microsoft investment, is far more revealing about Microsoft than about Facebook.

Most, if not all, of the mainstream media missed this point.  They all focused on Facebook and whether or not it was worth it.

The better question was what in the world was Microsoft thinking when they made such an absurd valuation?

The answer:  They weren’t thinking; they were FEELING.

Two feelings drive valuation:

1) Hope

2) Fear

Hope has to do with feelings about the future.  Facebook CEO Mark Zuckerberg must have told one heck of a story.  It was likely a story that used the magic words, “Social networking is going to be the OPERATING SYSTEM of the future.”

OH… magic hot-button for the folks in Redmond.  These are the folks who believe it is their birthright to dominate the operating system market for eternity.

Will Facebook become the next operating system?  Who knows.

This moves us to the second psychological aspect of valuation:  FEAR

Can Microsoft afford to not see such a change coming down the pipeline?  On the off, off chance this vision becomes reality, can Microsoft afford to be left behind in the operating system market?

For a company with $51 BILLION in annual sales based on their dominance of the operating system market, is $240 million (a mere 0.5% of one year’s revenues) a small price to pay as a form of insurance against this wild card scenario?

YES.

Think of it this way:  What if the next 10 years of all of your earnings could be wiped out by some catastrophic medical, geological, or military event.  Would you give up 0.5% of one year’s income to avoid, or at least get, early notification of such a change?

Here’s a simple example with round numbers.  Would someone making $100k a year, pay a $500 one-time fee to get 12 – 24 month’s advanced notice that his/her industry is going to disappear?  Put in that context, it doesn’t seem totally ridiculous, does it?

In a future, post I’ll talk about how to use HOPE and FEAR to drive the valuation of your company… and the right mechanism for communicating this to private and public investors.