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A closer look at Google’s acquisition of Nest: A smart move, but a silly price

Google bought Nest for $3.2 billion (£1.9 billion), a number that makes no sense to humans. At that point, we're talking silly money – Silly Valley money, to be precise, the giant tides of cash that slosh around between the San Francisco Bay and the Pacific Ocean without giving any benefit to the hundreds of millions of Americans whose incomes have flatlined.

To look at it another way, Google paid 28.5 times Nest's estimated annual revenue of $120 million (£73 million). Unless you have infinitely deep pockets (which Google apparently does) you only pay that kind of a premium if you think your purchase is going to completely transform the world, or if you think your company will completely collapse if you don't make the buy.

As $3.2 billion (£1.9 billion) is less than 6 per cent of Google's cash hoard, the search giant may not think twice about spending that much on a nice evening out and a few bottles of wine. But let's assume Google actually considers $3.2 billion (£1.9 billion) a meaningful amount of money and explore why the heck the firm thinks it should spend that much for a thermostat company.

Google can't make hardware without acquisitions. Google is a software and services company at heart, and it's done a great job at nurturing third-party hardware ecosystems around its software and services. But sometimes you need to lead by example. The Nexus Q proved that Google doesn't have great consumer hardware expertise in house. After buying Motorola for its patents, Google has backed off from shutting down its hardware operation and instead encouraged CEO Dennis Woodside to pursue ideas like the Project Ara modular phone concept. Motorola and Nest shows that Google may not be able to make hardware, but it can buy people who can.

Nest monitors the real world. Google's revenue model is all about knowing things about you. Recently it's been trying to expand that knowledge from the virtual world into the real world, for example with a new Google Now feature that summarises how much walking you've been doing based on collected GPS data. Nest lets Google break out into the real world in a big way: As it expands its home automation products, it'll know which room you're in, how long you spend there and what you're doing. That's useful information to leverage with advertisers and partners.

The "Internet of Things" is at an early stage. A clear trend from CES 2014 was that over the next three years, we're going to try to connect everything to everything else. Phones are being reinvented as "sensor hubs" that collect data, interpret and analyse it. There's a land grab going on for the best expertise and infrastructure in this new, growing field, and Google wants to have a strong position early on.

There's other good analysis of the nest deal out there, varying from the sensible to the hysterical. The Verge does a good job of rounding up the responses and Nest's CEO has been speaking with them and with GigaOm.

So much silly money

Nest is just the latest Silicon Valley acquisition to close at a completely ridiculous valuation, though. Admittedly, it actually produces things and has revenues, which makes more sense than spending $3 billion (£1.8 billion) for Snapchat, an insecure, faddish instant-messaging app, or $1.1 billion (£670 million) for Tumblr, which had $14 million (£8.5 million) in revenues when it was bought by Yahoo last year.

There have been smart, big-ticket acquisitions out there: Here's a list of dull-but-worthy ones that have been quietly enhancing the revenues of business technology firms. (Not that they never make mistakes; in so many ways, buying Autonomy severely damaged HP).

But buys like this enhance the sense that Silicon Valley is playing with Monopoly money, completely disconnected from the reality in which most Americans live. In Silicon Valley, twenty-something engineers making well into six figures spend well into seven figures for the average single-family home, while more than 20 per cent of San Francisco residents live in poverty and the median US household income flatlines at a level lower than it was before the "Great Recession" of 2008.

Maybe this is the new America – anchored by giant bags of money in the basements of New York City investment banks and Silicon Valley startups, while everyone else between scrapes for quarters down the back of their sofas. A revenue multiple of 28.5 times makes sense when you have more money than you know what to do with – and in the technology industry nowadays, that frequently seems to be the case.