Is Facebook Overvalued?

 

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Word count: 6991

 

ABSTRACT

 

Facebook is a highly popular social networking website that has had exponential growth. Current estimates of its value based on secondary market trading put a $100 billion price tag. This paper examines the validity of these valuations based on previous calculations, expected future growth, social capital, organisational structure and compares to similar companies such as Google, LinkedIn, RenRen, and MySpace. It is found that Facebook is overvalued by a factor of 3, and current valuations are fuelled by speculation based on Facebook gaining substantial market share in new forms of revenue generation. The IPO itself also suggests investment banks under price newly listed shares and in the case of oversubscribed high demand stocks initial overvaluation occurs over long run intrinsic value. The media also adds to speculation and that essentially, the market has put a lot of faith that Facebook will be the Google of social networking.

 

 

 

Contents

Chapter 1 – Introduction. 3

Chapter 2 – Methodologies. 5

2.1 A quantitative approach by Trefis. 5

2.2 A user-growth based approach by Cauwels and Sornette. 7

2.3 A market share approach by David Unterholzner from Donau Universitat Krems. 9

2.4 Implications of these valuations. 11

Chapter 3 – Can Facebook reach expectations?. 13

3.1 Facebook Mobile. 13

3.2 Social Commerce. 14

3.3 Facebook Currency. 15

Chapter 4 – Why the Gap?. 17

4.1 Fuelling factors. 17

4.2 Effects of IPO on pricing. 17

4.3 Setting up a short. 18

Chapter 5 – Social Capital and Organisational Structure. 19

5.1 Facebook’s social and economic benefits. 19

5.2 Why is it relevant?. 20

5.3 The Hacker Way. 21

Chapter 6 – A Comparative Analysis. 22

6.1 Google. 22

6.3 RenRen. 23

6.4 MySpace. 24

Chapter 7 – Conclusion. 26

References. 28

Appendix 1. 31

Chapter 1 – Introduction

“What’s your Facebook?” – A question that has essentially replaced “what’s your number?” for most young adults. The ubiquitous nature of Facebook, created in 2004 has generated a world-wide phenomenon of social networking, with user demographics spanning across the spectrum. A total of 12 billion hours per month is spent by people on Facebook, 20 million apps are installed everyday and 53% of employers research potential job candidates on social networks (Bullas, 2011). Facebook has taken the world by storm and now it’s ready to become a publicly listed company.

The value of Facebook can be judged by either private shares that are traded on the secondary market or the implied value by the price of Facebook’s float. Trading of private shares has pushed Facebook’s value past $100 billion, placing it just higher than Pepsi and four times the value of Tesco (Spears, 2012). Facebook have proposed to raise $5 billion in their SEC filing, and large media news networks like CNN have reported aims of $10 billion (Gross, Facebook S-1 Filing, 2011). Since they are expected to float 5% of the company, this implies valuations of $100-$200 billion.

The purpose of this essay is to explore the validity of these valuations. Does it make sense that such a young company with profits not even a hundredth of these estimates be placed at such a value? Three methodologies are looked at which forecast future revenue growth and use a discounted cash flow model to arrive at a quantitative valuation. The accuracy of these methods are discussed along with the basis of their assumptions. It is then seen whether Facebook is at a fair valuation, and if not what Facebook would need to do to reach it. Through the previous analysis it can then be established the direct causes of the gap and the effects of the IPO on pricing.

Facebook due to the nature of its company is based on social networks, and therefore has implications for social capital. The concept of social capital is explored with relevance to Facebook and why it should be taken into account in estimating its value. Furthermore, Facebook’s founder Mark Zuckerberg has had a lot of media exposure and is crucial in how people perceive Facebook to operate in the future. This also has effects on its valuation and how his actions have either been beneficial or not are discussed.

Lastly, Facebook is compared against other companies that have similarities in either company structure, i.e. other social networks or that derive their revenue in a similar way. Future outcomes can be inferred by looking at how other similar companies such as Google, RenRen and MySpace have operated and by drawing upon their similarities and differences.

Chapter 2 – Methodologies

Identifying an estimate for a valuation is challenging because there has been nothing quite like Facebook. There has been a small amount of similar websites such as Friendster (2002), Hi5, MySpace and LinkedIn (all 2003), of which only three (RenRen – the Chinese Facebook, Xing – the German LinkedIn and LinkedIn itself) have had an IPO. Most of these however have specific target markets with different sources of revenue such as premium services.

Three current valuations are looked at that use a discounted cash flow model to derive an intrinsic value based mainly on financial earnings data, particularly useful where there are no similar companies. The drawbacks are that it can be too dependent on financial projections which can be hard to accurately forecast, and is sensitive to key assumptions such as growth rates, margins and cost of equity. The basis of this is to forecast Facebook’s revenues, costs, and profits and then discount it back to a present day to get an enterprise value.

2.1 A quantitative approach by Trefis

Their valuation price is derived from forecasting fundamental drivers like pricing, market share, profit margins and separates Facebook into three individual divisions. The core of a valuation stems from what is driving revenues, costs and profits. 73.2% of the valuation is attributed to revenue from Text and Display Ads which are ads displayed over Facebook’s website in the form of text and pictures. The assumptions are as follows:

  1. Revenue per page view has a modest growth of 2% CAGR (Compounded Annual Growth Rate).
  2. Average monthly unique visitors will have continuing growth since 2008 of 15% CAGR.
  3. Page view per user per month has a 4% CAGR.
  4. Constant 77% average gross margin.
  5. Facebook will successfully innovate.

The paper has assumed modest growth for all factors apart from a very optimistic outlook for Average Monthly Unique Visitors. This is supported by ‘network effects’ and cites that in 2011 Q4 Facebook had an average of 2.7 billion likes a day, increasing content partnership and monetisation such as video-based ads, and innovation such as Facebook’s ‘Timeline’ and Open Graph capabilities.

The report says that by 2018 there will be 4.2 billion users online with 2 billion (60%) on Facebook. Is this realistic? The Boston Consulting Group has estimated by 2016, over 3 billion will be online (The Economist, 2012) and Areppim AG (2010) have estimated a plateau of 3 billion by 2020. There are reasons to believe that the exponential trend in user growth may not continue. Facebook has faced a lot of scrutiny over privacy issues, and as they try to increase monetisation these issues may become more prevalent. Threat of competition from Google+ who has already reached user growth levels beating that of what Facebook and Twitter had also exists. Although this may seem quite impressive, it is important to note that Google+ has used Facebook and Twitter to popularise itself so quickly, whereas where as Facebook did not. Nevertheless, the threat still remains and with Google’s 44% market share of global online advertising (ZenithOptimedia, 2011), ranked most popular website on the internet and with the integration of their online services (YouTube, Gmail, etc.) there could be large barriers placed on Facebook’s growth. Additionally, Facebook has almost no presence in the most populated country in the world, China which has banned the website and has yet to be the dominant social network of Russia where Vkontakte is most popular (Vicosblog, 2011).

The next 17.4% of the revenue is due to Transactions on Virtual Goods. These are revenues made from what people spend on Facebook games and applications i.e. non-physical products or virtual goods. The main component here is the Average Virtual Goods Spend per Facebook and extrapolates from the number of users and the profits made from this. Supported by a high growth rate in social gaming of 6% (industrygamers.com, 2011) and that Facebook is the most popular platform for this the estimates are robust. However, Facebook is highly reliant on the game developer Zynga which has tried to break away through its own platform, posing potential problems that Facebook cannot control. However, the agreement between them is mutually beneficial and longstanding suggesting that these events are unlikely.

The remaining 9.4% are from Social Commerce (5%) and Cash Net of Debt (4.4%). Social Commerce is a new phenomenon which is the sale of physical goods over Facebook. Currently, this does not exist as a platform on Facebook but the paper predicts that it will reach a 30% market share by 2018. The only real supporting rationale here is that Facebook is a large brand and has intentions to enter this market. With retailers already using Facebook’s advertising and gaining awareness through it’s ‘Like’ feature, being able to buy products that your friends like could be the next move.

This is seen as a best case scenario for Facebook, resting heavily on the assumption that everything goes to plan and Facebook experiences continuing high growth which makes this an upper bound. The next method explores this and asserts that some core assumptions made here do not hold.

2.2 A user-growth based approach by Cauwels and Sornette

The method here is entirely based on a user growth calibrated for a standard logistic growth. The enterprise values produced range from a base case of $15.3 billion, to a high growth case of £20.2 billion to an extreme growth case of $32.9 billion.

Observing the last three data of users, a levelling off can be seen.  The paper from this then adopts an S-growth curve under competition and finds that exponential growth ceases at February 2010 and starts to level off. Calibrating for this growth scenario, the paper predicts user growth in three different scenarios, where at best the levelling off occurs in 2012 at 2 billion users.

Explaining this in real world terms, this would be a large case of social media fatigue. Like MySpace which was highly popular until Facebook took the reins of social media and effectively destroyed it.

An enterprise value is calculated with an analysis that shows revenue and user growth follows the same trend. With revenue per user of $3.5 and an average profit margin of 29%, this results in a profit per user of $1. Although these values are derived from previous data, is it fair to assume that for the indefinite future this will not change? The next paper by Unterholzner shows that compiling every user into the same category would not provide an accurate estimate. There is enough evidence to suggest that Facebook already is and will expand into other areas of revenue generation. This method essentially predicts Facebook’s valuation if there were no innovation and that their main source of revenue heavily slows in growth. As well as this, claiming that the last 2 values are evidence for growth under competition is weak. From Dec 2009 to June 2010, Facebook user growth slowed in a similar fashion but did not star to taper off. Until a clear amount of successive growth decline appears, there is no reason to believe the tapering will start now. With this in mind, the valuation of $15.3 billion in the base case at a 5% discount rate can be taken as a lower bound.

2.3 A market share approach by David Unterholzner from Donau Universitat Krems

The key indicating measure used is the total amount of money that advertisers spend on online advertising in a single year based on a study done by PwC and the IaB. The model then looks at other potential revenue streams i.e. other forms of advertising. Facebook operates heavily in Text and Display Advertising (26% U.S market share), Rich Media (video, audio, streaming) and the Paid Search Market (targeted advertisements based on user’s internet searches). By 2015, it is assumed that Facebook will have Classified (targeted advertisements) and Mobile advertising. The advantage of this method is that it is able to reflect different market capabilities. From an advertiser’s point of view, a person in the U.S is more valuable than a user in India. Estimations for future market share and adding up revenues from different regions formed the basis of a valuation of $26.7 billion, with the best case scenario at $39 billion.

The contrast is stark, not only from current secondary market valuations but also from the previous DCF analysis done by Trefis. Examining the main differences between them, this method relies on projected percentage of total market share, with a projection of the CAGR (compounded annual growth) of the advertising industry. Rather than basing revenue growth on Facebook user penetration growth, it finds the ratio of advertising market share and the percentage of Facebook users. The key here is advertising market share is related to each country’s percentage of Facebook users. The paper assumes that by 2019, over 80% of all US internet users will be on Facebook with 25% of advertising market share. Considering Facebook is a young company and it would be expected that as more innovations occur, they would gain a higher market share this is a conservative estimate.

This method of calculation also takes into account for not only the growth in users but how the industry that Facebook’s main revenue source operates in fairs, which the previous methods would have ignored. It is also shown that user’s based in different geographical locations yield different revenue for FB, clearly an important factor.

2.4 Implications of these valuations

The estimated valuations range from $15 – $74.3 billion. Two out of three have similar estimates ranging around the lower end, however as Cauwels and Sornette seem to be quite conservative and Trefis to be over-optimistic; a valuation between these two would be a better estimate. Unterholzner’s paper provides closer valuations to this mark, taking realistic expectations of revenue growth leaving approximate valuations that are a quarter to a half of the secondary market valuations of $100billion.

For Facebook to reach such a valuation in Trefis’ method, revenues from advertisements would have to increase by 25%. This would mean either higher user growth, higher revenue per user or higher user traction. With optimistic estimations for user growth and traction, the main vehicle here would be revenue per user. The paper already takes into account potential revenue streams, such as transaction on virtual goods and social commerce as well as advertisement on mobile. It would be a stretch to see any significant room for growth in these cases. Unless Facebook reveals more innovations that have not yet been heard of and taken into account, there is no reason to suspect that Facebook will be able to reach these figures. In fact, the report notes as advertising monetisation rates on mobile devices have traditionally been lower this will put a downward pressure on revenue per user.

In the case of Cauwels and Sornette, the paper itself assumes that revenue growth is solely based on user growth, thus Facebook would either need to make more per user or increase its user base at a faster rate. Even though the paper heavily underestimates potential extra revenue streams and the effects of innovation, a 6 fold increase in revenue per user is required to reach their $32.9billion extreme growth case. This would require at least an 18 fold increase to reach estimates of $100, a very tall order.

For Unterholzner’s paper, Facebook would need to make substantial increases in advertising market share compared to its user base because the more users there are on Facebook,  the more more inclined firms would be to buy advertisements. Thus Facebook would need to incentivise firms to buy advertisements at a higher rate than user growth. The study has already accounted for Rich Media and Classified advertisement growth rate to accelerate to 10% as is Text and Display Advertising, as well as Mobile Advertising to go from 0.5% market share to 4.5% market share. This leaves Social Commerce as the only realistic source of extra revenue, which Unterholzner dismissed as a non-revenue generating strategy.

Chapter 3 – Can Facebook reach expectations?

Now that it is established what Facebook would need to do to justify valuations ranging around $100billion, can Facebook actually reach those targets? SharesPost Inc Feb 2012 sold shares for $40 at a diluted share count of 2.35 billion bringing Facebook to a value of $94 billion (Bloomberg Business Week, 2012). Their SEC registration (February, 2012), notes the main risk factors and how dependant Facebook is on user engagement and advertising revenue. Even taking into account that Facebook does stay on track in these respects, the main factor effecting valuation noted in the filing is that they “…may not be successful in our efforts to grow and further monetize the Facebook Platform.” The challenge with this is whether Facebook can effectively further monetize information without alienating users.

3.1 Facebook Mobile

“Improving our mobile products and increasing mobile usage of Facebook are key company priorities that we believe are critical to help us maintain and grow our user base and engagement over the long term.” – Facebook SEC

Currently there are no advertisements on the mobile platform. By 2015, the global mobile advertising market is expected to grow to $17.6 billion with a staggering 64% CAGR from $1.6 billion in 2010 (techcrunch.com, 2012). If these expectations are factored in Unterholzner’s model, the revenue from the mobile market would double, but not enough to push valuations to $100 billion.

ABI research (2011) shows that by the end of 2016, 1.6 billion people will access social networks over mobile, two-thirds of total users that access social networks. As Facebook is the most popular social network with an essential monopoly in most countries, these statistics show that Facebook will have to pay a lot of attention, regardless of its negative effects on revenue per user and lack of control in the mobile industry. The research also suggests that Facebook may need its own mobile operating system to fully take advantage. This would also help get around problems noted in their SEC such as “user growth and engagement on mobile devices depend upon effective operation with mobile operating systems, networks, and standards that we do not control.” However, there has been not yet been a mention of its own OS. Considering that the most widely used operating system is the Android OS, produced by their biggest rival Google this presents as a big hurdle as Google+ has another lucrative area of integration to tap into, and eventually gain a large market share of mobile advertising.

3.2 Social Commerce

This is a relatively new industry. It has originally existed as the influence of what people buy through word of mouth. Facebook has now bridged the gap between getting your word of mouth out to hundreds of friends and family who value your trusted opinion, made simple with a click of the ‘Like’ button, everyone is told about your preferences. A study by Booz & Company (2011) has calculated the industry will grow to a large $30billion market with a 56% CAGR. It will be double the size of the mobile advertising industry, so if Facebook are saying they are pushing for mobile advertisements it would be a strategic mistake to ignore social commerce.

Facebook is well placed to take full advantage of this opportunity as the leading social networking website, yet there has been no mention of allowing companies to sell products through Facebook. The report by Trefis assumes that Facebook will inevitably make substantial gains in this market, ending up at 30% market share by 2017, backed up by a report done by Webtrends (2011). They conclude that Facebook ‘is gaining tremendous popularity as a destination to connect with brands online, and is increasingly chosen over websites of certain companies.’ Thus, there is significant demand from users that prefer to access brands through Facebook. Over time as the online traffic landscape changes and traffic is diverted from e-Commerce websites to social commerce it is highly likely that Facebook will tap into this market. Booz & Company also find that ‘Facebook stores are efficient at acquiring visitors cheaply through wall posts, with post-launch wall posts generating on average 1,673% spikes in store traffic’, giving more credence to a significant potential market share.

Even if Trefis’ estimation of social commerce revenue generation were factored into Unterholzner’s model assuming similar margins, the valuation is only pushed up to $43.5 billion (Appendix 1). Although it is unknown how Facebook will go about in establishing a place in this industry, the figures and reports show that this move is likely.

3.3 Facebook Currency

Facebook has its own currency which is primarily used to purchase virtual goods on the apps created by developers. As noted before, almost all of the revenue from their virtual currency comes from Zynga so the strategy here is to become less dependent on a single developer. Can Facebook use this elsewhere to generate extra profit?

Tim Carmody from wired.com explains the three different ways Facebook can follow to expand its credit system (2012). Firstly, the ability to use credits outside of apps. Tying in with social commerce, if Facebook were to set up shops on their own platform, they could have credits as the preferred method of payment and take a cut from whatever is bought using this. The shop would be paying for the service of using Facebook’s resources through a percentage on the amount sold through Facebook. However, would developers and companies be willing to give Facebook a cut for this service? An article in gamepolitics.com titled ‘Developers Call Facebook Currency Transaction Fee a ‘Net Tax’’ (2012) shows that some developers saw a gradual decrease in revenue per user playing through Facebook credits, even with a higher conversion rate. If Facebook is able to work out a reasonable rate for credits, then more developers may be inclined to use this system.

The second model follows Paypal, the most widely used method of online payment, notably bought by eBay. In this model, Facebook becomes an intermediary for payment on other websites using credits. The incentive for providing this service would be the information gained in how each individual spends their money which in turn would help their targeted advertising system. Even though the article notes that there are users that trust Facebook with sensitive information, it is still an area of concern. Facebook has and will always have to tread carefully with this information, and if any information were to leak out this could seriously harm any progress in this area.

The third model is based on Twitter co-founder Jack Dorsey’s Square, an innovation that allows acceptance of payment through something that can be attached to your mobile or iPad. If Facebook were able to capitalise on their growing popularity of access through mobile phones, there could be a great opportunity here for channelling Facebook credits as an actual method of payment for physical goods, anywhere. This could also be another incentive for Facebook to create its own operating system. Again this would provide further information into what users are buying in real time, an asset that could become very valuable but there has been no indication of investment in this area.

Chapter 4 – Why the Gap?

The power of social networking demonstrated by Facebook’s immense popularity is undisputed. Because of this popularity, everyone wants to be part of the Facebook revolution and there are those that really believe in the Facebook story. Facebook has given everyone access to networks and resources so vast that they were not previously able to get. In essence, social capital has grown and become accessible for anyone. So what is creating the overvaluation?

4.1 Fuelling factors

Such a unique, high growth and young company will always attract a lot of attention. The effect is exacerbated by its immense popularity for all audiences, both private and public and the attention of investor blogs and news. The many lucrative potential revenue streams are being factored into its price at an inflated rate due to positive sentiment supported by Facebook’s strong earnings and track record. A clear example of this is looking at Facebook’s valuation just a year ago. Goldman Sachs invested with an implied value of $50 billion in January, 2011 (Craig, Sorkin, 2011) yet just in a year the secondary markets are indicating twice this with earnings no higher than expected and only the innovation of ‘Timeline’.  There has been no significant development that would warrant a doubling in valuation. As the most anticipated IPO since Google in 2004, these factors coupled with mass speculation and hype are driving up valuations that are essentially based on continued innovation, high growth, expansion into other industries and no large shift in technology.

4.2 Effects of IPO on pricing

As an IPO for any company is a momentous stage for them, there are clear pricing effects that may steer valuations away from their intrinsic value. A study by Derrein (2005) and find that IPO prices take into account both intrinsic value and market sentiment, finding if noise trading (uninformed investors) is bullish then IPO shares are overpriced over long-run intrinsic value, but exhibit first day positive returns. It has been well documented that many IPOs have substantial first day returns and what can be seen as a low risk easy way to make a profit. Many investors want to buy at IPO prices and ‘flip’ them after the first day pop. He also shows that long-term stock price performance is negatively correlated with individual investors’ demand indicating another warning signal that Facebook is overvalued. Campbell, Du, et all (2008) also find that underpricing is significantly higher for overvalued IPOs and is positively correlated to investor sentiment. Clearly with the oversubscribed Facebook, investor sentiment is highly optimistic and with 31 high profile banks underwriting there are numerous private institutional clients that are able to get low pre-IPO prices and realise large profits. The underpricing also generates publicity and induces investors to learn more about a firm, consequently generating a run up in secondary markets thus valuations stemming from secondary markets are inflated (Chemmanur, 1993).

4.3 Setting up a short

Taking advantage of the situation, a short on Facebook may be set up. The optimum time to initiate the short is at the closing price on the first day of trading. From chapter 2 and online sources, there is evidence of large divergence of opinion on Facebook’s valuation. Wang and Xia (2011) find that long run performance of IPOs measured from first day closing price is negatively related to the divergence of opinion. Due to extremely high demand, Facebook’s valuation may reach $200 billion by the end of the first day. With this in mind, it may be worth going long on existing mutual funds that already contain private Facebook shares, such as the Morgan Stanley Focus Growth Fund and shorting all other stocks in the fund until the end of the first trading day. Through this method you can capture gains that may not be accessible through directly trading the share due to the extreme demand. After this, a steady decline may be seen. If Facebook does not make significant movements in expanding its revenue streams, runs into privacy issues and misses expectations a huge market correction may occur. The most crucial times when this may occur are at quarterly earnings reports and the end of lock up periods (e.g. 91 days) detailed in their SEC.

Chapter 5 – Social Capital and Organisational Structure

Social capital is young and sociological concept that has many definitions, but “broadly refers to the resources accumulated through the relationships among people” (Coleman, 1988). This has a clear relationship to Facebook’s purpose and as stated by Mark Zuckerberg himself in his letter to investors, “Facebook…was built to accomplish a social mission — to make the world more open and connected.” Facebook is the engine that is producing high levels of social capital, and monetises it through advertisements and applications. If the telephone was the leap in technology for connecting people through wires, Facebook is the innovative leap for connecting people through the internet.

5.1 Facebook’s social and economic benefits

To see why people value Facebook, exploring the benefits of Facebook on individual’s lives and their engagement in social participation is a good place to start. Valenzuela, Park, & Kee (2009) conducted an empirical study across college students and found positive relationships between intensity of Facebook use and students’ life satisfaction, social trust, civic engagement, and political participation. Even though this is looking at a specific group of people, it shows that Facebook certainly has positive outcomes, which can be attributed to the accumulation of social capital.

Additional studies have shown that social capital is significantly and positively linked to advantages in economic growth, such as Beugelsdijk & Schaik (2005) in their paper ‘Social capital and growth in European regions: an empirical test.’ From a cross section of 54 European regions they find growth differentials in European regions are positively related to social capital. Logically, it makes sense that those countries with increased civic activity and participation would be able to bridge information asymmetry and create new links promoting economic growth. So if social capital is so beneficial, what mechanism does Facebook use in creating it?

Ellison, Steinfield & Lampe (2007) conducted a study that examines the relationship between Facebook and the formation and maintenance of social capital. They find that internet use alone did not predict social capital accumulation, but intensive use of Facebook did. Facebook has provided an easy, highly accessible medium for acquiring these different forms of relationships from bridging to bonding to maintaining social capital. Bridging social capital, which is the creation of weak ties and acquaintances, was most enhanced which crucially “provides benefits such as increased information and opportunities.”

5.2 Why is it relevant?

The question at hand is trying to verify market perceptions. What exactly is being represented by the amount of money people are willing to pay to own a part of the biggest and most popular social networking website? Value investors may argue that due to the social and economic advantages Facebook possesses, investing in such a company is investing in real value growth due to the unique and innovative nature that Facebook accumulates social capital.

The social capital produced by Facebook is special in that not only can individuals tap into its resources, but also firms that have a product to sell and want to market it. Facebook is able to more efficiently facilitate market clearing by matching up demand and supply. An example of this is demonstrated by Kenneth Wisnefski CEO of WebiMax, a social media marketing firm who said “We worked with a company that sold vintage Bruce Springsteen memorabilia. They did great on Facebook, because they were able to reach the group they wanted to reach” (MSN Money, 2012). Value has been created and monetised here through the medium of social capital on Facebook. Inc, an entrepreneurial website states that Facebook is able to build brand awareness, engage with audiences, create opportunities for special promotions and retain customers (Brown, 2011). So something that is mutually beneficial for all parties whilst creating opportunities for economic growth may have an intrinsic value that is reflected in its market price.

5.3 The Hacker Way

A company’s future is dependent on its management, and this especially rings true in the case of Facebook. An example of the effect of a company’s value can be seen when Steve Jobs resigned as CEO Apple shares instantly fell 5% reflecting sentiments of his importance to Apple. Facebook’s own SEC filing states a key risk factor that would adversely affect their performance is the loss of “key personnel” such as Mark Zuckerberg and Sheryl. K. Sandberg.

A plain shirt, jeans, sandals and a hoody. This is the attire of Facebook’s founder and CEO Mark Zuckerberg, also named Time’s person of the year 2010. In his letter to investors which came with his SEC filing, he outlined his vision for Facebook and revealed his company’s working ethos ‘The Hacker Way.’ He describes this as an “approach to building that involves continuous improvement and iteration” and the source of successful innovations such as Timeline, chat, video etc. The letter is reminiscent of Google founders Larry and Page with their motto ‘Don’t Be Evil’, stating he is not driven for profit but for the social mission of connecting people, building a strong company with a strong economic engine.

The letter to investors may be designed to keep faith in that idea. Zuckerberg has always known to keep a strong rein on his brainchild demonstrated by a controlling equity stake of 28.4% with a controlling majority of over 50% of voting rights. Zuckerberg wants to stay in charge and firmly in the driving seat.

Chapter 6 – A Comparative Analysis

To gain some context it’s useful to look at other companies that operate on a similar basis to Facebook. Highlighting their similarities and fundamental differences, their performance might be an indicator for Facebook’s future.

6.1 Google

Founded in 1998, Google has a market capitalisation worth $200 billion. That is twice the amount Facebook is said to be worth, yet Google earns the same amount of revenue Facebook makes in a year, in just 6 weeks. Google produces 10 times the amount of revenue Facebook does with approximately the same profit margin. However, as Facebook is a much younger company it may be unfair to compare their figures now. At Google’s IPO, it was worth $23billion. That is approximately 23 times revenue and 230 times profits. In contrast, Facebook will be going for a similar 25 times revenue but only 100 times profits. Google appreciated in value over the next year by 300%, so seeing multiples like this is not an instant indicator of an overvalued company.

Fundamentally, Google and Facebook are very different companies. Google is primarily a search engine and internet software company, although they do have their own social networking website Google+, it currently has less than 10th of Facebook’s users and is not core to their business. The similarity between the two companies mainly exists in their revenue stream, and if this is important to their valuations we should consider this. Google derives 95% of its revenue from advertising compared to Facebook’s 85%. They were making losses in the first two years of business and had only started making profits in 2001. On top of this, Google was exposed to 21% of its revenue reliant on third parties, whereas Facebook’s exposure to Zynga is only at 14%.

It is worth looking at the growth of the type of advertising industries both Google and Facebook are operating in. When Google had its IPO, paid search was the fastest US growing online sector of advertising which grew 55% in 2004 (Ramsey Report, 2004). In Facebook’s case, the display advertising market grew approximately 24% over 2010-2011 and is expected to slow to 20% for 2012 (eMarketer, 2011), in the US. Both were/are high growth industries, but Google had the advantage of being in one with twice the growth rate. However, the fact remains that even though Facebook is heavily reliant on Display Advertising, being reliant on Paid Search worked out well for Google and may be a source of reliable and high growth revenue for Facebook. Additionally, Display Advertising is forecast to overtake Paid Search in 2015 in the US. So Facebook is at a similar stage in their main industry as Google was, arguably slightly more matured.

Facebook is as well placed as Google was to become a highly successful growth story. Google revolutionised online search advertising, Facebook has revolutionised online social network advertising. It can even be argued that Facebook is even better placed with access to valuable information on user preferences in aid of targeted advertisements.

6.3 RenRen

RenRen is China’s answer to Facebook as it is banned in China. It is similar in structure as a purely social networking website. Because of its geographical limitations the difference is that it has adapted to the Chinese market (Daltario, 2011). Only 42% of its revenue comes from advertising due to less reliable data, with the rest comprising of revenue from games (Kelleher, 2011). It has 140 million users which is around a sixth of Facebook.

On the day of its IPO its value peaked at $7billion, fuelled by the unique opportunity to buy into a big social network (Wagstyl, 2011). Ever since, it has tumbled to a current value of only $2billion. This is due to continued poor performance, shrouded with overarching government regulations and a lack of transparency. RenRen were making losses in the run up to the IPO but with the hope that it would become revenue generating in a similar fashion to Google. But after flat results over Jan-Sep 2011, RenRen was continually punished in its share price. The harsh competition faced by RenRen such as Tencent Holdings, the world’s largest instant messaging service, Sina, Baidu and Alibaba eroded their market share and performance.

The fundamental flaw here was a lack of good management, and in fact due to controversy over figures released pre-IPO and accusations of fraud, a senior board member resigned. These factors coupled with poor profits put large downward pressure on RenRen. When compared to Facebook, which practically has a monopoly on global social networking and has demonstrated excellent management these risk factors are not as large. The most compelling argument for why Facebook will not suffer a similar fate is that Facebook has consistently generated profits with a very sizeable margin equalling that of Google.

6.4 MySpace

MySpace, founded in 2003 was the most popular social networking website during 2005-2008 (Cashmore, 2006). It was bought by Rupert Murdoch, CEO of Fox Interactive Media in the summer of 2005 for $580million. Considering that it had 3% of the users Facebook currently has (MacManus, 2006), a direct comparison weighted on user base if Facebook is $100billion would value it at $3billion, making it a cheap purchase for Fox. Growing at a phenomenal rate of 160,000 new users a day MySpace, like Facebook was a highly popular well placed social networking website but in the summer of 2011 it was sold to a consortium including Specific Media LLP and Justin Timberlake for only $35million giving Fox a 96% loss.

Like Facebook, MySpace’s success was based on its user base and growth which provided revenue through advertisements (MySpace WebArchive, 2011). It has also signed a $900 million advertising contract with Google in 2006, which even though initially was a triumph for MySpace eventually became a story of embarrassment as this year it could not meet online traffic requirements (Garrahan, 2009) and has made losses. The main driving factors that contributed towards its fall were due to, like RenRen, failing management and harsh competition notably from Facebook itself. The acquisition created tension between two different management teams. MySpace had failed to provide innovative new products, and when Facebook came around in 2004 with exponential growth, users were en masse leaving MySpace and flocking to the new, better and improved Facebook.

Again, this highlights main risk factors for Facebook declining in a similar fashion to MySpace. Without continuous adaptation to its market, a new and better competitor will come along. For Facebook to effectively keep its place as the most popular social networking website, good management would need be reflected in its user statistics such as stickiness and translate to higher revenues and profits.

Chapter 7 – Conclusion

Facebook is a highly unique company with growth unlike any other in the social networking industry. Its popularity has risen through its open structure which was based on community networks, for example universities, schools and work, and now boasts one of the most anticipated IPOs since Google with secondary market valuations of $100 billion.

The three valuation methods looked at all took a different view point into Facebook’s growth. The Wall Street analysts Trefis put a lot of weight in Facebook not only continuing in their user base growth, but successfully innovating and gaining substantial market share in areas like Social Commerce resulting in a valuation $74.2 billion. The analysis done by Cauwels and Sornette take a totally user based revenue growth model and claim that it’s growth under competition is beginning to level off. With huge direct implications for Facebook’s revenue even in the extreme growth case Facebook is only valued at $32.9 billion.  The final method done by Unterholzner, takes geographically separated revenue per user growth showing that it is inaccurate to assume every person is worth the same in terms of revenue to Facebook and arrives at a valuation of $26billion. It is clear from these methods that overall, Facebook is overvalued. The difficulty remains in clearly estimating its future growth, as Facebook is quite a young company and has not really diversified its revenue stream. Most of the extra value is derived from potential revenue streams including targeted advertisements, virtual online gaming and apps, and online shops in the form of social commerce and Facebook currency.

Looking at the effects of IPO on pricing and how Facebook fits into these models, there is a clear danger of overvaluation from simply uninformed investors that fuel demand and allow institutional investors to realise a large profit through cheap pre-IPO prices. There are many people that buy into the immense success story which even has a movie (The Social Network) about it. They expect Facebook to keep innovating and growing at high rates. There are also those that want to capitalise on first day returns and sell as soon as it pops. Essentially, the gap in Facebook’s value exists because it is based on speculation of Facebook’s growth and without the ability to short private shares the secondary market reflects the most optimistic investors.

To try and get a sense for the gravity that Facebook has in the world, the concept of social capital and its effects on society were explored. It is clear that social capital is an important resource for making progress in society in terms of civic engagement, political participation, connections in the workplace etc. But Facebook is able to actually take that social capital and monetising through useful data for firms looking to increase profit.

Comparing Facebook to similar companies, it has more in common with the successful Google. Mark Zuckerberg has made Facebook into what it is today, and makes it clear that he will continue to run Facebook. Since Facebook has released its earnings in the SEC filing, revenues and profits have been growing well with high profit margins similar to Google. They have also shown over the past year that they are innovating with the introduction of ‘Timeline’ which allows frictionless sharing, a concept that will increase the rate of sharing and essentially add more information to Facebook’s database. However, it is speculation like this that led to the tech bubble of the 2000s. If Facebook does happen to show signs of slowing growth, runs into privacy issues or misses expectations the bubble may pop resulting in crash that would send Facebook’s valuation closer to the range of $30billion. Close attention will be paid to quarterly earnings and the end of lock up periods. Until then, the market will believe that Facebook is on the path to world domination.

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Appendix 1

Year

2011

2012

2013

2014

2015

2016

2017

SC Market

5000

7500

1200

20000

30000

34000

37000

SC % Market Share

0

0.07

0.13

0.21

0.24

0.29

0.32

SC % Margin

0.77

0.77

0.77

0.77

0.77

0.77

0.77

SC Revenue

0

404.25

120.12

3234

5544

7592.2

9116.8

Revenue without SC

4118

5560

7143

8978

10769

12533

14001

Revenue with SC

4118

5964.25

7263.12

12212

16313

20125.2

23117.8

EBIT with SC

1276.58

1848.918

2251.567

3785.72

5057.03

6238.812

7166.518

Tax (25%)

319.145

462.2294

562.8918

946.43

1264.258

1559.703

1791.63

Net Profit

957.435

1386.688

1688.675

2839.29

3792.773

4679.109

5374.889

DCF

825

979

1115

1242

1333

1390

1399

TV
DCF

842.5428

1067.75

1148.299

1731.967

2048.097

2292.763

2364.951

32051.31

EV

43547.68

EV Calculation: Sum of DCF from 2011-2017 (11496.37) + Terminal Value (32051.31)

Terminal Value Calculation: (DCF 2017 (2364.951) * Perpetual Growth Rate (3%)) / (Cost of Equity (10.6%) – Perpetual Growth Rate (3%) = 7.6%)

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