Here is the first post in my series of 2012 predictions:
With the Facebook IPO fast approaching and a buzz of valuations approaching $100 billion, I have to ask: Does this make any sense?
I am the humble owner of The NorthStar Group, a small consulting firm helping business owners in the DC area to start and grow their business. I am not an expert…It’s just that things don’t seem to add up for me…
Sure, Facebook and social media have changed the world and how we interact with one another. Facebook provides customers with tremendous value, but providing value does not necessarily mean one will derive an adequate return on one’s investment given the investment’s risk and time horizon.
At a potential valuation of $100 billion and estimated earnings of under $1 billion, Facebook will have a price to earning ratio (P/E ratio) of over 100X. That means it will either have to see huge growth over the next few years or will have to be very safe with little growth for the next 80-100 years.
I don’t think investors want to wait 100 years to get their money back so let’s see what kind of growth we would need to get our money back in a reasonable time, say, 10 yearswith a reasonable rate of return of, say, 10%.
The Situation: Currently Facebook has around 800 million members, which produced expected net earnings of about $1 billion. That is $1.25 of earnings for every member.
Facebook makes money off online advertising. To make money off advertising requires traffic. There are a few variables that go into Facebook making money off ads:
- How many people visit the site: More people=more eyes on ads
- How many pages they view per visit: Move pages=more ads in front of the user
- The rate at which people click on ads they see: More clicks=more money to Facebook
Option #1. The only way to increase the click-through-rate (CTR) is to make better-looking, more engaging ads, which I assume advertisers are already optimizing.The quality of ads is largely out of Facebook’s control so let’s hold the CTR constant.
Option #2. What about increasing per-user page views and user activity? Well, people might become more active as Facebook expands its platform and features but the evidence shows otherwise. Even though Facebook is continually adding new features:
“…activities…seem to be falling out of favor [including] messaging to friends (down 14.8% in the U.S. and 7.4% worldwide), joining a group (12.8%, 6.5%), searching for new contacts (12.7%, 4.5%), installing an app (10.4%, 3.1%) and instant messaging (7.5%, 1.5%). Those activities are not only falling faster in the U.S. than elsewhere, but are declining even more among under-30 college-educated users in the U.S.”-Mashable.com
Further, Facebook relies on people continually posting updates and pictures to add value. Unlike Google, which provides real, standalone products such as Gmail and the Android OS, Facebook offers no value without user activity, which—by most measurements—is declining.
OK, so any hope of drastically increasing individual user activity is probably out.
Option #3. So what about increasing the total number of users? That sounds like a plan. So, how much would Facebook have to grow each year to reach our goal of a 10% return over 10 years? Well, holding earnings per customer constant at $1.25/customer, my calculations (NPV, 5X terminal value at year 11) show that Facebook would have to grow its users by over…
50% per year for the next 10 years!
“Sure, that’s high…But Facebook is the biggest and the best; and social media is growing way faster than that. Of course they can grow 50% Y/Y in perpetuity.” One eager day-trader or Morgan Stanley banker might confidently pronounce.
Yes, social media and Facebook have seen massive historic growth rates; but here’s the problem:
At 50% compounded growth, Facebook runs out of people—as in world population—in just seven years…and that’s assuming 100% world-market penetration. Yes. Every man, woman and child in the world…All “Facebooking.”
So, it seems that even in the best-case scenario Facebook is in trouble. But what if we are already seeing the dreaded “growth plateau” in a far-from-saturated market?
*Cue ominous music*
Global Web Index’s report, predicts the number of Facebook users in the U.S. will rise 13.4% this year, after 38.6% growth in 2010 and a 90.3% rise in 2009.
Currently, around 50% of the U.S. is on Facebook and already they are seeing a plateau in new-user growth, so, any hope for world domination looks pretty grim.
Therefore, the only path I see for Facebook to reach a $100 billion dollar valuation with their current business model is to increase the world population fast enough sustain its necessary growth…that’s a lot of babies.
So, for the sake of Mark Zuckerburg and the eager day-traders drooling over the highly-anticipated Facebook IPO this week…go forth…and procreate.
Let me know what you think on Twitter @BenNorthStar.
Check back for the rest of 2012 predictions.
Side note: Although the calculations make the $100 billion Facebook valuation seem impossible, there are changes to the business model I see that could justify it. For example: If they adopt the eBay model and allow vendors to sell directly off their Fan page it could increase sales conversions, diminish the role of individual websites and generate huge returns to Facebook…but I don’t hear people talking about any business model changes in their $100 billion valuations.
Disclaimer: Another potential life-saver could be that as revenues grow, their margins will also increase given the highly-scalable nature of their business; however, even if they are generating moderately better margins than Google, they would still have to accomplish a nearly impossible growth trajectory.