When Giovanna was offered a job at Facebook several months ago, we attempted to figure out what her compensation looked like relative to her other job offerings, just out of curiosity. Since unvested stocks were in the offering, I started looking at Facebook’s proposed IPO pricing. I discovered they had pegged the offering at an estimated market capitalization of around $80B (I avoid to use the word “value” here as I do the word “friends” in reference to said company) and was surprised that a company could reach that kind of valuation so quickly. This meant number crunching time.
The view in February 2012
This section of the post includes my views at the time I did the original analysis (and as privately shared in the computer science department).
Dissimulare etiam sperastine, perfide?
With a profit of $1B in 2011 and a high PE ratio of around 20 like Yahoo! Inc, this only takes us to a $20B market cap. Not $100B as the actual IPO was priced. But of course, the price should also include growth. With a phenomenal 65% year-over-year earnings growth rate from 2010 to 2011 (despite falling profit margins) and assuming this (unsustainable) growth rate could last for the foreseeable future, at a PEG of 1, that still only takes us to a $65B market cap. More realistically, growth will fall off fairly soon and perhaps even enter contraction. Supposing Facebook manages to convert every person 15 and older in the world into a user and maintains profit margins (i.e., does not lose revenue due to increased mobile device use, especially in countries such as India, or reduced revenue in countries where users have lower disposable income). Income would top off at approximately $4B and a lower PE ratio of around 12 might kick in. In this scenario, Facebook essentially tops out at a market cap of $48B. Again, that’s if every person on the planet of high school age or older adopts Facebook AND somehow, ARPU and profit margins are maintained.
A more realistic scenario is that revenue growth will drop to about 15% per year over the next few years. Supposing that Facebook is able to profit from advertising on mobile devices but less than it has from desktop users and with Facebook expanding aggressively as it is, this will mean eroded profit margins leading to profit growth of maybe 5-10% PA. Zynga, a large contributor to Facebook’s profits, has branched out to other platforms; profits from micropayments will decline. Supposing this happens in the next year or so. FB’s valuation ought to be about $20B.
And in a cynical view? Facebook has already reached saturation of users in the countries it has a strong base in and that most growth will come from countries that mostly use mobile devices and have lower income. Furthermore, Facebook will fail to generate nearly as much income in the mobile space as it has with desktop ads. Within the next year, profits will erode as advertisers become unwilling to pay the premiums they currently are for targeted advertising (e.g., not all newlywed couples will start needing maternity wear immediately as several of my friends have complained), increased mobile device use cuts into advertising dollars, and existing users slowly migrate to other services or at least have their attention divided amongst several social networking sites. Facebook’s revenue will take a turn and supporting their current infrastructure will become a liability. Valuation? About $5B to $10B.
My advice to Giovanna when she decided to take the job was to cash out her shares ASAP.
The view now
In April, Facebook reported a decline in revenue, but attributed it to “seasonal factors”. It’s YOY growth for the quarter was 45% but profit fell due to Facebook’s rising costs —probably increasing costs due to hiring additional staff and building infrastructure. GM has announced that it will stop paying Facebook for ads. Facebook’s cash-and-stock acquisition of Instragram seems to have short-changed the photo software company.
Jackie sent me a link shortly after the IPO with the subject “You Were Right!”, although for me to be right in my “realistic” scenario, Facebook’s shares need to drop to less than $9. Since Facebook’s shares have “only” dropped 15% from their IPO price, I could still be wrong, yet. (Note: Facebook’s shares had dropped just over 27% from its IPO price when this blog post was published, but had only dropped 15% when I first wrote this post the week before publication).