Last month, Facebook took the much-anticipated next step in its corporate life by filing for an initial public share offering with the intent to raise $5 billion. Facebook’s registration statement made public a wealth of previously private information about the company and its finances.
The raising of the veil confirmed what most had suspected — Facebook is a tremendously unique company in many respects. The number of users is staggering: 845 million monthly active users at the end of 2011, uploading more than 250 million photos on an average day. Users are eagerly embracing new ways of accessing Facebook; roughly half of active users access both at home and on mobile products. It has become an essential part of life for tens, if not hundreds, of millions of people.
Facebook’s domination of the social networking space provides it with a huge advantage over would-be competitors. When social network nonusers decide to become users, they are most likely to join Facebook since most of the people with whom they would want to connect already are there.
Facebook generates 85 percent of its revenue from advertising and the remaining 15 percent from fees arising from the use of their payment system. Zynga provides roughly 80 percent of these fees, generated when Facebook users purchase Zynga product. Advertising can be highly targeted based on a user’s “age, location, gender, or interests.”
Not surprisingly given its size and dominance, Facebook is quite profitable, earning $1 billion in 2011 on sales of $3.7 billion, a net margin of nearly 27 percent. Immediate estimates of Facebook’s value were in range of $75 billion-$100 billion, and two private-market transactions totaling 250,000 shares in the days following the filing placed values of $94 billion and $103 billion on the company.
Is Facebook worth $100 billion?
History has shown, with few exceptions (such as Google), that investments in large companies with high valuation ratios tend to end poorly. At a valuation of $100 billion, Facebook would sport a Price-Earnings, or PE, ratio of 100 — investors would be paying $100 for $1 in earnings. Why might an investor choose to do this, rather than investing in McDonald’s, for example, where they would be paying around $19 for a dollar in earnings? Given that $1 earned from McDonald’s will buy the same as a dollar earned from Facebook, and assuming McDonald’s is no more risky than Facebook, the only answer is growth. Essentially — and reasonably — investors expect earnings to grow faster at Facebook than at McDonald’s. As earnings grow, the company’s PE ratio will decline over time and its valuation will become more in line with that of other companies.
The 35 or so companies in the United States worth more than $100 billion have an average PE ratio of around 14. Investors looking for growth might invest in Google (2011 revenue growth of 30 percent) or Apple (64 percent), featuring PE ratios of approximately 20 and 13, respectively. As Facebook matures and its growth prospects become less astronomical, it too will feature a more reasonable PE ratio.
However, Facebook is currently an extreme-growth company in a growth industry, and as such might well be expected to grow faster than either Apple or Google, and thus be deserving of an ultrahigh PE. The question then becomes this: Can Facebook grow fast enough, for long enough, to justify its valuation? Answering this requires first identifying scenarios that result in sufficiently high growth and then judging their reasonableness.
Begin by assuming that 10 years down the road, Facebook will no longer be in an extreme growth phase and will be valued in similar fashion as Apple is today, with a PE of 20. Assuming investors expect a 10 percent annual return and that Facebook will not pay dividends, an initial value of $100 billion implies it will be valued at a bit more than $259 billion in 10 years. A PE of 20 would require earnings to be $13 billion, implying annual earnings growth of around 29 percent. Assuming no change in profit margin (currently 27 percent), this implies future revenues of $48 billion.
Facebook’s revenue may be viewed as the product of number of users and revenue per user. Facebook’s 845 million monthly active users (MAU) currently generate around $4.39 in revenue for each active user. Assuming no decline in profit margin and an increase in revenue per active user to $10, Facebook would need 4.7 billion active users by 2022, representing 62 percent of the United Nation’s 2022 world population projection.
Investors who believe this scenario likely should feel free to consider a $100 billion valuation to be fair. Others should be wary. While this scenario is possible, it is not likely, and most likely would be the result of optimism triumphing over investing commonsense.
A cautionary tale can be drawn from the valuations of Cisco and Oracle at the height of the Internet boom. These companies made hardware and software essential to the Internet, and it was well-known that the Internet was going to be “a very big thing.” Befitting their status as companies poised to benefit from years of exponential growth, these companies had high values ($452 billion and $211 billion) and high PE ratios (148 and 153). While the Internet has indeed become part of the daily life for hundreds of millions, forecasted growth failed to materialize for these companies, now valued at $109 billion and $144 billion, respectively, with PE ratios below 20.
Dr. James Bennett, CFA, is an associate professor in the University of Southern Maine’s School of Business. He teaches courses in financial management, modeling and valuation and has published extensively in the field of investments.