Facebook released their numbers in preparation for an IPO, showing 2011 revenue of $3.7 Billion and profits of $1 Billion. Speculation is the IPO will be valued as high as $100 Billion.

This would be a P/E of 100. That’s high, but then P/E’s are not as significant an indicator for young companies with a lot of growth potential. So can Facebook grow enough to justify a $100 Billion price tag? I’m not so sure.

The easy justification goes like this:

  • Facebook has been focused on user growth and they were still growing 100% per year. When they switch focus to revenues, they’ll make much more.
  • If they “just” double revenue and profits in 2012 and again in 2013, that 100 PE will shrink to a 25 PE.

So that would be a $100 B company making $4B per year on $15B revenue or so. (For comparison, Google has a $190B market cap and made about $10B profits on $38B revenue in 2011.) One could see the stock of a company growing like that getting a 50 P/E and basically doubling your IPO investment in 2 years. It’s plausable.

All those numbers were out my ass. It’s easy to multiply numbers on a calculator. But how will Facebook REALLY make an additional $11B in revenue and $3B in profit?

The Best Case Scenario

Facebook makes money on advertising on their site. They also make money from virtual currency sales, i.e. in-game payments in Zynga games. Roughly:

  • $3B from onsite ads.
  • $1B from virtual currency.

Both those numbers will have to double twice over two years to get to our $15B revenue target. (Same math as above.)

That’s hard to justify though. Google, who dominates the online ad market made about 1/3 of their profit from search ads or about $12B last year. We’re saying that Facebook can get to that same level of revenue in 2 years? Literally over half of the money spent on AdWords campaigns would have to be shifted to Facebook ads. I’m not that close to the ad space, but I’d love to see someone justify that.

But what the hell, this is the best case scenario after all. Ad sales grow to Google proportions and hit $12B in revenue.

Can virtual currency sales grow 200% over two years? Who’s the king in app sales? Apple. In the last quarter of 2011, when Apple made pretty much more money than any company has ever made, they made a cool $2B on “Other music related products and services”, which includes “revenue from sales from the iTunes Store, App Store, and iBookstore in addition to sales of iPod services and Applebranded and third-party iPod accessories.” (Apple’s SEC Filing)

Let’s say Apple keeps that up for the next 3 quarters. They will make $8B from app sales, music sales, books, and in-game sales. Facebook doesn’t currently sell apps, music, or books, but maybe they will start. Are they going to become half as big a player here as Apple is now? Let’s give them the benefit of the doubt. Facebook is one step away from the devices, so $8B would be a bit much. Let’s say they grow to $4B.

Facebook might add additional revenue sources. They could start making money in these ways (let me know if you have others):

  1. Sell ads on third party sites. (Google made $1B doing this.)
  2. Charge companies for their Facebook pages. (10M businesses x $10/month = $1.2B/year) (more ass numbers)
  3. Partner with Bing to launch a search engine of their own (Yahoo! made $500M doing this. Maybe Facebook can get to $1B).
  4. Get into LinkedIn’s business and sell job postings (LinkedIn had $250M revenue in 2010. Let’s give FB $500M).
  5. Get into Craig’s List’s business and sell property listings (Another $500M?).
  6. Get into Zynga’s business and develop games in-house ($2B).

We end up with $12B in ad sales, $4B in virtual sales, plus another $6.2B in new stuff for a total of $22.2B in revenue. At a 30% margin that’s $6.6B in profits. Our PE is now 15; market average. And with the growth they have, you could justify a big 50-60PE for a lot of investors. The company rises to a $300B to $400B valuation.

Worst Case Scenario

What’s the worst case scenario? Put simply, it’s that Facebook’s growth will slow down, and this IPO is just a big liquidation event for existing share holders to cash out.

Some bad things could happen:

  1. Zynga games and the like take off outside of Facebook. FB loses the games or is forced to lower their cut.
  2. FB increases the number or the invasiveness of ads on the site. People flee to Google+.
  3. FB starts charging for business postings. Businesses flee to Google+.
  4. FB Search, FB Jobs, and FB Properties all fail, costing billions in lost R&D.
  5. MySpace comes back. Diaspora takes off. Twitter gains ground.

In the past few years, those 100% revenue gains have come along with similar-sized user gains. But user growth has slowed. So they’ll really need to squeeze more money out of advertisers.

All this might lead to minimal gains in current revenue streams (let’s say 25% year over year) and then let’s assume they just blow their $5B raised on 1-5 above. That would equate to revenues of $6.25B – 2.5B (5/2 years) or just 3.75B revenue in 2013. That’s where they are now.

With revenues and profits stagnant after 2 years, IPO investors are tired of waiting it out and flee the stock. Facebook apologizes for the missteps and vows to focus on their core advertising which is still growing 25% per year. Still the stock tanks 50% or more if sentiment turns.

Summary

Well assuming the bullshit above stands, we got a 300 to 400% upside and a 50% or so downside. This actually might be a good investment. But I imagine I wasn’t tough enough in my worst case scenario. And I was surely too optimistic in my best case scenario.

Still, I wanted to think these things through. I wanted to focus on how Facebook will really make more money going forward, because that’s what they’ll have to do for the stock price to rise. And the money can’t come out of thin air. It has to come from some other company’s market share or from consumers and businesses purchasing something they haven’t before.

Personally, my initial reaction is that $100B is too high a market cap for this company. After doing this post, I’m actually more optimistic for Facebook… especially if the IPO price sees a little dip at some point without hindering the excitement around the company. Still, I think this is definitely too uncertain for me to be an investor or to recommend the IPO.

I’d really love to hear more feedback about this. Am I delusional? I’m especially interested in anything I’m not considering with regards to how Facebook will make money going forward. Is it more than just pushing their ads harder? Perhaps as a public company, Facebook themselves will comment on this sometime.

Comments (1)

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You make some great points here. I can’t believe that people are taking this $100 billion valuation seriously. Of the two scenarios you laid out, I would give 5 to 1 odds on the worst case scenario happening. We’ve already seen that small start-ups with a single focus can thrive even when Facebook tries to dominate their space (see FourSquare). The more companies that do this, the more Facebook becomes a utility to connect these services through a ‘sharing’ platform, much like Google+ is designed to do.

We know that Facebook’s single goal is to increase users causing Facebook to take actions that often lead to user revolt. As Facebook becomes more of a utility to share other services, it decreases their revenue possibilities, and invites competition by an open source utility to aggregate content from more focused social services like FourSquare, Yelp, etc.

My take on this is that Zuckerberg was young when Facebook started, and he got seduced by investors and didn’t realize what the long-term implications where of making the deals he was making with the people he was making them with. Whereas Craigslist and Twitter have been allowed to wander around and develop the tech, they have no deadline to raise revenue. On the other hand, Facebook is now going to IPO with no clear path to grow profits to meet the target valuation and has to deal with investors. Even though Zuckerberg has 57% voting rights, he will now be open to lawsuits from investors if he lets the company’s value drop.

If the best case scenarios you laid out were likely, wouldn’t investors hold out for another year to help make the case for this IPO? The logic seems very weak here, and Facebook is too old of a company to expect the type of growth it would need to justify a $100 billion valuation within 2 years.

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