What is Facebook worth? At what price should I buy into the Facebook IPO? Is Facebook really worth $100Bn?
845 million monthly active users is surely an impressive user base for any service. The question on everyone’s mind is “Should I try to get into the Facebook IPO? At what price is FB worth it?
If you want to read through my assumptions and the way I arrived at the valuation and defend it, read on. If you want to skip straight to the numbers, then scroll all the way down!
I would look at the valuation in two steps
1. What is the potential to monetize the user base through advertising and other means? Note: People familiar with the economics of internet advertising should probably skip this section!
2. Is there any potential to increase the user base or deepen potential for monetization?
Monetization of current user base
There is overwhelming agreement that online advertising improves brand awareness. But can online advertising spending grow at the fast pace it has so far? Print ads might move increasingly online (the rise of local advertising through the internet comes to mind) as more print media houses try to establish and monetize their reader base online. The NYTimes, the Wall Street Journal and the Financial Times are but three examples of this trend. Newspapers and magazines have long subsidized content with advertising and there is no reason to suspect that the same model may not be used online. Google, Facebook and many other providers of services are actually using the same principle – that their users are a good target audience for advertising and that their service can be subsidized (or supported entirely as is currently the practice) through advertising.
Now the interesting fact is that these service providers have not been able to charge for the service. Anyone who followed the growth of Google mail might remember YHOO and MSFT trying to entice users into buying a premium mail service with higher storage limits and higher attachment sizes. Google entered the fray and grew exponentially because they offered for free what others were trying to charge for. A new entrant that was hungry for market share thus grew from just being a one-trick pony in search into its current mammoth position and made portals all but obsolete. People’s internet usage pattern changed significantly. iGoogle is an attempt at encouraging more of a portal-like experience by allowing each user to customize and create their own portal! Google news upset many publishers and syndications by allowing people to read the news without leaving Google.
Now here comes Facebook and it wants to encourage precisely the same sort of behavior. But it tries to go even further than Google and wants every user interaction on the web to be through its interface. You might even think of it as the cable box equivalent or the remote. In the US, print media advertising is likely to be replaced more and more by online advertising. I am not arguing with that or what eMarketer predicts about the size of the online ad market. I’ll say though that I expect the growth of online advertising will slow down because the market has matured substantially (the recent Google earnings in Q4 might be a reflection of that – volumes went up 34% while pricing declined 8%).
I agree that Facebook and Google both allow marketing campaigns to be more precisely targeted. But then again, that is an efficiency improvement on ad spending. That is all. The overall ad spending cannot and should not increase just because of growth of online advertising. Entertainment content over Television still remains more attractive for advertising because of the sheer reach (and the CPM for even prime-time TV is $25 or so which is comparable to highly targeted online CPMs for premium content which can reach $20+) and has high potential for regular reinforcement. Besides, it is a multi-pronged attack on the consumer’s consciousness. Online advertising is far more discreet. I would argue that a CPM that approaches Prime-time TV is an indication that online advertising spending is starting to mature. This has already started to happen in the US.
What does Facebook bring to this world? The potential for even more targeted advertising so that more sites can generate CPMs that approach the $20 mark because they are likely to be able to customize advertising based on user profile? Possibly. But how much of this will remain with Facebook and how much will go to the Publisher? A good indicator is the upside the publisher has from increasing his revenues through better placement. Now this seems like a win for everyone – the Publisher, the Ad-buyer and of course Facebook!
As an aside, this point (that targeted ads get a Publisher higher revenue) is missed by both the NYTimes DealBook article today criticising how Facebook measures its Daily Active Users. Needless to say, the NYTimes DealBook article cites Barry Riholtz’s blog voicing the same critcism who is also wrong for stating that “they cannot be marketed to” if they do not go to Facebook’s site. Well, they can be marketed to more effectively on the site they do visit by signing in using their facebook account (The Huffinton Post is cited as an example) and the Publisher of that site can target ads far more effectively and can claim premium pricing for the ads sold. This upside in pricing gets split between Facebook and the Publisher. Neither of these writers seemed to appreciate how internet marketing works.
Think of Facebook as a filter for content. You will start seeing what your friends like or recommend or have read. Now this would weed out a lot of publishers from the Web who offer marginal content. The web will become a manageable place with a Times Square of sorts. But many such places could exist because of the potential to micro-segment the users with the wealth of data that Facebook collects. So yes, this will offer a good deal for publishers with great content but will be a disaster for the less premium publishers.
So we’ve answered the first of the two questions we wanted to examine and have concluded that there is definite value that someone like Facebook could bring to the world of online advertising.
But let’s look at the potential ad revenue from each individual user. To answer that would be to also answer the second question – whether there is any potential to increase the level of monetization or increase the number of users – either of which will bring growth to Facebook.
Potential for increasing monetization and for increasing user base
Let’s start with a disclosed number – the 483Mn DAUs (Daily Active Users) that Facebook has in December 2011. Now, take into account that this was holiday season and people would both have more time on their hands a reason to want to be active and send messages to friends and family. But let’s start with that number anyway.
Now consider another number – the 2.7Bn likes and comments on average over Q4 2011 (Oct-Dec 2011). If we assume that the 483Mn DAU is representative of the quarter, this translates to 5.6 interactions by each DAU every day.
the whole quarter. So this implies that the average Facebook user just has 5.6 comments/ likes over the whole quarter! That strikes me as not being quite active. The edit above is thanks to one of the commentators who pointed out this error – that the no: is daily not over the whole quarter.
And remember that we are still looking at DAUs and not the vastly higher number of MAUs (Monthly Average Users). But even the DAU number is reaching a plateau with Q42011 seeing the worst QoQ increase in DAU (Daily Active Users) since 2009 (which is where the figures start). See the table below.
Facebook's Daily Active Users - Reaching a Plateau?
DAUs as the prime driver for both volume and pricing
Now I’ve tried to project Facebook revenue using DAUs as the primary driver for growth. Some people might say that this doesn’t capture the potential as the no: of interactions (likes/comments) could go up and increase potential for capturing some more commercial potential there like what Comscore refers to as “Ads with Social” – where friends of a person who likes or comments on a brand/ purchase/ article/ movie/ event get ads with a personalized message such as “Joan likes this!”.
I must say that I considered that possibility but rejected it thinking that this argument is flimsy because the core product has remained constant over time. Sorry – I think that it is unlikely that usage patterns will change drastically over a multi-million DAUs. Besides, an increase in user interactions would only come at increased Traffic Acquisition Costs (through new features, tie-ups with other players like Zynga). So this would probably dilute margins. So to use a simple model, let’s stick to DAUs as the core driver for estimating revenues in terms of potential interactions that can be sold.
I’ve used DAUs as another driver as well – for pricing power. Simply put, the more users Facebook has, the more targeted its ads can be and the more an advertiser would like to pay for it.
People might also criticize me of failing to account for revenue share from what Facebook calls Payments and other such uses of the Facebook Platform. Well, my defense is that these are also linked to DAUs and is very intimately tied with average interactions per DAU.
Another argument against upside from increased interactions:
I would also argue that Facebook is mature and should not be regarded a startup now. How likely is it that people are any more active on average than they already are? I’ll say that the fanatic users would already be on it. You might convert a few new users into fanatics but most new users are likely to be less active than the average user now. So let’s consider the average no: of interactions as constant.
Incidentally, Google also reported in the midst of its Q4 (which was greeted with howls) that its Google+ now has 90Mn+ users and has doubled its users from just a quarter back. Any social network benefits from what economists like to refer to as a positive network externality – a snowballing effect of sorts after a critical mass has been reached. If you look at the Facebook numbers you would see a similar effect. Each time users in a new region adopt Facebook, there is a sudden spurt in the DAUs. But as we might see soon, as Google+ gains users, Facebook will lose out on potential number of interactions as its control over its DAUs time decreases. So we might even see the average no: of user interactions on Facebook go down over time.
Look at google – search has remained the good majority of its revenue even after so long. A significant chunk after that is accounted for by Gmail ads. Internet usage patterns evolve only over time. So a radical shift is unlikely. So let’s assume that the average no: of interactions over Q42011 for Facebook as constant over time (both for past and future).
Simple revenue model illustrating Facebook revenue with two drivers for revenue both dependent on DAUs
- Pricing power increases
- Potential commercial interactions
So here is a revenue model that I’ve devised that seems to fit the actual annual data below not too badly. Cells marked in blue are my assumptions. Other cells are either calculated or from the S-1 filing.
Simple revenue model using DAUs seems to fit historic data quite well
Dilution, dilution, dilution! Control, control, control!
Let’s look at the number of shares offered 117.097Mn of Class A shares with one vote each. Class B has 10 votes each (at least it has only 10 unlike Zynga’s insane voting rights that give Pincus 70 votes for each of his shares). What’s more, there are a lot of Class B shares out there – 1,758,902,390 of them.
On top of all this, Mark Zuckerberg has an option to purchase another 120Mn Class B shares which he apparently plans to immediately convert to Class A shares. I am not familiar with this structuring, so excuse me if this table seems to overstate the no: of shares by those 120Mn shares.
Potential outstanding shares:
Substantial dilution projected over 2012 as per existing options
I still haven’t factored in the 2005 equity plans and 2012 equity plans which could add a further 72Mn shares. But at over 2.5Bn shares, that is just rounding error in EPS. Oh and the public who subscribe to this IPO will have voting rights of 0.49% though they will hold nearly 4.7% of the Mkt. cap. Again, whether this worries you depends on how comfortable you are with the management team. But any board that allows structuring like this is a board I will not want or trust. I think the SEC should prohibit different classes of stock.
P&L projections and per share values
I’ve used the same revenue model I’ve mentioned before to make the revenue projections below. These are what I regard as the most optimistic – where DAU base does not decline and commercial potential from interactions continues to be tapped into aggressively.
DAU growth --> Monetization opportunities increase, but new geographies with lower ad rates prove a drag on pricing
Ad rates are much lower (as much as 50% lower in even in countries such as Singapore) in newer Geographies where FB userbase is increasing. This will prove a drag on pricing and has been factored into the revenue expectations.
Even as I expect DAUs to grow at 29% YoY well into 2012 and at 14% into 2013, let’s examine what this translates to in terms of earnings. Below are my P&L projections and EPS projections. To take away the effects of stock option expensing (so that I don’t double-count the effect of dilution), I’ve provided an estimate of earnings without expensing stock options but shown EPS on a fully diluted basis with these options.
Good, but not stellar!
Earnings growth is at a CAGR of 105.3%. If I consider earnings adjusting for stock compensation expenses, this slips slightly to 93.3%. Note that I am talking about the Net Income across all shareholders. As we are looking at EPS and Net Income across all shares after the IPO, I am doing this to be consistent.
With the tremendous dilution in stock after the IPO, I would say that it’d be tough to deliver earnings growth over 2012 at least as can be seen by the diluted EPS growth projected at a CAGR of 90.9% from 2011 to 2013 (Diluted EPS from $0.46 to $1.68).
At what price would I buy Facebook?
Let’s take a proven competitor for online advertising, Google. They trade at a P/E of just 12.25 for FY12E. Let’s be doubly generous and use a P/E of 15 for FY13E for Facebook. That gets me a price of 15×1.68 = $25.13!
Even at $25.13/share, Facebook will be worth a massive $63.2Bn! I think that is probably close to what it is really worth. Paying anything more would be flirting with the chance that they can power earnings growth in new ways and exponentially grow their revenue per user.
Note: Stocks mentioned in this article are FB, GOOG, ZNGA. I do not hold any position in any of these stocks and do not plan to initiate a position in the next 90 days.