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On Facebook Valuation

After more than a 50% drop in value, I’d like to jump in the Facebook conversation to explain why I believe that there is significant upside potential for Facebook shares. At the present time, there seems to be concerns on the large amount of shares that will be unlocked soon, but more fundamentally there is a cloud of doubt on: 1. how Facebook can monetize mobile traffic, 2. other sources of revenue available, 3. migration to other social platforms. The bottom line is, can Facebook generate loads of cash and sustain growth?

To address these concerns, I’d like to first cancel the first one – which is the 2 billion shares that will be outstanding. Although this represents a short term challenge of basic supply and demand, it does not affect the fundamentals of the company, which will be the ones who will dictate Facebook’s valuation in the long term. Thus, let us focus on the other issues at hand, which is how they will make money, and how they will retain control of the social layer.

To understand my point of view on Facebook’s social layer and what it represents for the company, you can see here and here. Basically, Facebook has a monopoly over the Internet’s Social Layer. Their 900 million member personal data makes them the most formidable partner to marketers trying to reach their customers online. So the question is, Can someone else build a competing product that is capable of amassing such a large amount of personal data from nearly 1 billion people? If your answer is yes, that still doesn’t erase the fact that Facebook still owns the personal data as well, which would allow them to monetize it. Therefore, even if some other social networking site can get people to share so much personal data with them (which I doubt), the time it would take them would give Facebook a considerable advantage over that competitor. On the other hand, if your answer is no, the value of Facebook is considerably higher than it is today because of what they will be able to do with that data that no one else will.

Will traffic for Facebook’s desktop site sink? Yes. Will traffic to its mobile app become higher than its desktop site? Yes. Will traffic to Facebook properties begin to decrease? Very likely. Does that matter? For its revenue, not much and here’s why. Investors sold Facebook shares after seeing Facebook’s first quarter report, where revenue growth from display ads decreased. This raised a red flag in Facebook’s ability to sustain their growth and valuation. Since then, the company has continued a downward slope to a market cap of around $50 billion. However, looking at display ad revenue from Facebook’s site as a measure of the company’s capacity to generate revenue is a mistake. I believe that this measure will continue to remain weak in comparison to other sources of revenue (although it will continue to rise), but it won’t matter as much for Facebook’s bottom line in the long term than other products.

Forget games, forget Zynga and its Farmville and all those other fickle products. Facebook’s value is in its ability to package all of its members’ personal data into an external marketing engine directly competing with Google Adsense. In 2011, Google generated $10.4 billion in revenue from “Google Network Members’ Websites”. Anyone familiar with the product will know that it is a contextual advertising marketing platform whose principal source of targeting relies on an algorithm that matches relevance of a web page and an ad, and can limit it to a specific geographical sector. The system allows anyone to create these ads in minutes, and is responsible for about a third of Google’s revenue. This will be Facebook’s greatest source of revenue if they are able to bypass privacy obstacles.

Google knows they need more personal info. They have plugged their social networking site Google Plus into every single product they have in hopes of preparing for the competition that Facebook will create. Google Plus continues to fail at this, and despite claims of high traffic numbers for Google Plus, we all know that our society “likes” (Facebook) instead of “plus” (Google). In other words, people visiting an external website are far more likely to click on Facebook’s “like” button, instead of Google’s. Everytime a user “likes” an item, Facebook’s value increases. As Facebook continues to dominate this personal data storage, their Google Adsense competing product becomes much more valuable than Adsense.

The product I am talking about doesn’t exist, but it has to. Facebook’s Adsense will be very similar to their internal ad engine, except that it will allow marketers to advertise anywhere in the web. Facebook will be able to command much higher rates than Adsense, because Facebook will allow them to target their customers in more detail. For example, a marketer could advertise to people that are celebrating their birthdays, people who are engaged, or to people who like Coca Cola. These are just very small examples of a much more elaborate campaign that can be tailored, given Facebook’s massive personal information.

Commanding a greater amount of money for these campaigns would allow Facebook to also share more money with the webmasters hosting the ads, which would be an incentive to drop Adsense in favor of Facebook’s product. That move could bite in directly into Google’s Members’ Websites revenue. Growth rate in that line has been a healthy 20% year over year. If marketers would be willing to pay more for Facebook’s targeted ad campaigns across the entire web, it could quickly become a $10 to 15 billion revenue source in the next year or two, which is five times Facebook’s 2011 revenue. Attracting more advertisers with this product would also benefit its internal property revenues, as more of their internal impressions could be filled and perhaps at a higher price.

If you believe the product I have just talked about will not exist, then a $50 billion market cap is probably right. However, if this product is launched, then the current valuation appears significantly undervalued. The more likely question is not if they will launch this product, but when. And when they do, it is my belief that Facebook and Google shares will be affected inversely.

All these considerations are for a term of 1 to 3 years. For the short term, uncertainty about the company’s direction and the large amount of outstanding shares could put some downward pressure into the stock, despite its fairly low valuation. For the longer term, as technology progresses, other significant sources of revenue can be mined from Facebook’s personal information field. For example, as web browsing transfers to mobile platforms, the combination of geographic location with personal preference data opens up the possibilities for other types of targeted advertising. To see a basic explanation of this, you can read the article I wrote on mobile ads. On the other hand, Zuckerberg’s voting power dominance of the company is a risk issue that can make investors uneasy. His ability to communicate his vision and remain relevant as technology changes will be a determinant factor for the company’s long term progress.

*This article is not financial advice, nor is intended to recommend the purchase or sale of any stock or investment. Please consult your financial advisor for investment guidance.

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