How To Win The Facebook Bubble

The Facebook controversy is almost getting old but something tells me it won’t be long before the company will cross the $100 billion valuation. Some authors have predicted Facebook to be valued at more than $200 billion by 2015. If this trend continues, Facebook’s stock price will eventually decline perhaps more sharply than Enron’s in 2001. Then, the only investors who may come out as winners will be those who can predict when the bubble will burst.

For any unbiased, rational investment analyst, there should be little doubt that Facebook’s potential for revenue-generation does not justify a valuation in excess of $50 billion (and even that would be pushing it). The valuation is entirely speculative in nature, based on the revenue stream that the company may be able to develop and sustain. There are four pieces that comprise the intricate valuation puzzle for private companies – existing cash flows, expected growth in profits, discount rates based on risk assessment, and an estimate of the company’s terminal value. The only way Facebook can achieve a valuation of $78.5 billion is by completely ignoring risk assessment and being extremely optimistic, or even unrealistic, about the potential for new revenue models.

Facebook Ads:

Text and Display Ads are Facebook’s primary source of revenue. Facebook Ads are effective in reaching demographically correct eyeballs through effective brand marketing. These advertisements allow local businesses to efficiently target their local audience; however, in terms of relative success, it is still not even comparable to the effectiveness of Google Ads. On Google, the consumer is looking and searching for information which creates the perfect environment for search-related advertisements. On the contrary, Facebook advertisements are enforced on users through miscalculated guesswork. In my case, Facebook has always made the wrong guesses – despite being a single, Economics major in college, I’m least interested in advertisements about dating sites and The Economist that typically pop up on my Facebook pages. As the company grows, revenue through advertisements will definitely increase but it would be beyond reason to argue that Facebook’s Ad revenue will surpass that of Google.

It is easy to turn the tide in topics that are inherently debatable. I can make a case for the success of Facebook Ads based on an insignificant number of businesses that have experienced staggering success by advertising on Facebook (for example, the local jewellers who are able to reach recently married local couples through Facebook Ads). Or, I can play up the success of the ‘Like’ button and how that has helped brands reach millions of people. The truth is that the highly exaggerated advertising success of the ‘Like’ button, or the astounding advertising efficiency of a small number of businesses, is merely indicative of the effectiveness of Facebook Ads on a broader level. Thats where Google steals the show in advertising – at the macro level.

The problem with potential revenue models:

The popularity of Facebook does not mean the website has an equally strong business model. Facebook’s 500 million users do not want to accomplish everything on the website. The typical surfer on Facebook uses the website to keep up with friends, make jokes, stalk half-friends, and to waste time. It would be naive to assume that people would want to use Facebook to check email, ask questions, participate in groups, rate stores, check into places, send or receive money or shop online. In July 2010, Facebook launched its Question/Answer platform which was very similar to Yahoo! Answers or Quora. The platform’s failure is a classic reflection of the fact that people are not looking to use Facebook to search for information or settle their intellectual curiosities. Thus, despite having 134 million unique visitors each month, commercializing the Facebook space remains a daunting challenge. Efforts to overtly commercialize Facebook are also likely to make the website less attractive to many users. 

Still, Facebook can possibly succeed in incorporating eCommerce, social shopping or perhaps even a search engine to develop an entirely new stream of revenue; however, the possibility is bleak at best. The claims that Facebook will take over the web, or will surpass Google in revenues in due time, are based on a set of unspoken and unexamined assumptions. And Facebook’s recent valuation of $75 billion on SecondMarket shows that many investors are not questioning these absurd assumptions. However, Goldman Sachs, the prime driving force behind Facebook’s investment campaign, has its own reasons for heavily investing in Facebook.

Why is Goldman Sachs so invested in Facebook?

Leading Facebook’s investment campaign and potentially pushing up its IPO value will almost certainly secure a front seat for Goldman in the Facebook IPO. If Goldman leads the IPO, which seems increasingly likely, it will secure the standard 6% of the offering fee. Regardless of the final negotiations of the offering fee, Goldman will be set to make billions of dollars from the Facebook IPO depending on the final IPO value. Keeping that in mind, it is strategically important for Goldman to drive up Facebook’s value in secondary markets. Moreover, the to-be Facebook millionaires and billionaires will require private wealth management services and Goldman will be in the right position to capitalise on that.

If I was an investment banker at Goldman Sachs, it would probably be in my interest to hype Facebook as much as possible. I would not be writing this article. Welcome to the world of investment banking.

Why does Facebook want to stay private?

Just like eBay makes buyers feel they have earned the ability to spend money through an auction, Goldman’s clients may feel that their exclusive ability to invest in Facebook means something. Goldman’s Facebook Fund is being marketed to clients as a seductively promising early-investment opportunity for visionary investors who can envision the company’s glowing financial future even without being able to access much of the financial and statistical information that is required to ascertain these claims. And seeing as many of Goldman’s top clients are absolutely thrilled to invest in Facebook, I would say the strategy is working out quite well.

Perhaps more importantly, in the absence of financial and statistical information, it is extremely difficult (if possible at all) to make a solid case backed by unequivocal evidence that Facebook is a ridiculously high-risk investment which will probably fail to offer the expected returns. Going public would mean that Facebook would have to release all such information which is currently not available to the public. Now why would they want to do that?

Market valuations of publicly traded companies are often critically questioned by sceptical investors. The increased regulation and information disclosure concerns, from Sarbanes-Oxley compliance to Regulation Fair Disclosure, would mean that Facebook’s stock price will likely be driven by gossip and perception often fuelled by hedge funds. Currently Facebook drives its own perception because no one else can access the financial information required to make any claims on the company’s projected growth in net income. That puts Facebook executives in a position of incredible power over investors and secondary stock markets, and retaining that power requires to keep the company private.

So is Facebook really overvalued?

In 2009, Facebook had a net income of $200 million. In 2010, the company earned $355 million in net income in the first nine months according to documents distributed by Goldman Sachs. The price-to-income ratio of Facebook is much higher than other Internet giants (like Google and Netflix); however, those investing in Facebook have argued that their investment is based on the projected revenue, or projected income, that Facebook will supposedly raise in the future. In that case, the price-to-income ratio is hardly useful, especially when the company’s most recent financial information remains undisclosed.

From a theoretical standpoint, it is quite clear that the rapidly increasing Facebook valuations on secondary markets are based on a set of unspoken and unreasonable assumptions on which potential revenue models can be built and argued. Unless the company has a realistic, highly innovative top-secret business model that is only shared with investors, which somehow does not get leaked out to the media, piling investments in Facebook are likely to leave a very small group of people with ridiculous amounts of wealth.

When the bubble bursts…

It seems that Goldman and Facebook are doing an impressive job of driving up the company’s valuation on secondary markets. If this trend continues, it will almost inevitably result in a ridiculously high IPO value. However, what happens when investors realise that their precious Facebook shares are not providing the returns they should? Yet worse, what happens when everyone wants to sell their Facebook shares more or less at the same time? Facebook’s stock price will drop more steeply than any other company’s in history. Something tells me there will be a few people who will have sold their shares before the bubble bursts, and they will have made a fortune. What about all the others? I would hope I’m not one of them.