The news that everyone had been expecting is finally official: Facebook has filed for IPO. With a $100bn valuation on $3.7bn revenue, the flotation has many worried that we're about to see another spectacular dotcom bust. To me, the landscape has fundamentally changed. We won’t see anything like the crash a decade ago. It’s almost because of the 2001 bubble that we’re not looking at another one.
It’s difficult to imagine Facebook crashing and burning given its huge user base and the advertising opportunities this will open up over the coming years. Along with the IPO, Facebook announced it had around 850 million users (I expect this to reach one billion in the very near future), which is around 50% of the internet population, or over 10% of the global population. Given its sheer size, reach and huge potential, it’s difficult to imagine a company that services more than 10% of the world, vanishing in a puff of smoke.
Companies today are also more mature in terms of their financials – in 2001 many of the companies went public on a hope and a prayer that markets would open up for them. Netscape only had $60m in revenues when it went public in 1995, yet all the hype sent its market value soaring to $3bn at the end of its first day's trading. In Facebook’s case, it’s been patient, laid the foundations of a strong business model and established the early signs of financial performance away from the prying eyes of the public markets. This has given it a significant revenue profile and decent profit margins that go with its gigantic user base.
The evolution of the internet as a part of everyday life, as opposed to a luxury only for the wealthy, means that Facebook’s potential market comprises of almost everyone on the planet. It will continue to expand its user base in emerging geographies even as it starts to plateau out in more mature markets.
Is $100bn a realistic valuation? It’s an enormous number, but it can be justified if you believe that Facebook can increase both users and revenue-per-user by introducing increasingly sophisticated advertising. Marketers and advertising agencies are searching for the holy grail, something that allows them to target accurately, to measure response and make the most effective use of their budgets and Facebook could potentially be part of that. As an advertising platform, Facebook has high levels of engagement and an extensive reach across the internet through its own application and also through its Facebook connect service. And Facebook has a tremendous amount of data on its user base, which suggests an advertising platform with unprecedented power and potential.
TV revolutionised advertising in the fifties and, if it pulls it off, Facebook could have the same impact that TV did and become the advertising platform for the 21st century.
At the moment, 85% of Facebook’s revenue ($3.1bn) comes through advertising, so it’s important to consider the future of the internet advertising market. Internet advertising is expected to grow by around 31% to $95bn this year, with display advertising accounting for around a quarter of that at $25bn. The online display advertising market is growing by around 36%, which is faster than the overall internet advertising market and will be the principal market for Facebook to go after.
But Facebook has other significant revenue streams. Many companies use its platform for gaming and other applications, such as Zynga. My point is this: you can see where Facebook’s revenues can come from. The market is there and if it executes well, it could fulfil its potential.
If Facebook can fully take advantage of this growing market, you can easily see its financial performance getting stronger and stronger. Revenues could potentially double (or more) year-on-year with healthy margins, delivering strong profits at the bottom line. Assuming that revenue doubles for three years, then it would reach $28bn by 2014 and, if Facebook can maintain its net margins, that would deliver a profit of around $9bn.
Google trades off a price-earnings ratio of about 20 (20x its profits). If you applied that to Facebook's hypothetical position in 2014, then it would achieve a market cap of $180bn - a decent uplift from its current valuation. And if it continues to grow at a good rate (for example, 50 – 100% per annum) the multiple could be even higher and deliver even better returns for investors. As another reference point, Amazon currently trades at an amazing 100x P/E multiple.
So, if Facebook has such fantastic potential and is unlikely to unravel, it must be a good investment, right? Well, perhaps not.
Simply put, for the same reasons that Facebook is unlikely to fail, I believe it is unlikely to make a great investment. Having already cemented its leadership in the market and developed a strong financial position, its valuation has been driven up already. Investing now, while probably safer than many imagine, is unlikely to deliver returns of seven or eight times over a few years – as you could have done by investing in Google in 2004. Facebook would have to be worth $800bn in 2020 to perform as well as Google has and the most valuable company in the world at the moment, Apple, is only worth half that! It’s difficult to imagine that the market is big enough to monetise the user base to the extent it would need to in order to deliver returns of that size. The smart money was in the venture capital and private equity investment.
So while Facebook’s IPO isn’t a sign of a bubble and the company won’t be going away, I won’t be rushing out to buy its stock.