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Why Facebook is worth so much money

Facebook is widely expected to make a preliminary filing for their IPO today. Bloomberg reports that they have chosen Morgan Stanley as their lead banker and plan to raise $5bn.

At this point it is clear that Facebook is worth a lot of money. The company has 800m+ users who love the service and made a $1.5bn operating profit in 2011 on revenues of $3.8bn (according to Business Insider). Moreover, the company is still growing fast. For these reasons the IPO is expected to price in the $80-100bn range.

For context, Google’s valuation is currently $189bn on 2011 revenues of $37.9bn and operating profit of $11.7bn. If Facebook makes it out in the $80-100bn range then it will be roughly 5x more highly valued than Google on a multiples basis.

The question for investors is ‘are they worth the premium?’

The bull case makes the following arguments:

  • Powerful network effects are at play in Facebook’s business. Social networks only make sense if your friends are there and even if there was an equivalent service it is very hard to imagine groups of people co-ordinating themselves to take their content and leave en-masse.
  • The apps and games platform is a formidable engine for growth. Facebook has fostered an enormous community of developers who as a buy product of building their own companies drive revenues for Facebook and improve the experience for Facebook’s users.
  • Facebook Connect – we are only seeing the beginning of this now, but the virtuous circle created between Facebook and their Connect partners is extremely powerful. All parties will benefit from the data created and shared via this mechanism.
  • Ad targeting – Facebook’s has a huge and growing ad inventory, the richest data on users any company has ever possessed, and a very effective ad buying system. As an engine for growth and profits it has the potential to rival Google’s Adwords.
  • There is still a lot they can do to improve – the refrain within Facebook is “we are only 1% done” and it is easy to see how they could extend their reach into new products and markets. An ad system that runs on third party sites which use Facebook Connect is one of the more obvious opportunities – equivalent to Google’s Adsense.
  • Facebook has a strong management team with a great track record of execution and innovation.

However, there are significant downside risks. Facebook could fade, as AOL and Yahoo did before it. Both those companies had positions that at the time seemed to match Facebook’s current dominance but were blindsided by changes to the way the internet works. AOL didn’t see the change away from walled gardens and Yahoo failed to adapt to the rise in importance of search and social. It is likely that the next ten years will see changes at least as radical as these and Facebook will have to remain fleet of foot if it is too justify its valuation.

As we sit here today the most obvious change that could damage Facebook is the shift to mobile. Facebook is a native web experience and works much better on a full screen. The other major risk from a competitive perspective is that social media activity fragments again. Before Facebook became dominant our collective social activity was spread across a number of services and that situation could arise again if disparate services like Twitter, Instagram, Pinterest and Tumblr continue to grow.

A risk to Facebook’s valuation (rather than to their business) is that growth tops out. I am persuaded by the argument that in the developed world social media is getting close to full penetration, and that future growth will have to come not from increasing the number of people and time spent on Facebook, but rather from better monetising their existing assets. Transitioning from one growth model to another can be hard.

I’m skilled in valuing companies in the $1-100m rather than the $80-100bn range but my gut is that Facebook’s assets are really strong and the team is strong enough to navigate around their weaknesses, at least for the next couple of years. Google IPOd in 2004 when their operating profit was $640m. By 2006 they had grown that figure to $3.5bn, and if Facebook can match anything like Google’s run a $100bn valuation is around 15-20x their two-year-forward operating profit, which is not outrageous.

I am sure we will learn much more about their revenue and profit expectations over the next couple of weeks. It will be interesting to see how the debate pans out.

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