What Price is Fair for Facebook?

by nikiscevak on January 3, 2011

My first reaction to Facebook raising $500m from Goldman Sachs and ‘a Russian investor’ at a $50bn valuation and perhaps up to $1.5bn more from private clients of Goldman Sachs was twofold: Bravo Facebook management for locking in such a rich valuation and secondly, if I thought the investors were so stupid as to pay such a price, what price would I pay for the company?

Facebook at present is the investment-equivalent of an alluring velvet rope leading to a private room at a nightclub: Nobody knows for sure what’s back there but they want to be there nonetheless.

Saying $50bn is too rich a valuation might seem just as idiotic as investing at that price because no one, except for Facebook insiders, knows for sure what the financial inner workings of the company are. But there are enough external references to the markets that Facebook operates in that can give some decent clues.

There are three parts to Facebook that have value at present. They are, roughly in order of importance: Facebook Credits, the self-service display ad business used by direct response marketers and brand-directed advertising.

Facebook credits is most analogous to Apple’s app store, where both process huge volumes of casual gaming transactions. Through June of 2010, Apple said the app store had 5 billion downloads and that it had paid out over $1 billion to developers, implying that more than $1.4 billion (Apple pays out 70% and keeps 30%) of transaction volume has passed through the app store.

Now, in terms of getting a time period estimate, last year roughly 4 billion apps were downloaded from the app store. Using the same monetization metrics and taking Apple’s cut, in 2010 we get to a figure of $288 million.

Facebook is likely on the same trajectory (say $300m for 2010 and $600m for 2011).

Facebook credits is a wonderful business and in itself is worth billions of dollars (but not tens of billions of dollars). For one, micro-payments have bad economics because credit card fees on small amounts take a large percentage of the revenue. There are moves afoot to reduce these fees by government but at present they are bad.

Let’s ascribe a $8 billion valuation to the Facebook credits business (probably about half of what Paypal is being valued at).

The direct-response, self-service display ad business has huge scale: Roughly one in four page views on the Internet in the United States are served by Facebook (and more in international markets) and the targeting mechanisms made available are rich and full-featured. There is one small problem though: Users are there to share information and photos with each other and not to make purchase decisions. Geocities had huge page views, Yahoo Mail has huge page views and folks like Meebo have huge page views but they don’t have huge revenue because of the context of the inventory: communications is a fundamentally bad environment for advertising.

The fact that Facebook has real information about users and has opened that up to targeting however, means that there still is an interesting business.

Also, because the advertising is self-service and Facebook have made available rich apis to manipulate the advertising, technology vendors that help companies manage their spending on search are now rushing to help advertisers manage their spending on Facebook too.

This development is no small thing because it means that Facebook doesn’t have to employ steak-dinner eating, fairway-walking to the 18th hole sales people for this part of its business and the profit margins can be attractive. In the years since the wonder that is Google Adwords, an ad platform has not come close until Facebook’s self-service business (and to be clear, Facebook is still not in the same ballpark but at least they’re playing the same sport).

The Facebook direct response business likely did $400m in 2010 and let’s say it will do $600m in 2011. But because this business has been riding the gravity-defying rise of Facebook users and there simply aren’t that many more people to join Facebook in the world the business has a lower ceiling than Facebook credits which will benefit from all sorts of things being sold within Facebook beyond games. Let’s give the direct response, self-service display ad business a valuation of $5 billion.

The brand-directed division will likely get the most attention but in my opinion is worth the least (and is lucky to be worth anything). Yahoo’s brand-directed display business is currently the largest in the world and investors effectively value it at zero since the Chinese and Japanese assets of YHOO account for the whole (or even >100%) of the stock price at present. AOL is valued at $2.5bn and it has a dying dial-up business that still accounts for the majority of cash flow.

Quite simply, the steak dinner sales people are expensive, the CPMs are forever falling because of competition amongst impressions and despite the ability to ‘measure everything’ the actual stuff a marketer wants to know is very hard to get at since they are impacting human psychology and people buy stuff in the real world as well.

Even with growing revenue in the hundreds of millions of dollars I still would only place a value of $1 billion for the brand-directed unit of Facebook.

That leaves a valuation of Facebook, in my humble opinion, of $14 billion.

  • Fair analysis, but you missed two likely new future business like a adsense like ad network and mobile/local.

  • Sandy Kory

    Very interesting post, as always, Niki.

    I think you are under-estimating the upside of their self-service ad business in two ways.

    First, Facebook has become increasingly commercial and will continue to do so as brands build out fan pages and more commercial apps come out (think categories like travel and careers). For that reason alone, I think investors are giving this piece of their business a valuation in the tens of billions.

    Second, Facebook will very likely launch an off-site ad network (akin to AdSense) leveraging the monetization lift they can offer publishers through social targeting. I wouldn't be surprised if investors are valuing this in the tens of billions, though I think that might be overdoing it.

    On the other hand, I don't think the credits business will ever be that interesting unless the virtual goods are in O&O properties (apps), meaning FB can keep all the revenue itself.

  • Hey Sandy, thanks so much for your comment and do agree I may be under-estimating the self-service ad part but at the end of the day, it has to be worth something and at $5bn is still a marvellous business and still larger than Yahoo US and AOL display (i.e. the largest display business on the web and it's just one part of Facebook).

    When you get to $50bn, the question in my mind turns to what ceiling of possible value can be created. Everyone will cite GOOG at $190bn but if you look back around at all the other businesses that operate online they're already the largest ex-Google (eBay and Amazon are bad comps as well in my opinion).

    I think at the end people just have to realize that display advertising on the Internet is just not a great business and the fundamentals of that market at some point will hurt Facebook. They have had the most amazing user growth and are on one of the most exciting trajectories but in the end they're still experiencing crumbling CPMs and will run into the ceiling soon.

    Either way, if not $14bn, then what is a fair price in your mind?

  • Great post. Been meaning to ask your thoughts on FB valuation. I am sure they are prepping for some sort of IPO...

    How about social gaming and being the platform for them? Vanity domain names for businesses + metrics (facebook.com/* for maybe $25 per year)? Social media marketing for enterprise (b-to-c campaigns with metrics)? Should valuations also include current monetization efforts/initiatives ++ potential money-making opportunities (accretive M&As, etc...)?

    Looking forward to your thoughts...

    -v

  • Hey there Victor, thanks for your comment. The gaming stuff is captured in the Facebook Credits business and I think it will become the biggest part of their business. On the other stuff I don't disagree but it all comes down to what price is all of that worth and I think it's just not that much.

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