Why I Can’t “Like” Facebook’s Valuation

Written by Chris Kanthan. Posted in Business, Opinion, Technology

Tagged: , , , , , , ,

Published on May 22, 2012 with 21 Comments

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Facebook' stock was initially offered to the public at $38 per share last week. Today the share price closed at $31.

By Chris Kanthan

May 22, 2012

The much hyped and anticipated IPO that placed Facebook’s valuation at a whopping $100 billion has been a huge flop, with the stock down by almost 30 percent from its peak share price of $45.

Compare this with other giant tech IPOs like Netscape and Google. Netscape more than doubled on the first day of its IPO. Google jumped 18 percent on the first day, and after 8 years the stock is 7 times its IPO price of $85.

Will Facebook perform like Google, or more like Zynga, whose stock has lost half its value since its IPO?

Here are the top seven reasons why I have to click on the “dislike” button for valuing Facebook at $100 billion when it made a net income of $1 billion on revenues of $3.7 billion in 2011.

1) Unrealistic P/E: The Price to Earnings ratio is the valuation ratio of a company’s current share price compared to its per-share earnings. The higher the number, the riskier it is for the investor. For comparison, Apple’s P/E ratio is about 13, Google is about 18, and for Facebook it was more than 100 at the IPO, possibly the highest among all the S&P 500 companies! Even after the stock’s fall on Monday and Tuesday, the P/E ratio is about 71. If you price Facebook like Google, the stock price would be around $7.

2) Shaky Growth Strategy: Facebook has maxed out its growth in the U.S. and other English speaking countries. In its IPO documents, Facebook touts fast growth in Asia.

But let’s take a look at some of the countries in Asia.

Facebook is banned in China, a country with 1.3 billion people. Chinese have their Ren-Ren which has the exact look and feel of Facebook. Nobody knows when China will open up and, even if it did, the barrier to switching to a new platform with limited differentiation is high.

India has over a billion people but only 10 percent of the population has access to the internet and less than 2 percent has access to broadband. Same with Indonesia, the fourth most populous nation in the world.

In Africa, a continent with a billion people, the statistics are even more dismal.

Let’s also not forget that we live in a world where half the population (more than 3 billion people) make less than $2.50 a day and the last thing on their mind is a ‘status update.’

Bottom line: Facebook’s growth has already transformed from an exponential curve to an “S” curve, and its growth will flatten out very soon (or may even decrease).

3) Low ARPU: ARPU is Average Revenue Per User (per Year). While Google manages to generate $30 per user, Facebook gets a pitiful $4.34 per user. Breaking it down by region, it’s about $10 for U.S. and Canada, $5 for Europe, and $1.79 for Asia.

The number for Asia is this high because of Japan and South Korea but will go down in the future since most of the new members will be from developing nations with a lot less GDP per capita.

In the first quarter of 2012, Facebook’s net income actually fell by 12% compared to 2011.

So the overall revenue per user will continue to go down unless Facebook comes up with a great new strategy.

4) Huge Dependence on Ad Revenues: Eighty-five percent of Facebook’s revenue in 2011 came from Ads. Facebook is trying to get more out of the virtual currency world but so far it has not been very successful.

So Facebook has tried several tricks like making the fonts smaller and increasing the number of ads per page from 6 to 7 (of course, most people never noticed the increase in the ads because most people never look at the ads to start with).

But there are only so many ads you can squeeze on a page before it becomes irritating and turns people off.

5) Efficiency of Facebook Ads: How many times have you clicked on a Facebook ad? Personally, I think I have clicked maybe 3 ads on Facebook in the last 5 years.

Many advertisers are starting to give up on Facebook. GM cancelled a $10 million Facebook ad campaign just days before the IPO.

According to analyst Carlos Kirjner, “The presumption that Facebook is not an effective medium for autos begs the question, ‘What other large verticals may find it inadequate?’ If it does not work for GM, will it work for P&G, or AT&T, or perhaps the highest profile Facebook customer, American Express?”

6) Growth of Mobile Users: More than half of Facebook logins are from smartphone users. Even in developing nations, the future acquisition will primarily come from smartphone users.

Currently, Facebook has no advertisements on their Facebook App for smartphones. Even without the ads, the mobile app is slow to load the pages. Whether Facebook ads can be integrated with the mobile app without disrupting the user experience is yet to be determined

7) Greed and Slime: The average investor must feel quite burned after the disastrous Facebook IPO. The ridiculous price of the stock had only one purpose—to make the early investors and the investment bankers rich. As Vanguard Founder and CEO John Bugle said on CNBC, ”This is a classic example of institutional greed, underwriter greed, and company greed.”

Early investors like Goldman Sachs added 25 percent more shares to the mix and raised the stock price at the last minute. And then they dumped their shares on the first day knowing very well the stock price was unreasonable and unsustainable.

Morgan Stanley, the lead underwriter, repeatedly stepped in and bought Facebook shares to artificially prop up the price of the stock in the last 3 days, which may be illegal.

Also, on Tuesday, it was revealed that just days before the IPO, Morgan Stanley slashed the revenue estimates for Facebook and warned a few of the big investors but kept it a secret from the public. Regulators are looking into it but it is not going to help the mom and pop investors who have collectively lost tens of billions of dollars in just a couple of days.

So much for believing in the “free market.”

There are lots of other reasons, short and long term, why the stock price may go down further. Facebook and its employees will be selling a lot of shares around November after the initial 6-month waiting period is over. This is expected to put more downward pressure on the stock price.

And looking into the future, who knows what consumers will like or want in 3 or 5 years? Remember MySpace?

When a rag-tag team of 13 employees can start Instagram and become an existential threat to Facebook, it’s time to pause.

Facebook’s stock closed at $31 on Tuesday. In the short term, it maybe a falling knife that nobody wants to catch. My estimate for a fair stock price is around $10.

Chris Kanthan

Chris Kanthan

Chris Kanthan has degrees in Physics and Engineering with a minor in Economics. And, just for fun, a diploma in Paralegal. He lives in the San Francisco Bay Area, has traveled to more than 30 countries, and deeply cares about politics, finance and food. He has also written an e-book titled "Deconstructing Monsanto" that is available on iTunes, Amazon.com and Smashwords.com. He can be reached at chrisk2000@yahoo.com.

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  • daggersedge

    You missed something here: many people are beginning to be turned off Facebook.  Why?  It has cost people their relationships, their jobs, and their futures. 

    People break up and get divorced because of something that someone puts on Facebook.  Maybe it’s a ‘friend’s’ picture of, say, the wife cuddling someone at a drunken party that does it.  Or the note the husband writes on an old flame’s page. 

    I don’t know how many times on various job-help forums I have seen people write about how they have been disciplined at work or even lost their jobs because of some unwise thing they wrote on facebook about their boss, their colleagues, or their customers.

    Then there’s the fact that some employers conduct searches of social media sites on prospective employees.  All those pics of drunken behaviour don’t do the candidates any favours.

    Certainly, at the moment, there are many people who either don’t know, don’t think about, or don’t care about the risks, but it doesn’t take that long for people to begin to think that maybe it’s not such a good idea to be on Facebook. 

    Of course some fools will continue to be on Facebook, no matter what, because they are fools.  How much money, though, can you get out of fools who might very well end up with no job and no prospects. 

    Given all this, I think 10 dollars a share is too high an estimation.

  • Ralph E. Stone

    @daggersedge:  Zuckerberg has said “That privacy was no longer a social norm.”  Unfortunately, the internet generation seems to agree with this assessment.  I have a Facebook account. I only include publicly available information such as, for example, my Fog City Journal articles. Even if I had dirty laundry, I wouldn’t air it on Facebook, nor would I disclose intimate details of my life. I am always surprised, however, what some of my “friends” disclose on Facebook.  Too often, this personal information comes back to bite Facebook users.  Why blame Facebook when users should know that everything disclosed on Facebook, or for that matter, on the internet, will probably be there for the world to see. 

    • daggersedge

      I’m not blaming Facebook, but the people who have been bitten by their own disclosures on Facebook will, I think, do so.

      I think there will be a backlash against too much openness and that social media sites such as Facebook will be caught up in it.  People’s reasoning will be that they wouldn’t have disclosed their personal details if such sites hadn’t existed.  Unfair, yes, but that’s the way of the world.  Mud sticks, even if the mud hasn’t been thrown at the right target

  • http://twitter.com/chrisk2000 chris k

    Facebook and the underwriters face class-action lawsuits and the US Senate is investigating as well..

    http://venturebeat.com/2012/05/23/facebook-class-action-lawsuit/ 

  • http://twitter.com/chrisk2000 chris k

    Main Street won’t be fooled by the uptick in FB today. Here is an article that explains how the underwriters are still manipulating the stock price (called greenshoe option…announcing more stocks than there actually are and hence creating artificial demand. The article explains it in more details) . Thanks to their friends in SEC, apparently it’s all good…

    http://www.cnbc.com/id/47539817 

  • http://twitter.com/AnnGarrison AnnGarrison

    The Obama campaign seems to put a lot of faith in Facebook.  Their ads are relentless on my page, no matter how many times I disappear them, and check “Irrelevant” just to see if they stop or slow down.

    • http://twitter.com/chrisk2000 chris k

      Haha…this shows how inefficient Facebook’s advertisement is.

    • chard

      I have yet to notice any ad for a product or service I’d be interested in, further, I don’t “click” them because I don’t want to draw even more.

  • http://twitter.com/AnnGarrison AnnGarrison

    Also, excellent analysis.  I just posted it to my Facebook page, beneath the news that Facebook just opened up an office in Dubai.  

    Most of my African Facebook friends seem to use Facebook on their phones a lot, but I don’t think Facebook makes any money on its cell phone users.

    • http://twitter.com/chrisk2000 chris k

      Facebook admitted to this problem in their IPO filings few days ago:
      “We do not currently directly generate any meaningful revenue from the use of Facebook mobile products, and our ability to do so successfully is unproven.”  

      http://allfacebook.com/sixth-s-1-amendment_b88442

  • Justaguy

    I guess the good thing about the free market is no one is required to invest in Facebook, or any other stocks for that matter. People who are distrustful of the free market won’t invest in this way and people who are trustful and get burned will stop investing and thus, over time, the free market will correct itself.

    • http://twitter.com/chrisk2000 chris k

       Standard argument… however the free market works better when there is trust in the system. When you buy something in Amazon and you know you are getting exactly what you are paying for, it’s good for the buyer, the seller, and the society in general. When Wall St can use things like “green shoe” option and falsifying statements to boost the stock price, it is no longer a “free market” but more like a “wild market”

  • http://www.facebook.com/people/Fred-Horgan/612804533 Fred Horgan

    $10 … seems about twice what I’d pay after reading your analysis … and even that might be too much!

    • http://twitter.com/chrisk2000 chris k

       haha…maybe I gave them some leeway. Facebook has to come up with some ways to become an essential part of people’s lives and not just be a time-killer. (Google is used for searches, emails, sharing documents etc which are productive tools)

  • http://www.facebook.com/people/Fred-Horgan/612804533 Fred Horgan

    The trouble with the free market is that it needs a free flow of information.  When the free flow is impeded, those below the dam get flooded.

  • Hminus82d

    that’s the truth, truth!!!

  • Steve

    Morgan Stanley, the lead underwriter, repeatedly stepped in and bought Facebook shares to artificially prop up the price of the stock in the last 3 days, which may be illegal.
    Bull, it is called stabilization and happens with every IPO.  

    • http://twitter.com/chrisk2000 chris k

      There was a time when it was illegal and thanks to ‘deregulation’ since the 80s, Wall St has been able to write their own rules. How can an investor know the real price of a stock based on true supply-demand when a party with huge conflict of interest keeps manipulating the price? Also, the “green shoe” option creates an artificial shortage of stocks and hence pushes the price up (it’s akin to a movie theater with 200 seats advertising that they have 300 seats and when a lot of people show up, they raise the price). Here is an academic article how such practice makes the stock skyrocket in short term but it is bad in long term: 
      http://www.csom.umn.edu/Assets/62572.pdf

  • Richmondman

    Average investors don’t buy into the hype.  Gamblers do.  Facebook is a gamble, pure and simple.  No sympathy for those who lose their shirts on this one.

    • Chr

      It’s not just about Facebook. It’s about fair-play, compliance with law, and equal treatment for all. Insider trading and a rigged system should not be condoned

  • http://www.facebook.com/people/Sunithi-S-Ramesh/100000179856985 Sunithi S Ramesh

    A good analysis.