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Weighing in on the Facebook Debate: What’s with the Valuation?

Posted on September 26, 2007

I knew there were some folks out there that had more of a contrarian view on Facebook and they are now emerging in force thanks to Kara Swisher’s latest post over at AllThingsD. The post, and reason for outcry, all centers around the valuation numbers being floated around Facebook these days.

Supposedly Microsoft is seriously considering an investment in Facebook that would value the company at around $10 billion. Yes, you read right, that’s billion with a B. And as if that wasn’t somewhat crazy in and of itself the Wall Street Journal article mentions that Facebook might actually be holding out for a $15 billion valuation (this valuation craziness caused Om Malik to create a Silicon Valley Funding Advisory graphic akin to the Homeland Security warning - if he can get this into a widget it’ll be on Olson’s Observations in a second - hilarious!).

Those are some big numbers for sure and there is no doubt that Facebook has a lot of potential but let’s take a quick look at their revenue numbers to date. Swisher has them pegged at around $30 million in profits on $150 million in revenue (not sure on the time frame for the numbers). If we look at those numbers and then apply a 10x revenue valuation, which is what a lot of folks initially look at when thinking about acquiring a company, that puts Facebook’s valuation right around $1.5 billion.

The $1.5 billion valuation is an order of magnitude away from the $15 billion valuation that Facebook is supposedly looking for (side note: every deal doesn’t follow the 10x “rule” - it is just a good benchmark to use in this post - in fact, a lot of IPOs go for more than 10x including Google’s). Again, Facebook does have a ton of potential but, as Swisher points out, we have seen this story before. That is to say a company with a huge valuation and a lot of potential that fades away.

That said, some of the examples she gives (like Geocities, Netscape, AOL and Yahoo!), don’t seem to help her make her point. Both investors, founders and employees cashed in big at all of those companies and stock market investors were also able to cash in on them for a while before the companies became cash cows as opposed to rising stars (any BCGers out there - did I get that right?).

One of Swisher’s other main points is that Facebook is not Google. This is dead on. She likens Facebook to Yahoo! which is a good analogy. The basic thing to remember is that Facebook is far more dependent on eyeballs than Google. Ah, but Google is all about ads and eyeballs seeing those ads so isn’t it one in the same with Facebook? Not at all.

Google places ads on many publishers websites (and many other places for that matter). If a publisher starts to wane and receive less eyeballs then another one comes along to fill the gap and Google will probably have ads on that site too. Facebook on the other hand only has their property. If eyeballs begin to go away Facebooks begins to lose revenue immediately.

Basically Google is far more broad than Facebook will probably ever be.

Now, let’s go back to valuation numbers for a second and see if Facebook is really that far off in their self assessment.

I took a look at where Google was right around its IPO. Those numbers were as follows: $105.6 million in earnings on $961.8 million in revenues (2003 fiscal year numbers - source). If you take the 10x approach here that would have put Google at a $9.6 billion dollar valuation.

Google actually IPOed between a market cap of $29 and $36 billion which is significantly more than the 10x valuation. Of course it isn’t an order of magnitude larger though (that would have put the valuation at roughly $96 billion). It was about a 70% premium to the 10x valuation or so. Also, when you look at valuation to earnings you’ll see that Google was about 307x while Facebook, at a $15 billion valuation, is about 500x (disclaimer: these are just quick semi-useful/interesting comparisons and not by any means a rigorous financial analysis).

However, the real question is how did Google grow post IPO and can Facebook grow as fast or faster? We’ve already shown that Facebook seems to be valuing itself higher than Google did back in the day. Of course that seems off due to the fact that Facebook is far less broad than Google was and is. So, how has Google grown? Here are the EPS (earnings per share) numbers:

2005 - $5.33

2006 - $10.19

Partial 2007 - $6.22

2007 Full Year Estimate - $13.20

The first thing I noticed was that if you bought the stock right after the IPO, and you look at current EPS numbers, you are in for around 10x earnings which isn’t too bad at all. That said, the growth is pretty obvious. Even though it is slowing down now EPS grew about 92% from 2005 to 2006 and it is on track to grow 30% from 2006 to 2007 year.

Can Facebook experience that kind of growth? It will for a little while perhaps but I don’t think it will for as long as Google did simply because, again, Facebook is far less broad. In other words it seems to have less potential than Google did. Again, Swisher makes that argument but I didn’t buy it fully until I did the numbers.

So perhaps Facebook is being pretty aggressive on their valuation compared to their revenue numbers and to where Google was at when they IPOed and how they grew post IPO. In fact, it appears they are being even more aggressive when you look at where a lot of their revenue actually comes from - a deal with Microsoft for ad serving that, according Swisher and her sources, is currently not profitable for Microsoft.

With all that said we should all remember that something is worth what someone is willing to pay for it so if Facebook can get $15 billion than they should. It seems they are making a lot of moves that may justify such a large valuation down the road as well which makes the valuation a little less harsh.

One of those moves was the Facebook lending application. Apparently that application is doing very well and, as we all know, you can make a lot of money in lending so perhaps this is the thing that will propel Facebook up to Google’s level or perhaps even beyond it. Or maybe the propellant will come int the form of their own, in-house, apps in general which can take many forms like P2P lending and selling virtual gifts. Of course there are two issues with that approach:

  1. The apps are diversified which means that Facebook could end up in the trap of doing a lot of things but doing none of them well.
  2. The eyeballs still matter. If there are no eyeballs the apps won’t be used and no money will be made.

We’ll have to wait and see what the future holds for Facebook. While I do think they are being aggressive with their valuation this early in the game I do think that people shouldn’t bet against them quite yet. They have shown they are strategically smart and have the incredible team needed to create a world class company with the nice big valuation that goes with it. As big a Google? Maybe not, but it could still be pretty big.

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5 Comments so far
  1. Carson Conant September 27, 2007 9:09 am

    This type of post is why I subscribe to your blog. I had a similar feeling when I heard about the Facebook “valuation”. Do you think that MS’s interest is not so much a value-indicator as much as an indicator of how much MS is willing to pay to keep Facebook out of the hands of someone else. They could be thinking that it could cost them X to invest in it with some exclusivity or Y to compete with it in the hands of someone else and if X

  2. Eric Olson September 27, 2007 10:01 am

    Hey Carson - I do think that it is probably a ploy to keep the valuation of Facebook high enough so that rivals can’t buy it out from under them.

    I also figure that they hope the ad situation will turn around at some point and MSFT will be the exclusive ad nertwork on Facebook thus allowing them to compete at a higher level with Google in the ad business.

  3. Mark September 30, 2007 3:39 am

    Good article, I like how you don’t just write off a $15B valuation for Facebook. And where are the people, and there were a lot, who said that Mark Zuckerberg was nuts for turning down a $1B offer last year? Never…..underestimate this (young)man.

  4. Scott Sambucci February 5, 2008 10:25 am

    Eric - I’m interested in your thoughts since posting this a few months back since Mark Zuckerberg’s interview on 60 minutes and the offer that Microsoft is making for Yahoo!

    “something is worth what someone is willing to pay for it” - “Res Tantum valet quantum vendi potest.” Oskar Morgenstern (Theory of Games and Economic Behavior) is said to have had this posted on his office wall.

  5. Eric Olson February 5, 2008 10:33 am

    Hey Scott - thanks so much for your comment. I have actually uttered those words many times. In the end of the day something is absolutely worth what someone is willing to pay for it.

    This post was mainly looking at whether or not someone should want to pay $15bn for Facebook and I think the answer is no. Of course if someone does than economic/financial analysis becomes useless.