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By Thomas Baekdal - May 2012

The Facebook IPO - A Classic Game of Hot Potato

Facebook has a problem. The new market is not as valuable as the old one, and the old market is slowing down. At the same time, the $ value per user has flat lined.

For those of you who are following me over at Google+, you will already know the story. The Facebook IPO is the closest thing we come to a social bubble. The numbers and valuations they throw around are just insane.

To illustrate this, I decided to compare Facebook with Ford by looking at four key metrics: Revenue, profit,assets, and market cap. And as you can see, something is completely wrong with this picture.

More to the point, Ford's market cap is valued at 70% of their total assets, yet Facebook is valued 1,370% higher than what they have in assets.

This is the era all over again. Value is being determined based on activity (page views, ad impressions, users), instead of real things like know and assets.

My post over at Google+ went crazy after posting this graph, within 24 hours it had a ton of views, 660 +1s, 595 shares, and 170 comments.

The comments were divided into two camps. One group agreed that this was insane, the other told me that I was wrong because I forgotten about the growth potential.

But I hadn't, I just didn't mention it. As I wrote in another post:

While I agree that Facebook will grow, they are only making $1.21 per person ...and they seem to be stuck at that level (it was $1.26 in Dec 2010).

That means that in order for Facebook to earn the same as Ford, they would have to reach 7.7 billion people - 110% of the entire population of the planet, or 300% more people than there are on the internet.

If we instead compare it to Google, they would have to reach 8.3 billion people. And compared to Apple, they would have to reach 22.5 billion people....or 321% of the total population of Earth.

If we instead look at revenue, the picture is even worse. Facebook would have to reach 33 billion people to match Ford, 9 billion people to match Google, and 26 billion people to match Apple.

The problem is that people only look at the growth trend itself (which looks to be impressive). But in doing so they don't realize that Facebook already has a 40% internet penetration - worldwide. That's impressive, but it also means that its growth is somewhat limited.

The only way for Facebook to succeed, at its current market cap, is if they can raise the $ value per user, and so far they have been completely unable to do that. Facebook is not actually growing that much, which Facebook itself have illustrated clearly on several occasions.

Here is the graph showing the growth in monthly active users:

Note: Sorry for the low-res quality - out of my control.

As you can see, the US market is flattening out, and Europe is not far behind. And while Facebook is still growing overall, it is nowhere at the exponential rate that people think it is. It is a steady increase month over month, with a slowing effect in their existing markets.

For a company that only makes $4 billion in revenue, I don't see it coming anywhere close to a $100 billion market value anytime soon.

More importantly, the revenue is actually down, and the revenue per user is flat. Here are the official revenue graphs:

Notice the small numbers underneath each graph, the one that says ARPU. It is short for Average Revenue Per User. As you can see, the ARPU has been flat lined for more than a year. But more to the point, the new market (where Facebook is still growing strong) have a much lower ARPU per person ($0.37) than the old market ($2.86).

This means that even with a steady influx of new users, the new markets are not nearly as valuable as the old ones.

There is no spectacular growth here, nor is there any trend curve pointing in that direction.

Don't get me wrong, Facebook is a very financially sound company. It has very good positive cash-flow. The cost of operating Facebook is dropping compared to their revenue. In 2009, the cost was 63%. In 2011, it was 52% of the revenue. And while the cost per user is up (in 2009 the cost was $1.4 per person and in 2011 it was $2.2 per person), the revenue has grown at a higher pace.

Facebook is a financially sound company and is doing great!

The problem is the stock market valuation, which is completely out of touch with reality. They are looking for a quick-win, and Mark will soon be a fanzillionaire - literally. This is because much of the value is made-up, but also because it is based on some imaginary value of fans and not real things like actual money.

What we have is a real bubble, which is further cemented by the $1 billion purchasing price for Instagram - a company that had no revenue at all. And today we learned that Pinterest has raised $100 million at a $1.5 billion valuation. Where do they get these silly valuations from?

For years we heard that all these social signals are incredibly valuable. If you have enough signals, you can use it for targeting, and money will fall from the sky. There is just one problem. We have not seen a single example yet that this true. Not a single company has been able to monetize these social signals in any useful way that results in real money at the level that these companies are being valued at.

All the successes we hear about are happening between investors and companies buying imaginary value. Instagram is not a success. It made no money! As a person, I absolutely love Instagram. But why would I pay for it? Why would I click on random ads from brands I don't care about? Would you?

It's the same with Facebook's IPO. People say it is going to be extremely valuable because of the open graph and all the information they have about everyone. And it is valuable - Facebook earns $1 billion per year, 86% from advertising. But there is a long way from $1 billion to $100 billion that the stock market thinks it is worth, and nothing as yet indicates that Facebook can grow by that much.

Advertising click-through rates are dropping on Facebook, which they tried to solve by putting more ads on the page. That might work in the short term for Facebook, but it is an absolute disaster for the brands who now have to compete with more advertising spots.

And this week, GM announced it was dropping Facebook ads altogether but would still use Facebook to post status updates. Essentially saying they want to use the power of Facebook, but not pay for it.

Facebook has a problem. As you can see above, the new market is not as valuable as the old one, and the old market is slowing down. At the same time, the $ value per user has flat lined.

Facebook needs to come up with a way to earn much more money per user to even reach their expected growth. And they are trying with 'pay to highlight', asking people to pay $2 to have a personal post highlighted for their friends. What a strange concept. Paying Facebook for having your friends notice what you write about. If you friends ignore you, the solution is not to pay Facebook, it is to get better friends (or at least write better posts)!

One possible solution, in my opinion, is for Facebook to create a Pro version for brands. That's where the value is. More brands will do what GM did - drop advertising and focus on direct engagement.

And, of course, I haven't even mentioned mobile, where Facebook makes no money at all. Display advertising and mobile is completely incompatible. And where is the mobile trend heading? Yep, to more mobile.

I'm not saying that investing in Facebook is a bad thing. It's a game of hot potato. If you buy it now and you are capable of selling it to some poor fool for an even higher evaluation before the next earnings call, you will have earned a lot of easy money.

But by the next annual earnings call, when Facebook fails to exceed expectations, things will come tumbling down, and whoever is left with the hot potato is going to get burned - badly.

Marks Zuckerberg, of course, will still be filthy rich. He was the first one to sell the hot potato. He figured it out!

Read also: The Facebook IPO: A Note to Mark Zuckerberg; or, With "Friends" Like Morgan Stanley, Who Needs Enemies? (thx @avinash for the heads-up)


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Thomas Baekdal

Founder, media analyst, author, and publisher. Follow on Twitter

"Thomas Baekdal is one of Scandinavia's most sought-after experts in the digitization of media companies. He has made ​​himself known for his analysis of how digitization has changed the way we consume media."
Swedish business magazine, Resumé


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