Facebook's share price has fallen somewhat since the initial public offering (IPO). Its valuation at the time of the IPO was $104 billion when it floated at $38 per share. At the recently deflated price of $29 its market value is about $76 billion. A $20-odd billion fall in a few weeks despite no major news or developments in this time is indicative of an over-valuation.
Today in fact Sanford C. Bernstein & Co. have valued the share at $25, triggering another sell-off.
Here are the main qualitative (and common sense) factors to consider before giving such a gargantuan valuation to Facebook or indeed any dotcom company:
#1: What do 900 million "active users" mean?
Facebook's very claim of having 900 million active users needs to be questioned. They haven't specified what constitutes an "active user" yet advertisers buy into that number wholeheartedly. If one person has a personal page, creates a page for his sole trader business, then creates another for his dog, and yet another for activism against Joseph Kony, does that constitute four users? And how often must one log on to be considered an active user? This 900 million number is the very foundation upon which advertising rates and the supposedly phenomenal reach of Facebook are based, yet this foundation is so vaguely defined and difficult to verify.
#2: Effectiveness of Facebook advertisements are questionable
I read an analogy that advertising on Facebook is like advertising at a crowded party. "Social networking advertising is like hanging signs on the walls of a house during a party and sending sales reps to mingle with the crowd," says Henry Blodget, CEO of Business Insider. "But the fact remains," he continues, "that the people at the party, who are sharing stories and photos and news and gossip, are not at the party because they want to buy something." Bottom line: people log on to socialise, not look at ads.
General Motors have canned their $10m Facebook campaign, citing the lack of effectiveness of their paid adverts on Facebook. This is not to be underestimated as it has made headlines everywhere and rest assured companies all over are going to be looking more closely at their ad spend with Facebook versus the return they are getting.
Search adverts on Google apparently still have a much better click through rate compared to Facebook ads. People are more likely to click a search-related ad because it shows up at the very point that they are actively searching for something. At the moment I search for a Canon EOS camera for example, to the right of my search results will appear some places where I can buy it from. Therefore, even if the search engine doesn't have as much information about you as Facebook does, it doesn't matter because the timing and appropriateness of a search ad is much better. Just because you put photography as an interest on Facebook for instance, doesn't mean you want to see camera ads every time you log on (which happens to me).
#3: What is the value of a follower?
Organizations the world over are scrambling to build up their followers on social sites. What's a fan or follower though? “Facebook’s a silo,” said Darren Herman, the chief digital media officer at the Media Kitchen, an agency that helps clients on Facebook. “It is very hard to understand the efficacy of what a Facebook like, or fan or follow is worth.”
This question has to be asked because companies spend resources trying to build up followers. They also employ people to post updates and respond to queries their followers have. Remember these pages are free, but if these pages do not translate to anything meaningful (like hits on your website), the chances of companies paying actual money to advertise on Facebook reduces.
People may vote, comment and ask questions on a page they "like." But does that mean they will buy your product? People are more inclined to make queries and comments when it requires little effort on their part, but that doesn't necessarily equate to interest. Talk on cyberspace is cheap. Oh no, but it's about engagement and brand building say the social media "consultants" and "gurus." Engagement is overrated. "The question with Facebook and many of the social media sites is, 'What are we getting for our dollars?'" said Michael Sprague, vice president of marketing at Kia Motors Corp.'s North American division. This then ties up to the fact that companies are not going to throw money and time to engage Facebook users if the quality of the engagement is purely social and for the most part, superficial.
I like BMW, Honda and Ferrari on Facebook. Which one I buy will not depend on who engages me the best on social media. The way they engage me is not going to sway my decision because I will base it on the same fundamentals as always: features, quality, design and price. It's the same with absolutely any product I will buy.
The simplistic yet revealing question is: does the follower engagement eventually translate to revenue or is the engagement little more than a flirt?
#4: Competition is diverse and there's little to stop a never-ending wave of new competitors from cropping up
Competitors to Facebook come in different forms. All websites and applications compete for one scarce resource: people's attention. If I'm on Google+, I can't be using Facebook at the exact point in time I'm scrolling through my Google+ newsfeed (even if I have Facebook open on another tab.)
Facebook however does not just compete with Google+ and Twitter. Think broadly: I use Whatsapp on my cellphone to chat with and message my friends. When I chat on Whatsapp I am not chatting or surfing Facebook. Whatsapp is therefore a competitor to Facebook. There are literally hundreds of other similar sites and applications (apps) all competing for the attention of people. Reddit, Digg, Twitter and countless others are trying to grow their user base and the time those users spend on their sites. Can Facebook really halt all of these sites and apps from eating into their pie?
As an indication of how easily a threat to a website can materialise, Instagram got Facebook so scared it shelled out a ridiculous $1 billion to buy Instagram. (What happens if another one of several excellent photo sharing apps becomes popular tomorrow? Another $1 billion?) Yes, a simple little app designed by two guys can become a threat in under two years. (Instagram was 18 months old when Facebook acquired it.) Could anybody ever become a threat to Apple or Boeing - much less make any impact to their market share - within 18 months of starting? Yet at the IPO Facebook was valued at more than Boeing, McDonald's, Ford and Disney.
#5: Fad culture
Facebook can be a handy tool to network and communicate, but ultimately it has a lot of pointless interaction. That isn't Facebook's fault, it's the people who use it who are to blame. People upload superflous pictures of the dessert they just ate, the places they visit and air all sorts of silly personal rants. I have grown tired of seeing such pointlessness and as a result log on less. I don't dare to extrapolate my personal feelings onto other users, but my impressions have to count for something. Facebook is becoming a place with too much information that's low quality to boot.
People look for shiny new things all the time and Facebook could become yesterday's news. Pinterest is the new blue eyed boy that is already valued at $1.5 billion, up from $200 million at the end of last year - yes, that's barely 6 months ago. It doesn't do the same thing that Facebook does, but again, it's stealing people's attention from Facebook.
Here's something else that's possible: People will get tired of excessive sharing and uploading of pointless photos and realise that nothing beats getting fresh air and living in the real world. Right now people are plugged in to cyberspace like zombies and it seems inconceivable that they will spend less time surfing the internet, but I feel we will mature and start regulating our consumption of electronic information. When such a mind shift occurs the whole dot com craze will simmer back to reality.
What Facebook does have going for it
#1: A huge user base
This base is (for now) still addicted to games, socialising and posting updates about every little thing that happens in their lives. While I just don't believe that user base is a genuine 900 million strong, it surely does number in the hundreds of millions.
For certain Facebook have a roadmap to leverage those hundreds of millions of users to yield revenue. There's little doubt they have the resources and people to make a transformation. But here's the thing with a website: people come to know and love it for one thing and you can't keep changing it as you see fit. In spite of sexy terminology like open graph and social metrics that Facebook and social media "gurus" throw around, people essentially use it to share photographs, statuses, message each other and play Farmville.
New features, as mindblowing as they may be, will not necessarily be accepted. In the same way that people are struggling to acknowledge Google as a social company with Google+, people can struggle to associate Facebook with anything but social. Attempts to start selling products like Amazon for instance in an attempt to boost revenue can be faced with rejection.
Facebook is a ubiquitous feature on the internet. It has become an identification tag that sites use. To comment on many sites you need to log in to Facebook. There are like, recommend and share buttons everywhere. Such features ensure Facebook won't become irrelevant for a while yet.
#3: Segments that do benefit from social media
Granted, certain segments can benefit from social media. Cool companies like Starbucks and Red Bull can leverage social media because people are inherently interested in their product and curious about their brand. In fact my friend Eran Eyal's business Springleap.com has almost 200,000 followers and he says Facebook has worked wonders for them. Online publications like Tech Crunch will also find social media sites driving traffic to their sites. Just remember that these are online-based businesses and are primed to leverage social media by very nature of the way they operate and what they do. If you are a plumber, tax consultant, glycerin manufacturer or even a major retailer, Facebook isn't going to change much for you.
It's not about Facebook
This isn't about bashing Facebook. It's about the ridiculous way in which dotcom companies are valued. It's as if a different set of rules apply to them. A price to earnings (PE) ratio of 20 is considered high for most companies, yet people saw fit to buy Facebook at a 107 PE multiple. Morgan Stanley one day valued Facebook at a nice, round $104 billion with no justification shared for this number, and the next day that's what the media publishes as "the value of Facebook." Dotcom companies can rise quickly, but they can also be reduced to nothing just as quickly because barriers to entry in this game are low.
Facebook made the internet social and gave each person a page of their own. And the way Mr Zuckerberg and the numerous smart people behind him grew it so quickly is phenomenal. But Facebook like any other site is susceptible to competition, fads and our ever decreasing attention spans. They are in fact vulnerable due to the fickleness of the very people that made it such a large network.
But look at Google!
People often point out how Google's share price has spiralled upward since thier IPO, insinuating that the same will happen with Facebook. It could, it could not, but as it stands right now, there is no reason except great expectations to call Facebook a $100 billion company. At the time of Google's IPO, I bet even the executives and founders themselves weren't sure whether Google would grow the way it did. With an internet company, often you just don't know.
However what I do know is you don't value any company on potential, you value it when you can reasonably understand and estimate its future cashflows. Facebook may have great plans and could very well justify its valuation in the future, but right now, as it stands today, there is currently nothing to indicate what sort of cashflows it will generate. Warren Buffett's deputy Charlie Munger was blunt when he said "I don't invest in what I don't understand, and I don't want to understand Facebook."
With that in mind, great story that it is, Facebook cannot be called a $100 billion company.
Out of interest, Mashable did a post in 2007 claiming that Facebook wasn't even worth $15 billion. How times change.