LONDON -- Facebook (Nasdaq: FB) finally floated -- and promptly dropped 18% from its $38 IPO price. So hyped was the new issue that, priced at the top of its valuation range, there was insufficient demand to support the stock once trading commenced.
But the short-term gyrations of the share price are only of interest to traders. Long-term holders of Facebook stock will receive a positive return on their investment when the company succeeds in monetizing its 900 million global user base.
The company is creating new business models to capture revenues from its free service. The debate on valuation is about how quickly and successfully it can accomplish this.
Behind the ballyhoo
That truly massive captive customer base is the reason behind the hype.
Even the Financial Times' authoritative Lex column had an online Facebook IPO calculator. Apparently, if revenue growth tails off gradually from 2011's 88% to a modest 10% by 2018, EBITDA margin remains steady at 50%, capital expenditure to sales drops steadily from 30% to 5% over the period, and the terminal growth rate from 2019 is 3%, then -- with a few assumptions about risk-free rate and equity risk premium thrown in -- Facebook's shares are worth $43.
To be fair to the FT, its purpose was to illustrate what heroic assumptions are required to get to a $100 billion-plus valuation. But that very methodology of plugging growth assumptions into a DCF model highlights the widespread mispricing of the business risk.
If Facebook takes a bath, it will be down to the kind of disruptive change that it has itself created. It's in the nature of such change that it's not readily predictable, but there are plenty of precedents that demonstrate the fickleness of consumer tastes in the social-network and technological spaces.
Fickleness versus stickiness
The closest precedent is, of course, Rupert Murdoch's ill-fated acquisition of MySpace. A $580 million investment was sold for $35 million six years later as the social network lost out to the then-smaller Facebook. Before that, Britain's leading commercial broadcaster, ITV (LSE: ITV.L), lost 150 million pounds of its 175 million pound investment in Friends Reunited.
Both initially benefited from the network effect. The more popular a social site becomes, the more attractive it is to new users. The same phenomenon has been seen with Twitter, which -- like Facebook -- took off as a youth trend and has progressively moved up the age brackets.
But things that grow exponentially can shrink just as quickly, or else reach saturation. Facebook is getting there: 70% of the world's Internet users outside China are already members.
It's true that Facebook is different. Firstly, there is nothing to compare with the global scale of its user base. If the network effect applies, then it must apply to Facebook in spades.
But I wonder how interconnected the linkages really are. I suspect there are lots of local and interest-specific networks. Those sub-networks are more vulnerable to being distracted by the next trend, whatever it may be.
Secondly, Facebook's stickiness comes from the sheer quantity of data people upload. For those under the age of 25, their "life is on Facebook." It would take a prohibitive effort to reload all those thousands of photos onto a competitor's site.
That is, unless…
A killer app may come along that allows you to transfer your Facebook data at a stroke. And why shouldn't it?
Right now, users seem content with Facebook's global monopoly. But a change of sentiment could pull Facebook out from under the regulatory radar. Who owns the data on users' profiles? Would preventing that data being transferred constitute anti-competitive behavior?
Facebook has largely avoided upsetting its users, apart from a few stumbles over privacy settings. But, as it seeks to monetize its access to members' data, that could become more difficult. To retain users, Facebook has to keep them happy -- and/or snuff out the competition. That's one reading of its $1 billion acquisition of Instagram and the smaller Lightbox, anyway -- expensive for what it got, but cheap for stamping out a rival.
If Facebook loses the collective goodwill it has garnered, then attacks could come from all fronts. Regulators in the U.S. have apparently pondered whether gaming on the site breaches U.S. gambling law, for example. Or it could just fall out of fashion, replaced by the latest thing that trendsetting youths deem cool and the rest of us follow like sheep.
To my mind, that risk of disruptive change to its business model deserves a pricing discount -- not a massive premium predicated on continued growth, as if the rest of the world stands still. As an investment, I wouldn't touch Facebook with a barge pole.
Of course, I could well be proven wrong -- but not until 2018.
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