1. Lockup expiration
Yesterday, 271 million Facebook shares were freed from lockup restrictions, with an additional 1.6 billion shares expected to be released from lockup restrictions over the next nine months. For context, prior to yesterday’s expiration, only 500 million shares could be freely traded. Over the short term, we should expect sellers to far outweigh buyers. Yesterday (lockup expiration day) there was a 6% drop in FB’s share price with 135 million shares traded, compared with 30 million shares on an average day.
2. Market saturation
Facebook claims it has more than 900 million active monthly users. That’s almost half of all Internet users on the planet. Is it more likely 5 years from now that they’ll have 500 million users or 2 billion users (think MySpace)? Even if FB can grow its active user base to 1.5B users, any meaningful revenue growth will have to come from new ways to monetize the users they already have, not from attracting new users.
3. Facebook’s addressable online advertising market is limited to “display”
So with almost half the total worldwide Internet population already active on Facebook, where can FB’s growth come from?
Consider that Google boasts an Average Revenue Per User (ARPU) of $29 (almost all of which is from online advertising), while Facebook’s ARPU is only around $4.
Google has 45% of the total (US) online ad revenue; Facebook has 6%.
So it’s easy to assume that Facebook can appreciably grow its revenues over time simply by doing a better job monetizing its existing user base with advertising.
But that’s not the case.
Display-related online advertising accounts for just 36% of the total online advertising spend, and Facebook will be hard pressed to expand its revenue beyond this segment. Search? It’s hard to imagine a scenario in which users are relaxing their privacy settings to allow their content to appear in search-engine search results, and even harder to imagine an advertiser paying for an impression tied to a search result returning some user-generated content on Facebook.
Facebook already has 19% of the total worldwide display-related ad spend. How much of the total display advertising pie can Facebook expect to command? Probably less than what Google can, which is about where it is now.
4. Facebook won’t even dominate the “display” segment
Why? It can be summed up in two words: Brand Risk. A brand manager doesn’t want his company’s brand identity damaged on his watch. GM’s decision to suspend its Facebook campaigns is indicative of the concern among (certain types of) brands that its brand identity will appear adjacent to inappropriate content. Companies like AdSafe and DoubleVerify (and others) are already making good money by providing marketers with safety nets that block their ads from showing up in places that could damage their brands. So it’s reasonable to believe that skittish brand managers will continue keep their ads off Facebook, preventing the company from dominating the display segment of the online advertising market the way that Google dominates search advertising.
How else can Facebook generate revenue? That’s a tough question. Can Facebook charge for its service like LinkedIn does? Can it build and monetize apps like Zynga does? Can it charge app developers a percentage to distribute apps like Apple does? And can any of these potentially user-annoying strategies appreciably move the needle? Even after more than 10 years in business Google is still generating 96% of its revenue from advertising.
One option is for Facebook to sell the “data” that they have on its users to advertisers. While a potentially lucrative revenue stream, it has the very real ability to creep out its users to the point where they abandon the site. Also of concern is the W3C’s Do Not Track initiative, which could make it alot more difficult for Facebook to collect and use targeting data on its users in the future.
5. Inconsistent financials
Even if you believe in Facebook’s long term prospects, there’s near-term risk not only from the effect of lockup expirations, but also from the company’s inability to post consistent numbers even for such a short period since the company has been public.
Revenues fell from Q4 2011 to Q1 2012, sequential (quarterly) revenue growth rates are slowing, and the company posted a net loss of $157 million in Q2 2012. What does that say about management’s ability to manage the business to Wall Street’s expectations going forward?
So what is Facebook really worth?
Even at a sub-$20 per share price, Facebook boasts a $42 billion market cap and a whopping multiple of 110.
Assuming the display advertising market continues to grow at 15- 20%, and Facebook can successfully grow its share of the worldwide display market from 17% to 25% over 8 years, the company will generate $16 billion in revenue in 2018, with a CAGR of 20% over the period.
For comparison, Google, which generated $38B in revenue in 2011 with 29% growth, has a $220B market cap. Since their growth rates are comparable, and since both companies have net operating margins around 27%, and assuming that Facebook will attain/maintain the same “market leader” premium Google enjoys, one way to value Facebook stock is to apply the same market cap : revenue ratio as Google. Doing so values the stock at $15 today, growing to $42 in 2018.