According to some, Facebook’s IPO — which could value the company as high as $100 billion — could be the most popular tech-stock issue since Google went public in 2004. The big issue for investors is whether the giant social network is actually worth that sum or, more specifically, whether it can grow at a rate that will justify paying that much for it now. With close to a billion active users, Facebook is already the world’s largest social network, and it is already generating billions from advertising directed at those users. So the bottom line for investors and analysts is, Just how much bigger can this company get?
Facebook’s user base is actually substantially larger than the 845 million number that the company quotes in its securities filings; that figure just refers to the “active” user base, or people who log in to the site at least once a month. And the engagement levels of those users are incredibly high: According to a recent survey, Americans spend more time on Facebook than on Yahoo and Google combined. That is part of the reason advertisers are so eager to do business with the social network: They hope some of that engagement will rub off on them or that they can inject advertising messages of some kind into that stream of activity.
There is no question this has already helped the company become a fairly major player in the display-ad business, even though it is only eight years old. Facebook accounts for an estimated 28 percent of that market, which puts it right up there with Yahoo and Google. According to the company’s securities filing, advertising accounted for $3.1 billion of Facebook’s revenue in 2011, or about 80 percent of the total, a figure that is growing fairly strongly.
Are Facebook ads really worth the investment?
Not everyone is convinced, though, that Facebook is an effective platform for advertising, because the activity that takes place there is primarily social rather than commercial. Sir Martin Sorrell, for example, who runs WPP Group — one of the world’s largest advertising and marketing firms — told the Guardian recently that he isn’t convinced that inserting ad or marketing messages into social activity is something that works:
The point is that Facebook is a social medium, not an advertising one, like search or display. It certainly is one of the most powerful, if not the most powerful branding medium. It is, however, a word of mouth or PR medium. You interrupt social conversations with commercial messages at your peril.
That could help explain why the click-through rates on Facebook ads — the thing that most advertisers are most interested in — are said to be extremely low, even compared to other web services. According to some estimates they are actually falling. What makes Google such a powerful force in advertising is that when people search for a specific keyword, they are often partway down the path toward a purchase of that product or service. But on Facebook, people are often just socializing or sharing photos — things that don’t necessarily translate directly into purchasing intent.
Facebook’s solution to this is social ads, or “sponsored stories,” in which comments and other content from users appear alongside an advertising message. But there are some pretty big questions about that as well, at least when it comes to powering enough ad growth to justify a $100 billion valuation. For one thing, some users don’t take kindly to the idea that their random remark about a company or a product could wind up being used in an ad without their permission. It is also not clear just how much engagement or “conversions” these kinds of ads can produce. Facebook is also working on ads related to the activities people engage in through “social-sharing” apps such as Spotify, hoping to target them based on their interests.
Raising red flags: Facebook’s e-commerce efforts
Advertising isn’t Facebook’s only profit-generating mechanism, of course. There are also payments for online goods, whether those are Zynga games, virtual gifts or possibly other services, and other forms of e-commerce. The company already makes about $500 million on payments per year, according to its securities filing. But when it comes to powering e-commerce via retail “storefronts” on Facebook, there are skeptics here, too. Many of them point out that a number of significant retailers, including J.C. Penney and Nordstrom, have closed their Facebook stores after lackluster sales. Forrester analyst Sucharita Mulpuru said in a report released last year that when it comes to e-commerce, Facebook may already be as big as it is going to get, because Facebook stores are largely ineffective, particularly when it comes to big retailers.
To some extent, Facebook’s biggest problem is the law of large numbers: It is difficult for a company that already has close to a billion users to continue to grow at phenomenal rates, unless you assume that eventually everyone on earth will belong to the network. The same goes for its revenue and market value: Facebook is already pulling in close to $1 billion in revenue per quarter, but the $100 billion market valuation that many are expecting from its IPO presumes Facebook will be able to increase that by several orders of magnitude — something that is exceedingly rare. And some have already raised red flags about the fact that the company currently makes about $5 for every user it has, much lower than other technology companies.
For that reason (among others) some believe Facebook may actually be closer to its peak growth instead of just getting started and that its IPO is more designed to help its early investors cash out their shares rather than being aimed at raising capital for growth. The reality is that for Facebook, raising money has never been an issue: It has been able to convince banks, hedge funds and private investors like Russia’s Yuri Milner to provide several billion dollars in funding over its short lifespan. It could be, as investment advisor Joshua Brown argued recently, that Facebook is a “red giant,” a star that is ready to flame out and collapse.
Brown’s argument hinges on the idea that Facebook is already such a huge part of its users’ lives that there is little room for it to play a bigger role in their online behavior. He also argues that as Facebook pushes to try to do that — or tries to squeeze more revenue out of those users either through advertising, e-commerce or some other method — it is almost inevitably going to increase the backlash the network has gotten from users who resent the intrusiveness of its services or the way it handles their privacy (there have already been some anecdotal reports about users deserting the social network because it is too noisy or because they are young and want to avoid their parents).
None of those factors means Facebook can’t continue to grow over the next few years, but it could mean it won’t grow all that quickly or that its growth rate will begin to slow. And that is not what a $100 billion market valuation implies. A market value that size assumes perfection and a double-digit growth rate that continues for several years at least. That could be the one thing Facebook can’t deliver, no matter how many users it has.