Facebook’s 100x valuation is pure growth speculation

The recent media coverage of Facebook’s new investments has been heavy enough and excited enough to doubt the accuracy, but a recent story from the Financial Post reveals some very interesting details (not officially confirmed of course). Even though this type of investment would be far outside my plan it’s a useful and timely exercise in valuation. According to the summary in the article, the net earnings this year are likely to be around $0.5B and the recent activity places the theoretical market cap at $50B, which makes it a neat 100X P/E ratio and draws a few comparisons to Google. This is right in the pre-2000 range of valuations – is it worth it? (interesting side note – Richard Bookstaber makes the case that in the 90s the actual supply of shares available for many tech companies was very limited and nowhere near the demand, driving up prices)

No sane investor would pay this much for a company without expecting top-level growth in the next year; if the possibility of failure is being discounted properly the implied growth if everything goes well is even higher. I haven’t worked out the implied growth rate but it’s not just 20%/year (of course if you discount future earnings using only today’s interest rates that could be pushing the valuation up). This much is clear to everyone. Now of course everyone will come out and ask if the valuation makes sense. I wouldn’t be surprised if this gets as polarized as gold in the next 3 months.

Following Tom Bradley’s example I won’t tell you my answer (I’m still working on that time machine), but I will ask one question. Many people will be focusing on the standard tech startup questions – is it really a business? Will it reach too far and collapse? But if we take the rumored financials as answers to those questions and assume survival and some growth, the big question is whether the growth is worth 100x earnings. According to a quote in the story, many of the actual investors are looking at the potential if past growth rates are extended into the future. Is that a reasonable assumption?

There are actually two sides to the earnings growth rate – one is the increase in the user base (simply getting new users), and the other is the increase in revenue per user (selling services to more people, selling new services, and selling higher-value services). Taking these into consideration, has Facebook reached a point not far from where Google is now, where the pool of potential new users is getting smaller and smaller? Will the advertising services be able to provide more revenue in the future or are they already reaching their full potential? Will new services contribute added revenues at an increasing rate? At this price some growth or strong growth isn’t enough – the effect will need to be dramatic.

I believe the answers to these questions are the key to the valuation; we can see how people with access to invest are answering them but fortunately most of us have the luxury of speculating without risking, at least for the remainder of this year 🙂