Facebook’s IPO – the Social Media Bubble?

The Facebook story is nothing short of incredible. In just a few years, it has gone from being a small-scale start-up to a business worth nearly $100 million. Now the social networking giant is to float on the U.S. stock exchange in one of the biggest technology IPOs ever seen.

Facebook has achieved what every company dreams of – it has become synonymous with the industry in which it operates. It now intends to sell its shares for between $34 and $48 each, giving an estimated value for the entire site of over $100 billion. Initially, its share price is likely to be between $28 and $35, with a higher benchmark potentially indicating significant interest among investors. If the final price is close to the top end of the range, this could see the social networking site becoming the most valuable U.S. firm to ever float on the market. Although its launch is stirring up a range of emotions, it is worth focusing on the hard facts.

IPO to Turn Past Success Into Future Income

A fundamental question that arises in the run-up to any company’s IPO is, “Why is the company floating?” In the case of Facebook, it appears to be a common case of turning its success into income – the company’s balance sheet reveals nearly $4 billion in cash. CEO Mark Zuckerberg is selling some of his shares – following the IPO he will still hold 28 percent, although he will have 57 percent of voting rights at the AGM thanks to privileged shares. Such a move sparks uncertainty. The situation could worsen significantly if key employees start selling their shares – their proceeds from such a sale would allow them to launch their own ventures. Some shareholders (including employees) are covered by lock-ups, although these range from 91 to 366 days.

It is difficult to put a value on technology companies such as Facebook because the models created for more “classical” types of business are useless for valuing websites. Although net income is equally important in the running of any business, it appears that, in the case of Facebook, investors are basing their valuation more on its potential than on the facts. And the facts are as follows: Facebook, despite impressive revenue growth (up nearly 100 percent in 2010/2011), it only brought in $1 billion in net terms – “only” because a market capitalization verging on $100 billion gives a price/earnings ratio of an astronomical 100 percent. On the whole, it is hard to say anything about the company’s book value because, beyond its cash assets, small infrastructure (in terms of capitalization) and technology, it is difficult to value the company’s remaining assets.

Facebook’s Users Don’t Count as Assets

What Facebook can boast about, and what proves its uniqueness as a company, is the number of its users – currently 950 million. At the same time, it is a problem that is keeping analysts awake at night – after all, how can you put a value on such a business? And, more importantly, how long will Facebook enjoy its monopoly? One could say that Zuckerberg’s empire is trapped. Facebook’s overarching business model for generating revenue is based on advertising. However, if the company attempts to “squeeze” more out of this business, irritated users can just switch to the competition (e.g. Google+, which many experts believe to be technically superior). History has shown that Internet users have a tendency to be fickle, as illustrated perfectly by the example of MySpace. A single error of company policy could precipitate its quick collapse.

Even in the IPO prospectus, the issue highlights certain dangers, although it seems many investors are not taking these too seriously. In addition to those mentioned above concerning the potential loss of key staff, the most significant risks include lawsuits from users, advertisers and competitors. In the last few years, Facebook has also had to pay $500 million in damages in conjunction with claims lodged by former shareholders.

Some observers are comparing Facebook with other technology giants such as Google and Apple. This is misleading, because Google and Apple are really in the advanced technology business, with a host of patents and real products, whereas Facebook’s value is built mainly on its users. Add to this the fact that not only is the price/earnings ratio of the social networking site several times higher than that of Google or Apple, but also its market capitalization is larger than, say, McDonald’s.

Will Facebook be the Next Dotcom Bubble?

All the fuss surrounding Facebook is due to its unique features and the completely new model presented by the company. The number of users is certainly food for thought, with nearly one-sixth of the world’s population using the site. However, as is often the case, the financial figures bring one back down to earth. And although Zuckerberg’s site has users, the problem is how to earn money from them. With this in mind, one of the biggest IPOs in recent history may turn out to be a spectacular flop in the long term.

When investors start putting such a high value on aspirations and an optimistic future that the price/earnings ratio is 100 percent, there is the threat of a speculative bubble. Are we about to see a repeat of the madness we witnessed in 2001, when the value of so-called dotcoms was skyrocketing? The fascination with this brave new world of online economy vanished abruptly when it was discovered that making money on the Internet is not easy. There seem to be parallels with the situation we are in today. What sets Facebook apart from other websites is its users. If they disappear, the company will be worthless compared to its current valuation.