What's the right valuation for Facebook (FB)? Discussion has tended to focus on P/E ratios and (largely unfavorable) quantitative comparisons to other major internet company IPOs in the last dozen years, notably Google's (GOOG). While valuation is an exacting art, projecting future cash flows and future growth is anything but precise for companies whose business model is evolving.
With an IPO such as Facebook's, the task becomes even more difficult. Google today remains dependent mainly on search, but Facebook is unlikely to have a revenue mix two years from now that resembles its current one.
Variant Perspective: Facebook > Apple (AAPL)
In this case, a variant perspective that's based on qualitative analysis can be less risky than would be the case if all the risks and key variables were clearly understood.
This article will leave aside valuation metrics in order to focus on an overlooked qualitative aspect of Facebook's investment appeal. It will contend that Facebook is likely to become one of the great platform companies of the internet, and that Facebook's price will benefit hugely from multiple expansion as the Facebook platform disrupts adjacent markets in entertainment, gaming and e-commerce.
The broad scope of these disruptions, combined with the scale of Facebook's post-IPO resources and capabilities, will make Facebook the most important company in consumer technology - even more important, in time, than its neighbor down the road in Cupertino.
Facebook Platform = Moat
In technology, a platform company is one that creates an economically-valuable ecosystem of independent developers and major enterprise partners around its core technology stack. Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), and eBay (EBAY) are all platform companies in the consumer space; Cisco (CSCO) and Oracle (ORCL) are two examples of enterprise platform companies.
For investors, the key point is that platform companies deserve higher valuation multiples owing to greater market share, pricing power, and long-term defensible competitive advantage (aka economic "moat") that arise from the commitment to and investments in the platform made by its partners and customers.
Facebook is showing every sign of becoming a platform company in gaming, and it will become one, I believe, in entertainment and e-commerce as well.
Already, the online gaming industry is orienting itself toward the Facebook platform as a convenient destination for social gamers as well as a marketplace for generating what will soon (2012 expected) become a billion-dollar revenue stream. Think of Apple prior to the explosive growth of the App Store.
From Social Network To Entertainment Hub
But gaming is merely the first of many platforms that Facebook's architecture will accommodate. If Facebook is already a core destination for gaming, there's a very good chance that Facebook will become a core destination for other forms of entertainment such as music, movies, and television.
Unlike the networks or Netflix (NFLX), which are only now discovering social experiences and scrambling to integrate them with their product delivery and consumption patterns, Facebook's social architecture is already in place. Dropping rich media content into the Facebook experience is not a business challenge but a UX and design challenge, and the strength and depth of Facebook's UX and design teams make it likely that this challenge will be solved, elegantly, in the near term. On the business side, watch for Facebook to strike major deals with content providers, especially in music and video, in coming months.
Older Users / Bigger Wallets
Investor skepticism about Facebook's valuation is rooted in the perception of Facebook as an online hangout featuring adolescent behaviors characterized by scarce money and abundant free time. That pattern is already reversing as Facebook's user base, having gone mainstream, reaches into older and older demographics.
Today the median age of the Facebook daily user is probably above 30, if data from surveys by Pew and online gamer studies by PopCap are accurate. This represents an inflection point for not just Facebook but the internet as a whole. An older Facebook demographic means that the Facebook experience will change inevitably to accommodate an audience with deep pockets, one that is less interested in connecting, or liking, or [be]friending, than in consuming content and completing transactions.
Of all the adjacent markets available to the new, grown-up Facebook, the most attractive will be entertainment, especially music. The core Facebook experience will quickly migrate from chatty time-wasting to more focused consumption of rich media, perhaps using social apps such as Spotify, perhaps using apps yet to be developed.
Other adjacent markets will in due course be penetrated. Over the next 2-3 years Facebook could start to resemble a virtual entertainment arcade: one part YouTube, one part eBay, another part Amazon, another part Netflix.
While the content partnerships need to be struck for this to become reality, Facebook's leadership team is already rich with veterans of Google and Yahoo (YHOO) who know how to strike those deals, and the IPO cash hoard will enable Facebook to hire hundreds of additional sales people, engineers and marketing experts.
Ecosystem Will Expand The Multiple
While the Street continues to view Facebook as a kind of portal, smart investors should begin constructing their valuation scenarios on the assumption that Facebook will become an entertainment hub with a dominant share of time online, one that spans gaming, video and music that is also an e-commerce platform with strength across mobile, social, and virtual transactions of all types.
Seen from this angle, one of the most important metrics for Facebook is not P/E or P/CF but the speed with which Facebook can take its cash hoard and put that money to work in generating new revenue streams from the following:
- media partnerships and rich media content;
- additional Zynga (ZNGA)-like large-scale gaming partnerships;
- a social e-commerce engine - perhaps enabled by acquisitions in the mobile shopping space - that can take significant share from Amazon and eBay.
Partnerships and the announcement and trajectory of new revenue streams from rich media, gaming and e-commerce are the kinds of milestones that investors should be looking at. The question isn't so much whether Facebook can derive significant revenue from these partnerships - Zynga has shown abundantly that Facebook can do so - but how many Facebook can sign and how fast Facebook can execute on them.
While execution risk is always present, the upside is immense. This extremely well capitalized, ambitious young company already controls what is by far the largest, most diverse, and now, wealthiest audience the business world has ever seen. Don't underestimate Facebook.