Facebook (FB) shares have been taking a hit since its IPO, so the market is clearly telling us that the initial offer at around $38 was overpriced. Original investors of Facebook as well as the underwriting banks (especially Morgan Stanley) are profiteers, whereas all who have bought shares since the IPO are holding the bag. Now that the price is discounted by 25%, is it a fair level to initiate a commitment? Let us look at the numbers.
How Does Facebook Make Money?
The most relevant figure to look at is Facebook's revenues. They stood at $3.7 billion in 2011, and have doubled every year since 2008. Nevertheless, the price to sales ratio is still at an elevated 15, meaning that investors need to wait a whopping 15 years until Facebook has generated enough revenue (not profit) to pay off the original investment of currently $62 billion. This ratio can only be justified with spectacular revenue growth short term.
| In Millions of USD | 2011-12-31 | 2010-12-31 | 2009-12-31 | 2008-12-31 |
|---|---|---|---|---|
| Revenue | 3,711.00 | 1,974.00 | 777.00 | 272.00 |
Source: Google Finance
If optimistic investors expect the trend to continue into 2012, we might be looking at around $7 billion by year end. Net profits were $1 billion, resulting in a proud 27% profit margin. Nevertheless, not nearly enough to compensate the current price level.
Do note that advertising still contributes a majority of roughly 85% to revenues. Besides advertising, Facebook is putting more efforts in unlocking new sources of income by gradually shifting toward payments and other fees. One potential source was tested a few weeks ago, whereby users could pay a small fee in exchange for a higher exposure of their posts. Question remains whether this really contributes to a diversified stream of income should advertising become irrelevant.
What Lies Ahead
Facebook does "not currently directly generate meaningful revenue" in mobile products, suggesting that this is an unexplored territory and could unlock the growth for the next few years ahead. Google (GOOG) demonstrates that advertising is still a dynamic business, but things can shift fast once technology-savvy users get increasingly immune to ads. Agreeably, Facebook is more diversified compared to Google, which gets 96% of revenue from advertising.
Also mind that Facebook is basically non-existent in China due to being blocked since 2008. If Mark Zuckerberg can find a way to penetrate this market, they will face entirely new opportunities.
Conclusion
Buying Facebook shares is still speculative. If you believe that it will continue to be the leader among social networks and retain current users despite aggressive competition coming from Google+, it can only be a compelling part of your portfolio at much lower share prices. I'm speaking $15 to $20 a share.
Considering potential future developments, current investors are paying a large premium and need to have far reaching imagination and hope that expectations will meet reality soon enough.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
