By David Cho
How much more valuable do you think Facebook (FB) is than Yahoo? Let's say I gave you 1% of Facebook's stock. How much of Yahoo (YHOO) would I have to give you to part with that share? 5%? 10%? More? (Or would you just move to Singapore and renounce your U.S. citizenship?)
What about Google (GOOG) stock? Would you make a 1% for 1% trade? What about 0.5% of Google for your 1% Facebook stake?
Well here's what the stock market thinks: Based on market cap, Facebook is closer in value to Yahoo than it is to Google. After sliding under $20 per share, just two and a half months after going public at $38, Facebook's market cap hit $45B, closer to Yahoo's $20B than Google's $210B.
The two companies represent two possible future states for Facebook. Google: Thriving, a colossus in digital advertising with a stranglehold on search, the kind of company that creates billion dollar businesses out of secondary products. Yahoo: Shrinking, trying to find its identity with a revolving door of CEOs, while seeking ways to improve monetization of its still massive user base.
These two companies pretty much represent heaven (Google) and hell (Yahoo) for Facebook. Or to steal from Dante's Divine Comedy (no, not this one, this one), Paradiso and Inferno.
Right now, according to Wall Street, Facebook is edging perilously close to Inferno. So what gives? Is Wall Street right, and more importantly, can Facebook find salvation?
By virtually any measure, Facebook runs a fabulous business. With a billion (!) engaged users, Facebook recorded $1.2B in revenue and $300M in profit in its most recent quarter and has $10B in cash to invest in the business.
But the stock market does not reward current performance. Stock prices reflect investors' expectations about a company's future performance, and particularly for stocks like Facebook, growth.
This is partly why Facebook's stock price took a beating after its most recent earnings announcement, even though it met the earnings guidance that it had set for itself. The problem was that many analysts believed that Facebook was "sandbagging" its numbers. The stock price reflected that expectation, and when Facebook merely met its earnings guidance, the stock took a tumble.
So what should we expect for Facebook's growth? Facebook will almost certainly start to create separation from Yahoo ($1.3B revenue in Q2 2012). But do we think it can eventually grow to Google's size ($11.0B), nearly 10x bigger than Facebook today?
To get a sense of Facebook's growth prospects, we can start by breaking down Facebook's revenue into its component parts: number of users; mix of those users; and average revenue per user (ARPU). Let's look at each piece individually.
Number of Users: This is all about product, and Facebook has obviously crushed it here. They have added 250M users in each of the past three years, and these users are becoming ever more engaged on the site. But how much growth is really left? In the US, its most mature market, Facebook grew its user base just 5% in April vs. the same time last year. In many other markets, Facebook appears to be hitting saturation as well. While some headroom still remains, Facebook is rapidly approaching a point where hyper-growth - driven by growth in users - will plateau.
Mix of Users: What do I mean by mix? Not all users are created equally. A U.S. user is more valuable than an international user, and a web user is more valuable (today) than a mobile user. As has been well-covered, however, engagement is rapidly shifting to mobile, and most of Facebook's user growth is coming in developing markets. Both factors will serve to mute the impact on revenue that arises from continued growth in users. In other words, even if you believe that Facebook can grow its user base by, say, another billion users, revenue will not necessarily double.
Average revenue per user (ARPU): This one is all about business model, and it is here that Facebook will need to generate consistent growth to find Paradiso. This in turn will come down to two factors: How well it leverages its competitive advantages of scale and data to attract large-scale brand advertising, and how successfully it grows new monetization models like payments.
On the first, Facebook has done well in attracting small and medium businesses and other so-called "performance advertisers" to the platform, but the game will be won or lost based on attracting the billions of dollars that brand advertisers like GM, Proctor & Gamble (PG) or AT&T (T) still spend offline. While online advertising has grown to nearly $40B per year, offline advertising (TV, print, radio, etc.) is still a ~$140B market. Facebook's scale will help in attracting these dollars, but they have hit bumps along the road in doing so.
To help land these brand advertisers, Facebook will also need to continue to be aggressive in how it uses user data to deliver strong ROI. We've already seen Facebook experiment here with sponsored stories, using your friends' likes to insert ads into your mobile feed. I expect we'll see many more experiments in the future as Facebook uses what it knows about us to improve ROI. In fact, Sidebark, the company I co-founded with Nick Stanev, was founded in part in anticipation that privacy concerns will get worse, not better, on Facebook.
The second factor of finding secondary sources to monetize the user base is a wild card. Facebook has been successful building payments as a meaningful revenue source, and many pundits have offered other adjacent businesses that Facebook should enter (Facebook phone, anybody?) But I think it's hard to rely on the discovery of new business models to project Facebook's growth.
So where does that leave us? Decelerating growth in users, unfavorable change in user mix, and a question mark in ARPU. In the short term, Facebook is certain to grow, but the question of Inferno vs. Paradiso will take quite some time to sort out. In order to catch up to Google and find Paradiso, Facebook must be aggressive in driving strong ROI for its customers, the advertiser. But to avoid Inferno, they must not kill the golden goose - their amazingly engaging product - through overly aggressive use of user data or otherwise sullying the user experience. It's a fine balance, so for now, I'll hedge my bets and say that Facebook is in Purgatorio and take my 1% to Singapore.
What do you think?
Note: Guest author David Cho is CEO and co-founder of Sidebark, the private photo and video sharing service. Prior to founding Sidebark, he was a leader in Bain & Company's digital media practice.