Friday, January 07, 2011

Is Each Dollar of Facebook Earnings Worth $106?

Thanks to the release of a private placement memorandum (PPM) for Facebook, we now know how broken our system is for valuing companies.  By annualizing its reported first nine months of earnings, we can estimate that it will report $473 million in profit for 2010. Since Facebook is valued at $50 billion, this makes each dollar of its earnings worth $106.

This valuation makes little sense when compared to two of the leading high tech companies. Apple – a much larger company with a stream of successful innovations trades at a surprisingly modest P/E of 22 and Google’s P/E is 25. Is there any rational basis for Facebook’s P/E? Only if you value it based on supply and demand for the shares in the context of an 11-year drought for hot IPOs.

Star System: Baseball, Banking, and Social Networking

At the heart of Facebook's exorbitant valuation is America's notion of a star system. Here, in many talent-based industries, we have thousands of competitors where there is a huge gap in pay between the average participant and the top ranked player. Simply put, to the victor go the spoils.

For example, in baseball, the average 2010 salary was a hefty $3.3 million, according to But the top-paid player -- the Yankees' Alex Rodriguez -- earned 10 times that amount ($33 million) and the players right below him -- A-Rod team mates CC Sabathia ($24.3 million, 7.1 times the average), Derek Jeter ($22.6 million, 6.8x) and Mark Teixeira ($20.6 million, 6.2x) -- made several times the average.

Both Goldman Sachs -- that's helping raise the latest round of financing -- and Facebook are the product of a similar star system. In order to get a job at Goldman, the top graduates of the top schools are winnowed through dozens of interviews. Of the ones who survive that, only a fraction make partner.

And Goldman's 375 partners make more than those at any other investment banking firms. One indication is that for the first nine months of 2010, the average Goldman employee made about $371,000, 94% more than Morgan Stanley's roughly $192,000, according to Bloomberg.

Similarly with Facebook, there are many social networking companies -- most notably, News Corp.'s imploding MySpace -- but only one with 600 million users. This is certainly valuable for advertisers who may want to concentrate their bets on those sites that are likely to get the biggest audience.

Of course, Facebook ought to be able to charge a price premium for that privilege. But as long as advertisers get a return on their investment in the higher priced Facebook ads, this price premium makes sense.

Is Facebook Worth Its P/E?

But for those betting on Facebook stock, the risk is greater. According to Facebook's PPM, it earned $355 million on $1.2 billion in revenue during the first nine months of 2011 -- leading to annualized earnings of $473 million for the year.

To be fair, Facebook's net margin of 30% is higher than Apple's 22% and a bit above Google's 29%. Moreover, one analyst told the New York Times that he thinks Facebook could be worth $200 billion by 2015 as its revenues double every year. (Obviously this trend won't continue forever but that may not be for a few years -- by which time investors will have a chance to take their profits.)

Zuckerberg Wins On The Ultimate Star System Statistic: Net Worth/Age

That would make CEO Mark Zuckerberg's 24% take quadruple from $12 billion to $48 billion. Of course the key statistic for the business star system is net worth divided by age. If Facebook quadruples by 2015, that statistic for Zuckerberg will rise from $462 million/year to $1.6 billion/year. By this measure, Zuckerberg currently outshines Google's 37 year old Larry Page who has a net worth of $15 billion for $405 million/year.

With Goldman raising $1.5 billion for Facebook coupled with its $450 million investment, the implied valuation of $50 billion seems high at a P/E of 106.This valuation is grossly distorted by the fever of investors who want to make easy money by getting into Facebook stock a year before it goes public when there is no business risk associated with the investment.

And that fever is made even greater by the many investors willing to fork over $2 million to get into Facebook who Goldman is deciding are not worthy of their share. Indeed, the star system is working for those who want to get into this investment -- and a big part of that system is the envy of those who have been deemed unworthy.

Meanwhile, there's at least one party that will enjoy the privilege of taking advantage of Facebook's excessively high valuation -- Goldman Sachs. How so? Bloomberg notes that Goldman "may at any time further reduce its exposure to its investment in Facebook (through hedging arrangements, sales or otherwise), without notice to the fund or investors in the fund.”

This is just another smart thing that Goldman does for itself that the rest of the non-stars can't. And the simple reality is that given its control over a chance for the rich to get even richer, this economic star system perpetuates itself and there's not a darn thing you can do about it.


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