Why Facebook May Really Be Worth $50 Billion
It was recently announced that Facebook received a $500 million investment from Goldman Sachs that puts the total value of the company at $50 Billion. Wow! Congratulations Mark Zuckerberg!
However, a valuation that high begs the question: Is it really worth that much? I admit, I was skeptical at first, but having run some numbers, it appears decidedly less ridiculous than I first thought. In actuality, the price reflects some fairly reasonable assumptions.
How to Value a Company
Valuing a company is a subjective process. What might be worth a lot to me might not be worth so much to you. We could have different ideas about what the future will bring or I might already own something that would make such a great fit that both assets together could be worth far more than the sum of the parts.
Whatever the methodology, there is only one reason to buy a company: You have to believe that buying it will earn you more with less risk than putting the money somewhere else.
Here are some ways of figuring that out:
Discounted Earnings: This is the most common way to value a company. After all, what is an investment if not a stream of future earnings? US Treasury Bills are considered risk free, so they give very little income. Corporate bonds give you a fixed income every year, but there’s always a chance that they will default, so returns are higher for corporate debt.
Stocks, however, are riskier than bonds. There is no rate of return specified and, if things go poorly, you lose everything while the bondholders at least get paid something. Therefore, investors expect a better return from equity investments. The S&P 500 has delivered about 9% returns over the long term, with a lot of ups and downs.
Discounting earnings, however, is complicated and subjective. You have to not only project earnings, but also make a judgement about what interest rate you will employ to discount them. Therefore, Price to Earnings (P/E) ratios are often used as useful shortcuts and PEG ratios take into account growth as well. Looking at both, you can get a basic idea of value.
Revenues: Of course, sometimes discounting earnings and P/E ratios aren’t viable because either the company is a start up without significant profits or it has fallen on hard times. In those cases, Price to Sales ratios make more sense when comparing to similar companies.
Alternative Methods: While some method of discounting earnings or comparing companies by turnover are standard, there are a variety of other methods. For instance, Enterprise Value estimates what a company might be worth to an acquirer. Cable and Telecom companies have sometimes been valued on the basis of subscriber base, etc.
There are, of course, other things to consider. For instance a company whose management is highly regarded will be worth more than a similar company that doesn’t instill confidence. Some industries get a lot of attention and that will also drive perceptions of value.
Nevertheless, no matter what method you use, you will want to compare the company to others that run similar businesses.
Probably the best place to start getting an idea what Facebook might be worth is to look at mature media company valuations. I’ve analyzed a handful in the table below:
The first thing that should catch your eye is that $50 billion is a lot of money to pay for a media company. It’s almost as much as Disney and more than News Corp or Time Warner. These are big, well managed companies that have a consistent profit history.
Furthermore, media companies aren’t cheap. The P/E ratios of most companies in the chart exceed the S&P average (around 15 and 13 for trailing and forward P/E’s. respectively).
Of course, we have no idea what Facebook earns, but it has been reported that their revenues for the past year were around $2 billion, which would indicate a price/sales ratio of a whopping 25! (Compared to between 1 and 2 for most media companies)
When comparing to mature media companies on the basis of any metric, valuing Facebook at $50 billion looks very aggressive
Google and Apple Comparisons
Of course, Facebook is very different than a mature media company. It is very young and growing super fast. Therefore, we also want to look look at other high-flying tech companies like Google and Apple.
When measured against these companies, $50 billion for Facebook starts looking considerably less crazy. First of all, it represents only one quarter the value of Google and one sixth the value of Apple. Facebook’s price/sales ratio of 25 is still much higher, but it is growing at exponential rates (if reports are to believed, 100% last year).
Another important point of difference is that these companies have much higher profit margins than the mature media companies, which means they earn more on less revenues. It’s fairly safe to assume that Facebook’s margins are also high, or will become so.
Finally, it must be said, that the market caps of Google and Apple aren’t excessive by any means. Their forward P/E ratios are similar to that of mature media companies. The combination of strong top line growth and meaty profit margins makes these companies relatively cheap, despite their high valuations.
How To Get to $50 Billion
To be honest, there’s no way to be sure what Facebook is worth. Only time will tell us that. However, the important question to answer is whether we can believe that it is worth that much without making any wacky predictions.
In order to answer that particular question, I used the following assumptions:
- Facebook 2010 revenues: $2 billion (from unsubstantiated reports)
- Facebook revenue growth: 100% (also from reports)
- Benchmark ROI: 9% (historical S&P average, including dividends)
- Facebook PE in 5 years: 25 (the same as Google)
- Facebook profit margin in 5 years: 20% (Between Google and mature media companies; same as Apple)
Now, if we assume investors would be happy with anything over 9% return on their investment, Facebook would have to be worth a bit more than $70 billion in five years. Using a P/E of 25 and 20% profit margins, that would imply earnings of 2.8 billion and revenues of $14 billion. Even compared to mature media companies, those do not seem excessively high.
Moreover, to achieve these numbers, Facebook would only have to grow their revenues at an average compound rate of about 50% per year. That’s a lot, but well under their current rate, if reports are to be believed. That doesn’t mean it’s a lock, but it’s certainly doable.
So while $50 billion for a company that was launched in 2004 might seem outrageous at first glance, in reality it is not unrealistic. The bigger question, of course, is where it will go from here. There remain many open questions about where the revenue growth will come from.
One thing is for sure, this is going to be fun to watch!
Update: Recent reports put Facebook’s margins at 30%-40%, which makes the valuation even more tenable.