Facebook does have a value, doesn't it?

Musings around past: Exactly seven years ago when I joined the ever-growing population of "Internet-ers", I had never thought that I would become so addicted to this experience that even a few hours at a stretch without it could be torture for me. Eventually, I joined the social networking site "Orkut" and had a chance to again experience the power of Internet. Shortly after joining the Orkut family, I also came to know about Facebook (FB). And it was sometime 2nd or 3rd week of December, 2007 when I first opened my profile on FB. Later on, I found Orkut less fascinating than FB, so I deleted my profile form Orkut and continued with FB only. Since then, I have always shown my love to this "Social Network" created by Mark Zukerberg. Facebook has succeeded in attracting above 500 million members on January 10, 2011. And there is buzz around that it has plans to launch an IPO shortly. At the same time, we got to know that i-banking giant Goldman Sachs bought a small share of FB for a whopping $ 500 million! Next to follow this suit was Kleiner Perkins that invested $ 38 million for another small stake in FB (WSJ Report, Feb. 14, 2011). Wow!! What is making FB so attractive: both as a business and as a social network?

A series of observations that I took meantime, led me to think of what makes it a "Beauty on the Web"? I am not trying to value the FB, rather I am just trying to explore why investors would be willing to put their money in a social networking site where above 500 million members are sharing loads of information free of cost! It has no predicable cash flows, it has utmost uncertainty of its subscriber base, and little has been disclosed so far about its business model and financials! Why did GS put into such a heavy amount of investment in FB?

Something called finance: Following the fundamentals of finance, to make valuation of any company we need to know its cashflows. We are not able to do that in this case. So, let me point out some other aspects that is giving it a interesting investment sense. Among its peers, FB is rated as a company with moderate valuation. A Wall Street Journal report quotes it next to Google and Amazon.  In this report, Facebook is valued at $ 50 billion, after Google ($ 200 billion) and Amazon ($ 80 billion). 

First thing that is making FB a hot among investor-biggies is its potential business in Internet advertising. One of the reports of the Interactive Advertising Bureau (IAB) quotes that the total market value for the Internet Advertising was around $ 28 billion for the year 2010. And it is not unusual to estimate that this market will double in size as consumers become more attentive towards Internet-based media. It is estimated by the industry experts that internet advertising market is going to balloon. Given the presence of FB on the Internet and also its subscription base, it is bound to have a substantial chunk of internet-based advertising business. No doubt about it!

Is it really worth it? Now, let me try to calculate a hypothetical cashflows for FB to reach a estimated valuation. If the Internet-advertising continues to grow at a the same pace it is growing today, and the market stays as it is, Facebook is expected to generate $ 24 billion a year in revenue from Internet advertising sharing with other Internet advertising giants such as Google and Yahoo! This figure is not a (highly) prediction, man! This is what Google is already generating right now, and FB is supposed too have an equal market share of internet advertising business with Google.

Apart from Internet advertising business, there is a portion of company budgets which falls into “marketing” and both Google and Facebook are also going after those budgets as well. This means there’s easily billions of dollars to be spent on alternative advertising solutions. Take Groupon and LivingSocial, for example. These companies, combined, could easily generate more than $5 billion in revenue this year alone.

As such, we’ll see both Google and Facebook try to get in on the action as the deals market explodes. Facebook has already launched its own deals product, based on Places, and Google has already attempted to acquire Groupon for more than $5 billion. If Facebook can get a piece of these budgets, you could easily see the company adding billions in additional revenue through such sources if successful. For the time being it’s not clear whether or not Facebook Deals will eventually become a new revenue channel on its own; however, we can just about guarantee Facebook will try to get a piece of this explosive market (Sourced).

With these observations in mind, it’s somewhat reasonable to expect at least a few billion in annual revenue through new marketing products for small businesses within the next 5 years. This would bring Facebook up to $27 or $28 billion a year in revenue.

Yuppiee... It's Awesome: With all this (hypothetical) revenue, Facebook actually would have to be worth $200 billion, right? Well, if the market stays the same as it is today (which it of course uncertain; the basic principle of finance), Facebook would have a market cap of a little more than $200 billion if valued at a revenue multiple similar to Google’s (similar businesses, similar valuations, though higher growth). That’s something amazing! So from the perspective that investors can purchase shares at a $50 billion to $70 billion valuation, and Facebook will have been a great buy! (Only if at any point of time, Facebook would ever bring an IPO!!)