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On December 31, 2009 Steven Bertoni of Forbes wrote an article entitled “How Much is Facebook Worth“, where he said “firms are pooling clients’ money to buy privately held Facebook shares — and probably overpaying.”  At the time of this article, the implied valuation of Facebook was around $11 billion according to SecondMarket and SharesPost, which stated that the Facebook stock was trading at $25 per share.

If you are an accredited investor and were a reader of this Forbes article one year ago, this advice, from one of the most credible sources on stock market analysis, may have cost you a lot of money.  However, if you were a reader of SecondShares $50 billion valuation of Facebook just a few months later, you may have been able to save face.

Keep in mind, Forbes Magazine describes itself on its website as “Business News, Financial News, Stock Market Analysis – online source for the latest business and financial news and analysis. Covering personal finance, lifestyle, technology and stock markets”.  It doesn’t state that they cover “secondary private company stocks”.  I feel its a bit irresponsible for a brand like Forbes to tell their readers that investors are “probably overpaying” for a stock, without providing any real research or market analysis to support that opinion.

In the article Bertoni went on to say, “of course trying to value Facebook is as difficult as hiding from your former high school sweetheart online“.  First, I’m not quite sure Bertoni actually tried to value Facebook with any real market research or analysis, other than according to him, extrapolating its value “for fun” with the same multiple that Google had in its 2004 public offering, which was 15.7, to Facebook’s then estimated revenues of $300 to $500 million.  Second, considering Facebook is where your high school sweetheart would likely find you online, shouldn’t that have been one of the indicators to Bertoni that perhaps he’s not qualified to understand the value of Facebook.  ;-)  Okay, he left that one open.

But seriously, Bertoni’s skepticism continued with, “despite the big run-up (in stock price) in six months, little has changed about the business of Facebook“.   Sigh.  He even cited Facebook’s 350 million membership count, as well as their revenues of $300 to $500 million.  Yet, he felt their business had little change?  Really?

Well, its been twelve months since the Forbes article begged the question, “How Much Is Facebook Worth?”, so let’s take at Facebook’s continued trajectory to see if its overpriced today, “for fun”.

Facebook has gone through a 5 to 1 stock split and its stock is currently trading on the secondary market, among sophisticated accredited investors, at an implied valuation of around $50 billion.  They now have over 500 million members, or they’ve gained nearly another 200 million members in the last year.   Their estimated revenue for 2010 is now $1.2 billion, and they are at the earliest stages of deploying their monetization strategies.  In fact, according to VentureBeat, Facebook is about to get very serious about its revenue.  Facebook just leased two floors on Madison Avenue, with the potential to expand up to 150,000 square feet or 600 people, nearly all of which would likely be in sales.

Fifty percent of their 500 million members logon to Facebook every day, and they spend over 700 billion minutes per month on Facebook. The average member has 130 friends, connected to 80 community pages, groups and events and creates 90 pieces of content per month, which in total is more than 30 billion pieces of content (web links, news stories, blog posts, notes, photo albums, etc.) shared every month on Facebook.  Additionally, there are more than one million developers and entrepreneurs running a business on Facebook from over 180 countries, which over 70% of Facebook users interact with every month.  In fact, companies such as Zynga, RockYou, Slide and more have built sustainable businesses that have created billions of dollars in shareholder value on top of Facebook’s platform, just as companies such as Intuit (INTU) and Adobe (ADBE) have created billions of dollars in shareholder value on top of Microsoft’s platform.  Its no wonder Microsoft was the first to fully understand the future value of Facebook when it invested $240 million in Facebook at a $15 billion valuation or 1.6% of the company.

I will slightly agree with Bertoni regarding his supply and demand argument (that Facebook shares are for sale, and everyone wants Facebook bragging rights), but that doesn’t necessarily mean that the investors are overpaying for their Facebook shares in the secondary markets.  Remember, the secondary markets are illiquid, they’re not for traders, they’re for investors, like Microsoft’s investment.  So the question isn’t whether or not your share price is ‘exactly’ where you’d like it to be today, its whether or not you believe it will be worth more in the future, and with Facebook’s growth trajectory, vision and track record, I think we know the answer to that.

The question I’d really like to know is whether Forbes believes Facebook’s stock is overpriced today.

Jay Gould maintains a long position in shares of Facebook (private).

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There is a new single purpose fund on the block, 137 Ventures, which has been setup specifically to purchase stock options directly from Facebook employees. The fund is headed by Justin Fishner-Wolfson, a former principal at Founders Fund, which is an early Facebook investor. 137 Ventures is reportedly raising as much as $100 million to purchase stock options from the Facebook employees.

137 Ventures has setup a unique strategy for acquiring the stock options from Facebook employees. According to WSJ’s Tomio Geron:

“For borrowers, 137 Ventures is proposing to charge about 12% interest on the loans, as well as a 10% upfront fee. The upfront fee will be paid in stock of the company for which the options are exercised, while the principal and interest apparently will be paid in cash.”

Facebook employees stock options expire 90 days after an employees leaves the company, and considering most employees can’t afford to exercise their options, this fund may provide the fully vested employees the option to cash out their stock at Facebook and move on to a new startup to begin vesting new stock options. Essentially, once an employee is fully vested at Facebook, there’s little upside in staying on board. The loans are needed by employees not only due to the cost of exercising the stock options, but in many cases there are heavy tax burdens as well. Essentially, the Facebook employees are subject to taxes on the difference between the current value of the stock and the price at which the employee exercised the option, which can be rather significant for Facebook stock options today.

As for the limited partners in the fund, 137 Ventures is proposing to charge a management fee of $1 million plus 1% annually. The fund also has a carry of 20% above the net IRR of 25%. The fund is setup for five years, with three possible one-year extensions. Borrowers must use the company stock as collateral on the three-year loan, and the stock must be worth at least two to three times the amount of the loan.

VentureWire interviewed Cyan Banister, an angel investor and the chief executive of model and photography startup Zivity LLC, who said “I’ve personally loaned large sums of money to employees so they can leave Facebook. I’m not in the business of doing this. Clearly if my friends have a need and are stuck there, there’s clearly an opportunity here and (the loans) need to exist.”

A fund like this wouldn’t work for smaller startups, but with companies like Facebook, Zynga, Twitter, Groupon and others, it may just work due to the number of employees and their growing valuations and likely eventual IPO’s towards liquidity. With more than 1,000 Facebook employees and recent secondary transactions for its stock above $40 billion and growing, the market for just Facebook employee stock options is becoming an enormous market in itself. Typical investors like to see a 2 to 3 year horizon for liquidity, but with these high profile startups, the secondary market is already providing their required liquidity. Additionally, Stock Options Funds like this may not work with smaller startups that have fewer employees and lower valuations due to the risk that they may be acquired for a lower valuation that the purchase price of the options. The risk is that the preferred stock in these companies will monetize before the common stock, which is what the employee’s stock options are. However, in growth stage companies like Facebook, Twitter, Zynga and others, this risk is much lower.

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EDITORS NOTE:  THIS POST WAS ORIGINALLY POSTED ON 2/28/10 ON THE RESEARCH SITE, TRACK.COM.

Current trading price in private market: $38      Target price:     $100

Overview:

  • Facebook is the most powerful website the world has known : With over 400 million reported users spending an average of 55 minutes per day on its site, Facebook is the most ubiquitous and transformative media company on the planet poised to create tremendous shareholder value as it begins to monetize its vast audience. Facebook already has ¾ the reach of Google and three times the average time spend per user, yielding Facebook double Google’s aggregate global time spent; and Facebook is on a dramatically steeper growth curve, growing its reach by 150%+ in 2009 vs. 40% growth for Google.
  • Facebook already drives more traffic to the leading portals than Google: While Google has long been the major driver of traffic to the majority of websites in the world, “friendcasting” on Facebook (when a friend uploads a link to content and someone clicks on it) is already a larger driver of traffic to sites like Yahoo and MSN than Google, according to Compete.com. If Facebook successfully leverages its new relationship with Microsoft’s Bing, implements more social search tools, grows its fan pages, and enables the continued natural growth of “friendcasting”, Facebook should surpass Google as the largest driver of traffic globally later this year.
  • Facebook is tracking to be a $100B company: Google has demonstrated how to monetize the time and data users give to the site daily. Facebook’s potential to monetize both time spent and data shared may be even greater than Google as it generates more time and significantly greater data on its users. Facebook also benefits from a network effect that doesn’t exist at Google. Each incremental user adds geometric value to the network. As Facebook achieves its goal of building the dominant global networked communications platform, it will begin to leverage its reach and earn its share of global advertising, ecommerce and payment revenues, possibly rivaling Google’s earnings potential. We estimate that Facebook will be worth more than $100 billion by 2015 using the same multiples on Facebook’s forecast 2015 EBITDA as Google is valued at today. More aggressive (but still reasonable) multiples and growth rates would yield values rivaling Google’s market cap of $140+ billion, ex cash.
  • Facebook is worth $50B today: If Facebook is worth $100 billion in 2015, discounting that valuation back to today with a 15% discount rate, gives the company a current value of ~$50 billion. Regardless of the discount rate you use, Facebook offers a very compelling investment opportunity at current prices.
  • Facebook is privately traded at 60%+ discount to its current value: Most investors don’t know you can buy Facebook shares today, pre-IPO. While the market for Facebook shares is not robust, there were millions of shares traded last year through private marketplace websites like Second Market.com, SharePost.com and others. Only accredited investors are allowed to participate. Currently, ask prices are about $38/share, implying a market cap for Facebook of ~$19 billion. Relative to the $50 billion fair market value we see in the company, this represents a 60%+ liquidity discount.
  • Facebook only has to earn $7 per user in EBITDA to justify our valuation: Dividing our $50B target by Google’s current trading multiple of 18X EBITDA implies that Facebook currently has earnings power of $2.8B in EBITDA. Dividing the $2.8B by the current base of 400 million users implies $7 of EBITDA per Facebook user. Facebook will have far more than 400 million users in 2015, so this is a conservative estimate. Even at $7/user, our projection is that Facebook would earn significantly less per user than other major internet companies. Amazon earns $15/user; Google earns $20/user; and eBay earns $34/user. While each of these companies operates with different business models, they all rely on aggregating huge volumes of users to create value for their investors. Facebook will earn ad revenue like Google, commissions on transactions like Amazon and eBay, and fees on payment processing like eBay. In presenting this metric we are demonstrating that even if Facebook’s earnings power is significantly less per user than other major internet players, it would still command a $100B market cap.

Quick Facts (according to Facebook , Alexa.com and Compete.com):

  • #2 website globally in total page views behind Google; should pass Google in first half of 2010.
  • At 30%, Facebook has the same global reach that Google had 1 year ago.
  • Both Google and Facebook should have global reach of ~50% by end of 2010.
  • 2 years ago Facebook’s global reach was just 6%.
  • Internet users spend 3x as much time on a Facebook page as they spend on a Google page.
  • Over 700mm pieces of content are uploaded on Facebook daily (eg. 100mm photos daily).
  • Average user spends 55 minutes/day (~23% of total time online) on Facebook, 50% of users log on daily.
  • 67% of US online users are on Facebook.
  • ~70% of Facebook users live outside the US.
  • Among top 36 countries: Facebook’s page view rank is #1 in 4 countries; #2 in 23 countries; #3 in 9 countries.
  • Facebook just received approval for patenting its news feed, the core functionality of its website.

Investment Thesis:

Facebook is already the world’s dominant website

  • However you measure it, Facebook’s global scale and growth are astounding. Of its reported 400+ million users, ~120 million are in the US. That’s 120 million out of ~180 million US internet users (according to Commscore); indicating that about two-thirds of all US internet users are now on Facebook. Facebook says the average user is on Facebook 55 minutes per day, out of a total average of four hours per day of total internet usage by the average US internet user. Those statistics are consistent with recent research based on Compete.com statistics indicating that Facebook now accounts for 25% of total US internet page views and 15% of page views in the UK. As a result of its dramatic surge in uniques and page views, Facebook is now directing more traffic to major portals like Yahoo and MSN than Google through “friendcasting” – the name given to the process of clicking on a link your friends post in their Facebook newsfeed. In this report we want to discuss two implications of Facebook’s dramatic growth.

Facebook has blown by MySpace in social networking and is poised to pass Google in 2010 in directed traffic

  • The world of television presented us with about 10 channels in the 70’s, which grew to 500 channels as digital proliferated in the late 90’s. The internet now brings us hundreds of millions of channels (i.e. websites, Facebook profile pages, blogs, etc.), which we have only been able to navigate with search. Yahoo dominated search in the early days, but they were passed by Google when Google came up with a better algorithm presented in a simpler design. Because they are the dominant search engine, Google emerged in the early part of the last decade as the dominant source of traffic for most sites.
  • MySpace was the early dominant “social network”, but the users weren’t really networked. We had to surf MySpace or hope someone came to our MySpace page to get any real value, and significant technical improvements were glacial.
  • Facebook’s improvements were simple but monumental. They used basic newsfeed technology to enable us to know what our friends are doing, thinking, buying, playing, or posting, simply by going to our own newsfeed. They also opened up their platform to third party developers, who quickly provided the Facebook community with a wide array of incredibly popular applications like Farmville, which has over 80 million players. In fact, Facebook states that there are more then 250 applications that have more then 1 million active users. While many of us used to go to Google to find the latest news, or would surf major or minor news sites to see what was going on in our world, our news and information is increasingly brought to us by friends who post news of interest to them or about them, which appears in our newsfeed. Friendcasting on Facebook will be complimented by Facebook’s increasingly deep integration of Bing’s search tools on Facebook, as well as by other social search applications on Facebook that let us mine the behavior and opinions of our friends. We believe Facebook will pass Google in terms of traffic generation to other websites in 2010.
  • Because we tell Facebook so much about ourselves, and because we spend so much time on Facebook, Facebook knows dramatically more about us than any other website in history, and Facebook’s willingness to share this data makes them an incredibly attractive partner to websites who like user data (which is almost every website). The question now is: how will Facebook leverage its powerful position to generate revenue and profits for their shareholders?

Facebook will be worth over $100 billion

  • Facebook will generate revenue from advertising, both display ads and through increasingly integrated search tools. Microsoft’s Bing, as the search provider on Facebook worldwide, compliments Facebook’s powerful “friendcasting”. Rather than merely offering links, the Bing integration will present more of the features available on the search engine itself. For display advertising, Facebook will increasingly be presenting ad formats that feature social actions. Social integrated ads perform better and provide a better user experience since they are consistent with the context and feel of Facebook. Facebook ads will also be increasingly targeted to people based on the information they provide Facebook. This combination of targeting and social relevance will drive enhanced performance and rates for Facebook display ads.
  • Global internet advertising is poised to grow to $96 billion in 2015 (according to Magna), a 10.5% five year CAGR. Traditionally in media, companies with scale are able to grab outsize share of ad spend. Therefore, as Facebook has the most global scale, its safe to assume that Facebook will attract its fair share of the market. While Facebook is still growing rapidly, we assume in our valuation thesis that they account for only 15% of total internet traffic in 2015. According to Drake Direct, based on Compete.com data, Facebook is already at 15% in the UK, and they are at ~25% in the US. We believe 15% is a conservative view of Facebook’s page view and time spend share in 2015, given its current trajectory. We estimate that Facebook’s 15% share of the global internet audience yields them a 15% share of the global internet advertising market, yielding a forecast of $14.5 billion in advertising revenue in 2015. Today this may seem like an aggressive assumption based on the fact that Facebook currently does not command a comparable CPM to many other websites for their display ads. But Facebook has just really begun to monetize their traffic and weave in targeting and social relevance, and they haven’t even begun monetizing social search. Where Google offers advertisers strong targeting for purchase intent, Facebook is the holy grail of targeted brand advertising, and is posed to make significant headway in search.
  • Facebook Connect is another powerful platform for Facebook to leverage and eventually monetize its user data. Facebook Connect is quickly becoming a de facto registration platform on the net. Currently, over 80,000 sites have already implemented Facebook Connect, including many large sites like CNN. Facebook Connect is emerging as the internet “passport” that enables people to enter any website, as well as interact with their friends who are also on that website. This will likely become another significant revenue platform, as Facebook could potentially harness Facebook Connect to create a leading ad network, leveraging their deep relationships with advertisers and their mountains of user data. For purposes of this analysis, we’ll assume they derive zero revenue from Facebook Connect in 2015. Therefore, in our analysis, investors are getting a free call on this massive business opportunity.
  • Next up, and just as interesting, is Facebook’s recently introduced payment system. Initial testing on Facebook indicates Facebook consumers prefer Facebook’s system to the other payment systems available on Facebook. Facebook is charging a whopping 30% fee to the publishers selling virtual goods (similar to Apple’s 30% take on applications sold on its iPhone platform). The system includes many other benefits for publishers (e.g. preferred placement in the gaming directory, better advertising rates) that only Facebook can provide. Analysts estimate that Facebook’s payment system will grab more then 50% share of payments on Facebook and generate $200 million this year based on projected sales well north of $1 billion in virtual goods in 2010. But payments on Facebook will be just the beginning for the payment system. Facebook Payments is well positioned to take meaningful share from PayPal all over the internet as users will increasingly be using Facebook Connect on ecommerce sites around the net. Paypal is expected to generate $3.3 billion in revenue on a base of 88mm active accounts in 2010. We believe Facebook Payments could grow to a $2 billion dollar business by 2015.
  • Given the simple analysis above, we project Facebook will drive $16.5 billion in revenue in 2015. While this is a big number, it is just over 1/3 of what Google would be projected to generate in 2015 if Google grew revenue at a 12% CAGR (about ½ it’s recent revenue CAGR of 20%). For ease, we assume Facebook achieves the same 35% EBITDA margin as Google is currently experiencing. Let’s similarly assume that Facebook, as a public company, would be valued using the same EBITDA multiple as Google is valued at today, which is 18X 2009 EBITDA. The math above implies a value of $103 billion based on 2015 projections.

Facebook is worth $50 billion today

  • If we discount $103 billion back by 15% per year, we get a price target of $51 billion today. This implies a value that is more than two-and-a-half times the $19 billion value Facebook shares are currently trading at on secondary private marketplaces. The table below looks at how our valuation would vary depending on various multiples and discount rates. Even at a 21% discount rate, Facebook would be worth more than 2x the current share price.

  • Another way to value Facebook helps put our target in to perspective. Based on current membership levels, we are valuing Facebook at $125 a member. If Facebook were valued on an 18X multiple of EBITDA today, that implies that Facebook has the power to generate $7 in EBITDA on average off its members, or $20 on average per member in revenue (assuming 35% margins). Neither number appears a stretch. Amazon earns $15/user in EBITDA, Google currently earns $20/user, and EBAY earns $34/user. We recognize these companies all have different business models, but we think it is helpful to put some context around our $7 EBITDA per Facebook user projection.
  • Is a 15% discount rate too low given that we’ve seen other social networks appear and then fade, most recently MySpace? We’ve seen other internet leaders founder – is Facebook like Yahoo? Is it possible Facebook is just a fad, as some argue? Our thesis is that Facebook is already deeply ingrained in our daily lives, and this is just the beginning. There are many reasons why the switching costs are significant, and Facebook keeps adding new ones – most recently Facebook was granted a patent on “the feed”, a core feature of Facebook’s functionality. Facebook is averaging over 100 million photos uploaded per day. People don’t like to leave those behind. With an average of 130 friends per user, almost everyone has many connections that only exist on Facebook. The average person is a member of 13 groups. As we increasingly move to mobile, we are bringing Facebook with us. The Facebook iPhone app has been downloaded by over 28 million people. In addition, every wireless operator is advertising the availability of Facebook apps on their phones.
  • Maybe our estimates are too conservative? 15% share of online ad revenue and 35% operating margins could prove too low. The data table below shows that each 1 percentage point of share of the online ad market for Facebook is worth $3 billion present value at a 35% margin. With 30% reach of global internet usage today, it is conceivable that Facebook ad share could be well over 15%.

Facebook shares are available for accredited investors to buy and sell, and the current value is $19 billion

  • There is a secondary private market for Facebook shares on sites like Sharepost.com and SecondMarket.com that make markets in shares of dozens of private firms, enabling employees to monetize some of their options.
  • After proving you’re an accredited investor, the transaction is papered, with the seller paying transaction costs.
  • While Facebook enables employees to sell their shares, the buyers of these common shares are prohibited from subsequently trading their shares until Facebook goes public or is acquired.
  • Right now, shares are being offered at $36-$38 per share, implying a market cap of $19 billion.

Catalysts:

  • With only $600 million in rumored revenue in 2009, Facebook has done little to monetize its vast reach. As Facebook revenue generating initiatives start to scale, private market values should increase.
  • When the company goes public, the liquidity discount will evaporate and prices will rise to fair value.

Risks:

  • Shares bought in the secondary private market are not liquid and do not entitle the owner to the information usually provided by public companies to their investors.
  • Another competitor could arise and take market share from Facebook. In fact, to the degree that Facebook attracts 15%+ of all internet time, every other website on average is generating 15% less traffic. So it’s easy to imagine other sites working together to try and thwart Facebook. But like Google, other websites will increasingly see Facebook as a “frenemy”, a strong competitor for the mindshare of internet users but also a driver of massive traffic.
  • Facebook either may not be capable of or may not be concerned with generating massive revenue or going public. This is unlikely since history has shown that once eyeballs are assembled, advertising and other monetization opportunities present themselves. Some people thought no one would advertise on MySpace, and they were proven wrong. And Facebook is far more advertising friendly than MySpace as pages are much less free form. While a few companies (most notably CraigsList) appear uninterested in maximizing revenue, Facebook’s significant VC investors will help drive both monetization and an eventual liquidity event. In addition, like Google, Facebook will need to generate cash to help finance its increasing spend on R&D to drive innovation.
  • Privacy remains a significant concern of internet users globally, and with all the data Facebook aggregates and make available, they are walking a fine line. Facebook has clearly had some missteps in the past, most notably its Beacon information sharing product in 2007 that caused an outcry from privacy groups. They have also had technical glitches, one as recent as last week where messages were misrouted. As a result of these lapses, Facebook is acutely aware of the privacy issue and they appear to be thoughtful in their approach. Google also struggles with privacy, as evidenced by their recent bungling of the introduction of Google Buzz.
  • Given Facebook’s increasing stranglehold on internet usage, governments in the U.S. and elsewhere could step in and, in some way, break up the near natural monopoly on social networking that Facebook will have. Google is already starting to face serious antitrust issues in Europe.

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