Facebook, a social networking site, has grown at an exponential rate that far surpasses market expectation, so much so that its growth rate is referred to as the “ Facebook phenomenal”. In 2004, Facebook had 1million monthly active users, and in comparison, it had reached 845million monthly active users in 2011. This phenomenal led to one of the biggest initial public offerings (IPO) the market had seen in recent years, with total capital raised to be valued at $16B, given the $38 per share offering price. Facebook was valued at around $96.6B in total. Prior to the IPO, the market perceived the valuation with positive approval signaled by both Facebook’s private market share auctions and analyst’s reviews. However, as it will be examined below, Facebook has been significantly over-valued by the underwriters. In addition, the market changed its opinion of Facebook shortly after the IPO, criticizing the valuation of the company was too high. The differences in market reaction showcase shortfalls in valuation, and it is recommended that analysts and Facebook should have used real option to valuate its market value. Over-valuation
There are three main reasons why Facebook is overvalued at $38 per share. Aggressive Assumptions made by underwriters
The first reason is the $38 per share price is based on overly aggressive assumptions made on Facebook’s future revenue. Facebook generates its revenue in two ways - display advertisements on its website and retain royalties from third-party developers for using Facebook’s online payment platform. Out of the two streams of revenue, advertisement accounts for about 82% of the total revenue, and royalty payment only accounts for 18%. Lead underwriter Morgan Stanley, has justified its pricing based on the assumptions that Facebook’s revenue will grow moderately considering the increasing popularity of its mobile app. Morgan Stanley estimated Facebook revenue to grow at 28% CAGR from 2013 – 2016, with advertising revenue growing at 31% and payment revenue growing at 17% per year. However, it is arguable that these assumptions are overly aggressive, and they will be extremely hard to realize.
Upon examining the future prospect of revenue generated from advertising, it can be said that the estimated 31% growth rate cannot be achieved. First of all, given the online advertising market size, and current Facebook market share, Facebook will not be able to achieve the projected annual growth. In 2011, Facebook’s share of the online advertising market is 27% of the $25B industry. It is projected that the online advertising sector will grow to $45B in 2015, and given Facebook’s current market share, Facebook should be able to generate $12.15B in advertising revenue in 2015. However, this only accounts for 20% CAGR.
Second, it is uncertain whether Facebook will be able to continue maintain its 27% market share. Facebook disclosed to the public that its current advertisers do not have long-term advertising commitment with Facebook, and many of its advertisers only spend a small proportion of their marketing budget with Facebook. In addition, many companies have started to question the effectiveness Facebook ads. Facebook differentiates its service by emphasizing the premise that ads are more effective if a friend recommends it on Facebook compares to traditional online advertising. It can be observed that companies, such as GM, are starting to doubt the effectiveness of the so-called social advertising by pulling out their ads on Facebook. This can significantly impact Facebook’s share of online marketing in the future. In addition, Facebook disclosed to the public that it might not be able to retain advertisers if it does not reduce its current ad price. However, considering that Facebook is already pricing its ads lower compares to other websites - Facebook charges $0.58 per click vis-à-vis the industry norm of $1, it is...