As Facebook nears its debut as a public company, would-be investors are pondering the $96 billion question: Can an eight-year-old company run by a hoodie-wearing 28-year-old possibly be worth that much?
Analysts are divided, with some suggesting that the valuation is simply too high, and others coming up with scenarios in which Facebook could be worth even more, given the right conditions and a leap of faith.
Andrew Sheehy, chief analyst at British-based Generator Research, says the number is too high, reflecting outsized expectations for the social networking company. A market cap of $100 billion would give Facebook a price-to-earnings ratio five times that of Apple, the nation's most valuable company. Apple clocks in at about 20 times earnings, based on its most recent fiscal year, while Facebook would be valued at 100 times its $1 billion in annual earnings.
Such P-E ratios are a typical way investors measure the value of a company, although they also have to factor in the rate of a comapny's growth. But even if Facebook profits grow rapidly it will be years before its P-E ratio comes down to the level of other tech companies.
Morningstar analyst Rick Summers offers a preliminary valuation of $71 billion for the company and forecast a growth trajectory that would bring Facebook up to $40 billion in revenue by 2021, from $3.7 billion last year.
"Facebook’s ownership and control of its user data affords it substantial competitive advantages," he wrote in a recent research note. "Within Facebook, the company continues to build a rich database of friends, actions, demographics and applications."
Most of Wall Street's top tech industry analysts are barred from commenting on the offering because they work for one of the 33 investment banks underwriting the massive offering, which is expected to be priced Thursday and begin trading Friday on the Nasdaq stock market.
That leaves investors largely on their own, especially since most individual investors will be unable to buy shares until they begin trading publicly, when they easily could be far more expensive than the initial public offering price, which will value the company at an estimated $77 billion to $96 billion, according to the latest documents filed with federal regulators.
Facebook's 900 million-plus user base is far and away its biggest asset. It represents a huge number of eyeballs for exposure-hungry advertisers, along with a vast warehouse of data about users' online behaviors, preferences and habits. The company has done a good job of turning that data into dollars so far but will have to invent new ways to make that data generate revenue to justify such a rich valuation, analysts said.
Facebook recently raised eyebrows by reporting quarterly profits that were below year-ago levels, although revenues rose 45 percent.
"Growth is decelerating, but it's decelerating from enormous down to large," said Barry Randall, chief investment officer at Crabtree Asset Management LLC. "Its major problem now is managing people's expectations."
Summers, of Morningstar, acknowledged that the IPO hype glosses over some shorter-term issues with which Zuckerberg and his team will have to deal. "The market may be underestimating several near-term challenges for the company," he wrote.
Some analysts voiced concern that the rapid increase in Facebook's mobile traffic will continue to erode ad revenues. In March, the company had 488 million mobile users, which presents a challenge because the small screen size of smartphones means much less real estate for ads.
In an amended filing with federal regulators last week, Facebook said, "Growth in use of Facebook through our mobile products, where our ability to monetize is unproven, as a substitute for use on personal computers may negatively affect our revenue and financial results."
"The rapid shift from online usage to mobile devices that are harder to monetize is harming Facebook's growth prospects in the near and medium terms," Sam Hamadeh, founder and CEO of PrivCo, which does research on privately held companies, said in a report. Even analysts who are more positive agree that growth is slowing.
In a research note in response to Facebook's recent disclosure of weaker revenue numbers, analyst Ken Sena at Evercore Partners lowered estimates for revenue and earnings margins, although he still said the company was worth $130 billion to $150 billion.
Even if Facebook figures out a way to tuck ads into smartphone news feeds without alienating users, Sheehy said relying on online ads isn't going to be enough. "They have done a very, very good job at executing target advertising," he said, which is why Facebook was able to generate what Sheehy, of Generator Research, called its "tremendously impressive" $3.7 billion in revenue last year.
"But it's just not going to scale," he said. Even if Facebook triples ad revenue to $12 billion by 2016, that's nowhere near enough to justify a $96 billion valuation, he said. To do that, "They'd have to develop a completely new incremental business."
Analysts have plenty of ideas about how Facebook could do this. Morningstar's Summer pointed out that the site has already morphed from a social destination to an identity for users to log into other websites. It's also a platform for a growing slate of apps and layered networks like BranchOut, which Randall suggested could become a revenue stream in the future.
Eventually, he predicted, "They'll monetize it by allowing smaller companies to build businesses on top of their database and eventually charge them for doing so." The site also does a robust business in the sale of virtual goods, which could be the first step into selling physical goods and expanding into the burgeoning e-commerce and payments arena, following in the footsteps of eBay.
It's not impossible. Apple grew faster than Facebook would need to in order to justify a $96 billion valuation, but Sheehy pointed out Apple also revolutionized both the music industry and the mobile phone market. That sets the bar high for Facebook.
Evercore's Sena has faith.
"We believe that Facebook's ad model is only now just beginning to reflect the power of its audience platform," he wrote. "Moreover, while we continue to believe that Facebook will redefine advertising and that the company is on course to be the most valuable media company in existence."