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Screens outside the Grauman's Chinese Theatre on Hollywood Blvd. advertise for people to "Become a Fan" of the theatre on Facebook in Los Angeles, Monday, May 14, 2012. (Danny Moloshok/AP/Danny Moloshok/AP)
Screens outside the Grauman's Chinese Theatre on Hollywood Blvd. advertise for people to "Become a Fan" of the theatre on Facebook in Los Angeles, Monday, May 14, 2012. (Danny Moloshok/AP/Danny Moloshok/AP)

Can Facebook live up to its IPO hype? Add to ...

The pricing of the biggest technology IPO ever rests on products and services still largely not invented.

Facebook Inc.’s initial public offering, expected to debut Friday, will put a price tag of as much as $104-billion (U.S.) on the social networking pioneer, and make the eight-year-old company more valuable than McDonald’s Corp. or Royal Bank of Canada.

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The IPO will be a key test of whether investors are willing to buy into the money-making potential of social media. Facebook’s meteoric growth has turned it into a phenomenon, but it’s still not clear whether the business of linking people together can generate the enormous profits needed to justify the company’s ambitious stock price.

At their debut, the shares will be valued at as much as 82 times Facebook’s earnings last year. In contrast, the broad stock market trades for only 14 times earnings.

To bring its stratospheric valuation into line with the market, the company must find a way to increase its earnings more than fivefold over the next decade.

The practicalities of doing so are daunting.

The social networker is working hard to expand its base of users – but with 900 million people already using its services, it would have to sign up most of the rest of the world’s population – outside China, where Facebook is banned – to achieve that fivefold increase.

More realistically, it could aim to boost the money it makes from its fans. Each user generated only $5.11 in revenue for the company last year. Facebook is counting on services that have yet to be devised to add to that total.

A key priority is finding a way to generate income from the growing number of people who connect to Facebook through smartphones and other mobile devices. In the company’s own words: “We do not currently directly generate any meaningful revenue from the use of Facebook mobile products, and our ability to do so successfully is unproven.”

Mark Zuckerberg, the company’s 28-year-old founder, chairman and chief executive officer, has been vocal about the need for innovative products that can generate additional fees or more advertising revenue. The company recently paid $1-billion to acquire Instagram, a photo-sharing service.

However, recent trends show growth is slowing. In the first three months of this year, average revenue per user declined 12 per cent, compared with the previous quarter. The company’s overall revenue growth dwindled to 45 per cent, down from 88 per cent for all of last year.

Whether the drop was “seasonal” as management suggested, or related to advertiser concerns about the effectiveness of the medium, the ride ahead looks bumpy. The Wall Street Journal reported Tuesday that General Motors Co. has decided to stop advertising on Facebook because the ads had little impact on the auto maker’s customers.

Facebook has been developing new approaches to appeal to advertisers, but it is not clear how successful they have been.

“Advertisers may view some of our products, such as sponsored stories and ads with social context, as experimental and unproven,” the company warned in its registration filing.

A $104-billion valuation for Facebook would translate to 33 times annual advertising revenue. In comparison, Google Inc. trades at just 5.5 times ad revenue. To fall in line with Google’s more modest valuation, Facebook must boost ad sales to $18.9-billion, or six times the level reported for last year.

At similar stages in their development, both Microsoft Corp. and Google managed to boost their revenue sixfold within eight years. But while most people in Canada and the U.S. have a Facebook account, the company’s services are still not regarded as essential in the way that Microsoft and Google’s are.

As it figures out its path to growth, Facebook is also going to have to rein in spending. Costs as a percentage of revenue reached 53 per cent last year, up from 48 per cent the previous year. If the social networker has to spend more to attract users, its profits will suffer.

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