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Facebook founder and CEO Mark Zuckerberg speaks to reporters at Harvard University in Cambridge, Mass., in this Nov. 7, 2011 file photo. The social network filed an initial public offering prospectus on Feb. 1, 2012, with an eye toward raising $5-billion.


Hype? Not really. Facebook Inc. is so much of what people say it is. It's an unquestioned technology leader with an astonishingly large user base. Its ability to customize advertising is something old-media companies only dream about. And unlike so many other tech offerings, the company is already deeply profitable.

That helps explain the rich valuation – 27 times sales, 100 times trailing earnings – that the expected $100-billion (U.S.) price tag on the company implies.

But what Facebook may not be any more is a growth story. Details provided in the company's filing this week for an initial public offering indicate that the social networker is a maturing company with an unclear path to boosting its sales. And that suggests that investors who buy in when the shares debut on public exchanges, probably in May, could find the Facebook offering a rather, well, unfriendly experience.

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To understand the obstacles ahead of the company, begin with a simple observation: Facebook can increase its sales and profits in two ways – by attracting more users or by producing more revenue from each of those users.

At the end of 2011, the company had 845 million "monthly active users" out of roughly two billion Internet users worldwide.

While Facebook says it "aim[s]to connect all" those Internet users, some are nearly sure to resist. Facebook already has 80 per cent penetration in Chile, Turkey and Venezuela, and 60 per cent in the United States and United Kingdom.

Facebook's own data show the challenge. While the year-over-year gains in users remain impressive, the sequential gains are shockingly small. The 845 million users in December, 2011, were just 5.6 per cent above September levels. (Facebook provided data for just the last month of each financial quarter of the past few years.)

In three of the four monthly data points Facebook provided for 2011, the sequential growth rates were in the single digits. (The growth rates are slightly better, but similar, for "daily active users," the number of people using Facebook on a daily basis.)

It's true that the number of global internet users will continue to increase, and that Facebook has more room to grow in certain emerging markets, such as India and Russia. What is the saturation point, however? Are there so many more millions of potential Facebook users in the near term? Or, put another way, how many people already connected to the Internet, particularly in the developed world, are waiting around to give this new "Facebook" thing a try?

(Don't hold out hope that Facebook's purported mission of connecting people so they can, among other things, hold their governments accountable will ever get the country entrée into China.)

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If user growth is slowing, that leaves the revenue per user as the key to Facebook posting stratospheric gains to justify its valuation. The Wall Street Journal quotes Kevin Landis, a portfolio manager who has bought Facebook shares in the private markets, as saying, "This is a company that has only just begun to scratch the surface of making money off those hundreds of millions of people getting on Facebook every day."

Well, that's one way to look at it. Another is that Facebook, to date, has been shockingly ineffective at mining its users for money.

Here's a statistic from the Facebook filing: "On average, users in the aggregate spent more than 9.7 billion minutes per day on Facebook on personal computers during December, 2011." (This leaves out all the Facebook time from users of mobile devices, where the company hasn't been able to figure out how to effectively display ads.)

Let's say that figure from December is typical of the full fourth quarter, which had 92 days. That's 892 billion minutes of user time in the fourth quarter. During that period, Facebook recorded $1.13-billion in revenue.

The math: It took Facebook almost 800 minutes of user time, more than 13 hours, to get one dollar in revenue.

Facebook futurists have all sorts of visions of the world buying its movie tickets or purchasing music or whatever else through Facebook, rather than any other online platform. And maybe that will happen.

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Or maybe Facebook is now what it always will be: A pleasant diversion for its users, who militantly refuse to pay for the service and are constantly complaining about their privacy and Facebook's attempts to monetize them using their preferences. (If you're on Facebook as much as I am, you know that's true. Or just log in to see yet another friend asking you to change your settings so their data doesn't get widely shared.)

Right now, Facebook is an amazing story. If it doesn't figure out how to take the next steps to evolve its business, however, we might look back and see the company has missed one of the greatest opportunities in business history.


Could Facebook post a loss? It's a strong possibility

Employee stock compensation is massive at Facebook – roughly 25 per cent of the fully diluted share count.

It'll show up in a deeply unpleasant way this and next year – in profit-killing charges.

Much as tech companies dislike it, they must follow accounting rules that say stock-based compensation is an expense. It's a non-cash cost that directly reduces operating margins and net income.

Facebook faces more costs than most. In a note in the IPO filing, Facebook says it has $2.463-billion (U.S.) of compensation expenses that it will recognize over roughly the next two years.

As impressive as Facebook's profitability is, it managed to produce just $1-billion in net income in 2011. That suggests that the stock-compensation charges will cut deeply into Facebook's profitability in the next two years — even perhaps swinging the company to a net loss, depending on 2012 results.

Would Facebook stock be expensive? The most expensive, actually.

There are plenty of stocks that have nosebleed valuations, based on one yardstick or another. Facebook is uniquely expensive, however.

We used Standard & Poor's CapitalIQ to screen U.S. stocks to find out if Facebook has any peers. Assuming a $100-billion (U.S.) valuation for the company, Facebook would have a trailing price-to-earnings ratio of 100 and a price-to-sales ratio of 27. Its enterprise value — market capitalization plus debt — would be 48 times its EBITDA, or earnings before interest, taxes, depreciation and amortization.

There are 5,725 companies listed on major U.S. exchanges, according to CapitalIQ. There are just about 130 stocks with a 100 P/E. There are just under 200 stocks with a price-to-sales of 27. And there are 107 with an enterprise value-to-EBITDA of 48.

There are none that achieve the heights Facebook does in all three metrics, however.

David Milstead

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