Wednesday, January 5, 2011

The Facebook Valuation!

One of the biggest stories of the last week was Goldman's $ 500 million investment in Facebook for approximately 1% of the company. Extrapolating from the transaction, we obtain an implied value of $ 50 billion for Facebook, a number that has been making the rounds in news stories over the last few days. There are three questions that emerge from this news story: (a) With private businesses, can you extrapolate from a single transaction amount to an overall value? (b) Why would a company worth billions choose to stay private, when it clearly has the option to go public? (c) How would you value a share in a non-listed, non-traded company (as opposed to a publicly traded company)?

a. Can you extrapolate from a single transaction amount to an overall value?
Sure, as long as the transaction is an arms length one and all you are getting in return for your investment is a share of the company's equity. If, as is common, there are side benefits or side costs that go with the transaction, extrapolation will yielding a misleading estimate of value. In the case of the Goldman transaction, there are plenty of reasons to be skeptical. In addition to getting a piece of Facebook, Goldman also gets the following benefits:
a. Investment opportunities for Goldman's clients: As part of the deal, Goldman will be raising $1.5 billion from its clients to invest in Facebook. While this may seem to be a favor that Goldman is doing for Facebook, the reality is that Facebook is a hot company to invest in and this will allow eager investors an exclusive entree into the company.
b. A front seat for the Facebook IPO: If at some point in time, Facebook decides to go public, Goldman is likely to be the lead underwriter and reap a big share of the commission.
c. Private wealth management services to Facebook's potential billionaires and millionaires: When Facebook goes public, Mark Zuckerberg and a number of other executives will have the capacity to sell their shares in the market. While I do not expect a wholesale cashing out of equity positions immediately after the IPO, it is likely to happen over time, at which point these very wealthy individuals will need some private banking help and Goldman will be there to provide that help.
The profits and fees from these added businesses could account for a significant chunk of the $ 500 million that Goldman paid in this transaction. Exactly how much will depend on the likelihood of an IPO and the fee structure for the transaction. If, for instance, the present value of the expected fees from these side benefits is $ 200 million, the implied value for Facebook will be $ 30 billion, rather than $ 50 billion.
One more note of caution. Strange though this may sound, I would trust a market price derived from a consensus of a thousands of buyers and sellers to get the value right more than I trust the price from a single transaction, even if the buyer and seller are supremely sophisticated.


b. Why would a company worth billions choose to stay private, when it clearly has the option to go public?
Facebook's reluctance to go public may seem surprising. After all, the conventional wisdom has always been that companies like Facebook should get a more favorable response from offering shares in the public market place than from private offerings to venture capitalists and large investors. Here are some reasons, rational or otherwise, for why Facebook may be holding back:
i. Extending the tease: Looking at the favorable publicity that Facebook has got in the last week from the Goldman deal, it does not look like waiting to go public is hurting Facebook, at least for the moment. In fact, it may be making Facebook an even more desirable investment to those who cannot invest in it right now.
ii. "Proprietary" information: While I don't think that this is a big factor for Facebook, there are some companies that choose to stay private because they are afraid of revealing proprietary information about their products/services to the general market. Instead, they can provide the information, with sufficient restrictions on disclosure, to a few wealthy investors who can then invest in the company.
iii. Founder idiosyncracies: If the founder and majority stockholder in a company decides that he does not want the company to go public, the company will not go public. In the case of Facebook, it is entirely possible that Mark Zuckerberg has decided that he does not want to take the company public and he does not seem the kind of person who can be dissuaded easily.
iv. Regulatory and information disclosure concerns:  From Sarbanes-Oxley to SEC restrictions, public companies are constrained in ways that private businesses are not.
v. No valuation scrutiny: As a publicly traded company, no matter how well regarded it may be, the market valuation will be questioned by skeptical investors. Scaling value to earnings or book value, investors will argue that the company are over priced, relative to other companies in the market. (Take a look at Apple, Google and Netflix, all big winners over the last year, and you will see this phenomenon at play). Facebook gets to have the best of both worlds, again at least for the moment. We get glimpses of its immense value, each time a transaction is made, and no real way to examine whether the value makes sense, since we do not have access to much of the information we need.
In summary, Facebook is in a unique position. It has the profile to raise capital from wealthy investors are favorable terms and is getting many of the benefits of being a publicly traded company without any of the costs. Could that change? Absolutely. If there is bad news (or even rumored bad news) about the company and some or even a few investors have trouble exiting the company, the estimated value could melt down quickly.

(c) How would you value a share in a private company (as opposed to a public company)?
Let's assume that you are one of those lucky investors that has a chance to invest in Facebook. How would you go about valuing the company?
i. Financial data: You have to get your hands on some operating numbers. All you have right now is rumor: Facebook supposedly will generate $ 2 billion in revenues this year and there is no word on how much earnings they will have. You cannot value a company based upon information that is this threadbare and you will need fuller financial statements.
ii. Future projections: Once you have the information, you have to make projections for the future, valuing  Facebook just the way you would value any young, high growth publicly traded company. I have a paper on the topic. Normally, with private businesses, you will discount the value for lack of liquidity but I don't think this is a concern with Facebook shares, even if privately held.
iii. Ownership protections: I don't know about you but I just finished watching Social Network, the movie, and I am not sure that I feel secure that my ownership rights will be protected by the controlling stockholders at Facebook. I would need to make sure that there are enough protections in place for existing stockholders in the event of new capital being raised or an IPO.

So, is Facebook worth $ 50 billion? Based upon current revenues of $ 2 billion, it is richly priced; 25 times revenues and god only knows how many times earnings. The justifications that I hear from analysts for the high valuation are:
(a) An unprecedented platform: The 500 million users provide a platform that could generate much higher revenues and earnings in the future, but a lot of things of things have to go right for this to work out. I am not a big user of Facebook, but my gut feeling is that an overt commercialization of the space will make it less attractive to many users. So, it has to be subtle and creative commercialization... while fending off competition. (Remind me again what happened to Myspace, another hot place to be not so long ago).
(b) Goldman knows best: Smart investors (like Goldman) think its worth $ 50 billion. So, it must be worth $ 50 billion. This line of reasoning is so absurd that it is not worth pursuing. If you think that Goldman does not make big valuation mistakes, you are wrong. What Goldman does well is cut its losses, if it does make mistakes.  You and I will not have that option.
(c) The Big Story: To those who use the big story justification, everyone will be on a social network in the future, and you need to pay a premium to be part of the movement. Having heard variants of the big story before used to justify other bubbles (dot com, telecomm, PCs), I don't buy this. I think the market may be right about the macro story but is being hopelessly over optimistic about the micro pieces. In other words, we may all be parts of social networks a decade from now, but can all of these social networking platforms (Facebook, Twitter, Groupon...)  be profitable? My guess is that there will be a few big winners and lots of losers, before the final story is written. (Remember that the market was right in 1998 about dot-com retailing being the wave of the future but most dot-com retailers never made it through to nirvana. Amazon did and it is worth almost $ 80 billion, but it is the exception.)

51 comments:

Rob said...
This comment has been removed by the author.
Rob said...

Excellent post Professor Damodaran.

Personally, I think it's just Goldman jockeying to win over the underwriting business once Facebook goes IPO.

We are talking about the most anticipated IPO perhaps in the history of business. Goldman will do ANYTHING to gain a leg up, even if it means investing billions at a ridiculous valuation.

- Tech Insidr
http://www.twitter.com/techinsidr
http://www.techinsidr.com

Alex Osterwalder said...

Insightful perspective, Aswath. I've started to look at it from the business model angle in collaboration with others by reverse engineering their model here:
http://www.businessmodelalchemist.com/2011/01/reverse-engineering-facebooks-business-model-with-ballpark-figures.html

regards from Switzerland, Alex

K e m p f said...

Great post.

As it was noticed here in Brazil, it was a kind of fast valuation. I didn't read much in foreing news.

On the specialized news here, they say that Goldman's investors had just one week to decide if would they invest or not on Facebook. Moreover, they must sign s confidenciability term.

Maybe for some of the reasons you said, as the possibility of the IPO, Goldman have valuated Facebook in so higher price.

Come on, 25 times (suposed) revenues is crazy, but once more as you said, we don't know very much about Facebook, and probably Goldman knew.

FKempf

Regards from Brazil.

K e m p f said...
This comment has been removed by the author.
Krishnan said...

Prof Damodaran,

Thanks and very well written; I suppose the large ticket transaction that happened prior to the Goldman one was when some investors bought it at $75 / share (if I recollect, sometime in last July); I think it is steep, when the likes of Google are trading at 13x revenues

As you have correctly pointed out it, Goldman will make money by other means...

Cheers
Krishnan

Krishnan said...

Again going back to my previous comment, if one goes to secondtrade.com, one can see transactions of this type - $34 billion was the last valuation when a PE bought into it, I thought they had paid about ~ $75 could be wrong!

Thanks, Krishnan

al said...

In my view point a) explains the valuation. Indeed, in 2007 Microsoft valued Facebook at 15B while in 2009 a Russian firm valued at 10B.

It would be interesting to understand how negotiation works in these cases. Clearly public companies don't have that kind of negotiating power.

Basile24 said...

dear professor Damodaran, I miss your classes!!!
Best,
Ric

recon.lallu said...

hey, yes even me was amused by the valuations... i aint very sure abt the business model, but most of the value is generated from the api.. i guess... products are made by users nad facebook doesnt have ip rights related to these creations.. any competitor can seriously erode the first mover advantage.. even a sound analytics company like spss didnt get such valuations, and analytics is true ip.. unlike newspaper (read facebook) subscriptions :)

Navaneetha Krishnna said...
This comment has been removed by the author.
Navaneetha Krishnna said...

Dear Professor Damodaran,

Great article professor.

In my opinion, 25 times Revenues is supposed to be highly optimistic. Also, shouldn't Goldman be concerned that Facebook is still private and has liquidity issues? If I remember, last year same time, I never had a Facebook login, but was overusing Orkut. But today, I almost dont visit Orkut which share some qualities of Facebook. Giving due credit to Facebook, nevertheless, in my view, it's just time until someone else comes up with an even better business model.

Regards
Navaneeth

Nilesh said...

thanks Professor Damodaran, you continue to delight with great insights :)

tks,
nilesh

Saurabh said...

Professor,

The recent sell off in the Indian equity markets seems to be a situation of panick without any significant economic event.Although inflation is an area of concern, don't you believe that the markets do not reflect the current potential of the firms.I shall be really greatful if you could respond with a blog post on the recent debacle in the equity markets in India,Bangladesh and Pakistan.

Thanks
Saurabh

Aswath Damodaran said...

Saurabh,
Everything is relative. The market retreat looks like a debacle only if you compare it to where the index was a few months ago. If you compare it to where the market was 2 or 3 years ago, investors really have little to complain about.

Mike said...

Hello Professor,

Nice article, good points.

However, I think that you have left out one important point.

What is the business justification for Goldman for this risky investment?

Answer: This is a low risk, high reward investment. Goldman will have the upside and the taxpayers will have the downside. Remember Goldman got the TARP during the last crisis. They have every reason to believe that if they lose, they will be bailed out again at the taxpayers' expense.

I would like your insight into this moral hazard.

Aswath Damodaran said...

Not every activity exposes taxpayers to downside risk. In fact, what Goldman is doing is exactly what you want investment banks to do. The activities that should worry you are Goldman's investments in hedge funds or mortgage backed securities, where the potential losses are wide and deep. What potential downside is there to taxpayers in a Facebook IPO?

Mike said...

It might not be explicit.

If Goldman loses this facebook bet and other highly leveraged bets, they have an implicit guarantee to be rescued by the government. When that happens, who is going to foot the bill? You and me.

I believe that a few years ago, Goldman sank 100 million in webvan venture and lost.

If Goldman had no connections with Washington, and if it was not 'too big to fail', would it invest 500 million in facebook?

Mike said...

Yes, Goldman was here...

http://www.zdnet.com/news/online-grocer-webvan-raises-275m/102863

Saurabh said...

Thank You professor for replying to my question.Your explanation is justified.But does that mean we shall view valuation with a market cap perspective only in a 2-3 year relative time frame? I am a complete novice and do not understand the technicalities of valuation, shall be very obliged if you throw some more light.

Mike said...

Prof,

Perhaps this is a field outside your specialty.

If it's not, I would love to see a blog from you on the 'revolving door' between Wall st and Washington.
The nexus between wall st and Washington is dragging the country and the world down.

Please refresh your memory, or read this interesting article:
http://baselinescenario.com/2011/01/06/why-is-the-us-taxpayer-subsidizing-facebook-%E2%80%93-and-the-next-bubble/

Any comments?

Best regards,

Aswath Damodaran said...

Mike,
Goldman is not using leverage on this deal. That is why I am less worried about the taxpayer backlash. On the issue of the revolving door between Wall Street and Washington, I will demur. Implicitly, you are then suggesting that there is corruption in the process. If it exists, it probably takes the form of deliberate loopholes left in regulation. I don't believe that to be the case. I hesitate to attribute to malice that which can be explained by ignorance.

Mike said...

Well, I don't think it is due to malice, but I strongly believe it is due to Greed.

May be I am mistaken. May be you are right. May be there is no corruption.

Regards.

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Jyothi said...

Prof,

it was great to read ur comments on the goldman-facebook investment. In India too the deal was widely discussed among finance practitioners and many like me felt the valutaion didn't stack up by any yardstick whatsoever. Also in recent years, people's mistrust of Goldman and its ways of doing business, has grown and so even if there was a perfect logic to what they did, people would smell a rat.

Best regards

Jyothi

Carl said...

Does options methodology offer us a way to think about the implied valuation of $50bn? Could the pricing of investments from GS and their investors be driven by the value of out of the money calls, and might we be confusing implied market value with a grossed up options premium or an out of the money strike price?

vrraghy said...

Dear Professor,

I just learnt a lot on reading this post.

My only concern is this:
As you had stated, in a decade from now, every one of us would have to be in a social network, by sheer reality.
In that case, if every service provider goes commercial, the extent to which the end-user would be affected looks very high.
I feel that there arises a need of a social network emerging with a promise of remaining open and free.

Thanks for the knowledge.

Regards,
Raghavan VR

Bala and Insanity said...

Dear Sir,

Facebook haven't started monetizing beyond advertising. Seeing groupon's valuation, facebook could be worth more than $50 B.

Perhaps there is a bit of speculation and also a high risk factor, yet I feel a $50B valuation is logical.

With an excellent brand recognition and high scope for profitable diversification, would valuation based on current cash flows and growth expectations be sufficient.


Regards,
Bala

Mike said...

Hi Bala,

This valuation is educated guess.

As professor has already mentiond, 'What Goldman does well is cut its losses, if it does make mistakes'

Regards

alok agrawal said...

Excellent Article Mr. Damodaran, I visited your blog for the first time and really felt enlightened after going through such a nice articles. It remind me of one thing "Don't follows the herd,Instead use your own sense". If every investors think like you before investing then there will be no bubbles and no financial meltdown.

Felipe said...
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Felipe said...

Good Valuation exercise Facebook has been providing us.

It is quite a guessing work (or at least a painful process) to provide a concise Valuation to private company and its performance ratios before the firm becomes public and the relevant ratios becomes broadly analyzed by investors.

At this line of thought, it is unknown as well to determine the management quality and stance components and its future.

Questions emerge endlessly.

Will Facebook be a predator and jump into M&A attracting fast-growing companies like itself? Does geeks like Facebook´s Ceo, Mark Zuckerberg, can recognize others geeks in order to bring to light another internet phenomenon?

We frankly dont know, nor even Goldman does..

Great work professor enlighting the uncertainty around Facebook´s Valuation and i am afraid we will have to await more from firm´s top executives to answer some of those questions to provide a "fairly" valuation and nor guessing work.

End: Why are they so speechless?

Sunshine... said...

Prof. Damodharan,

Thanks for a very enlightening post. It was only today that me and some of my colleagues were discussing the same deal and I am of the opinion that like many other social networking websites, Facebook might also erode in positioning in a couple of years time as the security aspect of the website is diminishing with the ever increasing subscriber base. And this would surely lead to decrease in the value. Has such a thought not entered Zuckerberg's mind? If it has, then I feel that we may expect a facebook IPO anytime soon.

Please share your opinion.

Regards!

Mike said...

Hi Sunshine,

Are you implying that if the ceo Zucker expects a decrease in valuation, only then he might want to offer an IPO?

Mike said...

Sunshine,

You are right. The zuckers and the companies always do what is best for them. If Zucker thinks he will benefit from an IPO, he will go for it. If GS thinks it will benefit from a facebook IPO, it will support and promote the IPO - as long as the public is willing to believe them and take the offer.

mihaialexandrupop said...

fb is not IPOing, but linkedin is, so I think we can have take on that for the valuation issues of the sector.

Surely there are some major differences in the businesses, for once linkedin in ranks low on cool factor, and is the "straight" network, but on the other side it has probably the best audience at world level in one place.

Give it a thought, and lets try to make both of them more SMART, namely at some point to put some figures in the story.

Mike said...

Hi Prof,

Here is some inside information from a former Goldman employee.

http://www.youtube.com/watch?v=52D6gUb0GoY

richcp said...

I always love reading your posts. It keeps me grounded sometimes. Read my thoughts on Facebook Valuation.

http://www.richcp.com/valuations/

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joe said...
This comment has been removed by the author.
Florin said...

I think there are a few assumptions made if we believe that the price paid by Goldman is the right price:
1. Converting facebook's huge user platform to revenues. That is a huge step that has a high probability of FAILURE from my perspective. Because it's a social site, I don't believe that a subscription model would work and not convinced that ad revenues would be substantial
2. We are assuming that Goldman paid this price based on their assessment of 'true value'. Goldman has a good chance of finding a 'greater fool' through IPO not to mention the additional perks that you were talking about in your post

Socialfuel said...

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