A business proposal disguised as a piece of reporting slipped through the editorial filters at the New York Times recently, which allows us to discuss how one might look at business proposals, or marketing plans.
The article in question "reports" the "projection" by some previously unknown "research" firm that the "value" of Facebook (the company) "could" reach $125 billion. This would be 2.5 times the value paid by the most recent round of investors, led by Goldman Sachs. The price paid by these investors is 25 times the annual revenues (which is not an official number but one that is being whispered about). Further, whispers have it that the price-to-earnings ratio would be close to 100. (Just for comparison, when Google went public, investors rewarded it a valuation of 40 times earnings.)
Why was this article published by the Times? It's one-sided, not authoritative, uses a sample of one, and contains no insight or analysis. In fact, it reads like a press release by the researcher known as Trefis. Worse, as I show below, the assertion is breathtakingly foolish.
My favorite line is that Trefis thinks that a valuation of $100 billion is "certainly possible". Is it possible to be "possibly possible" or "probably possible"? Or maybe "impossibly possible"? Trefis is "certain" that such a number is "possible" but not certain of that number, only that it is possible. My head hurts thinking about what they might actually mean by "certainly" possible.
As for the "math", Trefis claims that there are four developments that would push the valuation to $125 billion:
- ad revenues per page double
- page views up by 50%
- share of search market hits 10%
- game revenues per user double.
The first thing to note when reading this sentence is whether we should attach "AND" or "OR" between each condition. Do they need all four conditions to happen to justify the forecast or just one of four?
Usefully, an interactive graphic is included in the article, a quick check of which shows that changing one condition does not push the value to $125 billion. Here, I doubled the game revenue per user which expands the value to $54 billion, a far cry from $100-125 billion. (The Trefis value of $45 billion is what their base case is without the above four assumptions.)
This means investors would have to buy the "certain possibility" that within the next 5 years or so, a bunch of things will double.
Worse, what does it mean by "game revenues per user double"? In Chapter 1 of Numbers Rule Your World, I call this sort of thing " the discontent of being averaged". Facebook's revenues from games and apps are being averaged here, divided by the number of registered users. In the next 5 years or so, one would expect to see registered users grow, probably very rapidly.
Requiring that the average (per-user) revenue to double is difficult if the base of users stays put; when the base of users is also growing rapidly, it is quite unthinkable that you can double per-user revenue. Let say they have 1 billion users today, each contributing $1 revenue. If the user base grows to 2 billion, and we require that each contributes $2, then the total revenues would be $4 billion which is 4 times those of today!
The exact problem also applies to the "ad revenues per page views". Page views would need to soar dramatically to hit the valuation, which means this is another assumption of super-duper growth.
Averages are very dangerous things. It causes one to think simplistically, and oftentimes, simplistic logic leads to errors of great magnitude.
Finally, I did a little experiment. I can increase the registered user base which would increase game revenues per user, which would allow me to expand the value further to hit $125 billion. What would the registered base need to be by 2017 in order to get that valuation?
A picture speaks louder than words:
What's the world population again?
Maybe we have moved from "certainly possible" to "certainly impossible"?