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Money May 21, 2012

Facebook is a bubble and it will burst

By Vivek Kaul

So let me be a killjoy this Monday morning and say that Facebook is a bubble. And like all bubbles it will burst.

The price of the Facebook share closed at $38.23 at the close of trading on Friday. At this price the company was worth around $104.6 billion.The basic question that crops up here is that whether Facebook deserves such a high price. "It's exceedingly dangerous to pay a $100 billion valuation for a company that hasn't figured out a way to make money," Aswath Damodaran, a professor at Stern Business School, New YorkUniversity, told Barrons Online. Damodaran is one of the world's premier experts on valuation.

Facebook versus Google

Facebook earned 43 cents per share in 2011. At its Friday closing price of $38.23, the company has a price-to-earnings (P/E) ratio of around 88.4 ($38.23/43cents). Now compare this to Google, which is the closest comparison we can make with a stock like Facebook. Google had an earnings per share of $33 in 2011. The market price of the company closed at $600.4 on Friday, implying a P/E ratio of 18.2 ($600.14/$33). This makes Facebook around five times as expensively priced as Google (88.4/18.2). The P/E ratio is equal to the latest market price of the share of a company divided by its earnings per share.

Even if we were to look at the expected earnings for the current year, Facebook is expensively priced. Analysts expected Facebook to earn around 50 cents per share in 2012. This means that the forward P/E ratio of the company is at 76.5($38.23/50cents). Google's forward P/E for 2012 works out to 14, making Facebook more than five times as expensive as Google once more.

Facebook is a bubble. And like all bubbles it will burst.AP

Let us get into a little more detail here. Both Google and Facebook have around 900 million users. "There isn't much scope for growth here, really - we're beginning to run out of connected adults on the planet," points out venture capitalist Mahesh Murthy on his Facebook page.

Google had sales of $39.98billion with a profit of $10.83 billion. From almost a similar number of users Facebook had sales of $3.71 billion and profits of $1 billion. Hence Google makes average revenue of around $44 per user. At the same time Facebook makes average revenue of around $4 per user.

It is rather ironic that even though Google has average revenue per user that is 11 times that of Facebook and also earned a profit which was nearly 11times, the P/E of Facebook is five times that of Google.

So what are investors paying for?

Investors are essentially paying for the future growth of Facebook. As Kevin Landis, chief investment officer at Firsthand Capital, a Facebook holder, told Barrons Online: "The investment thesis is pretty simple. Facebook knows more things about more people than does Google, and those people have stronger emotional connections and loyalty because that's where their friends are...So given a few years to figure it out, Facebook could end up being worth more than Google, which has a market value of $200 billion."

One advantage with more user data is that Facebook can help advertisers reach their targeted audience better. When companies advertise in mass market mediums like newspapers or television channels they have no clue on whether they are reaching their target audience. But with Facebook they can be sure.

At least that is the story being bandied around by analysts who are bullish on the stock. But companies aren't buying this yet. In fact General Motors, a company with one of the largest advertising budgets in the United States, recently pulled its ads from Facebook, cancelling its $10 million Facebook advertising budget.

As Matthew Yeomans wrote in a recent column on in the Guardian: "GM clearly believes Facebook users aren't engaging in banner and targeted advertising and, in that analysis, the company is probably right. Frankly I've never met a single person (apart from those who work in the digital advertising industry) who believe online banner ads are effective".

This is something I totally agree with. What makes it even worse on Facebook is its cluttered look. In fact I only realised that my homepage on Facebook page has ads when I went looking for them. In comparison, the Google.com page has a very clean look and with a white background the targeted ads are easily available.

Given this, Facebook might find it a little difficult to grow its revenues. As Murthy puts it, "This (the valuation of Facebook) might make sense if there was room for Facebook to grow. Where is that? More ads per user? Would we really like that? More charges per ad? Advertisers are already smarting at FB's rates. Will you pay for apps on their store? Will you pay for premium listings? Not many will, I believe. The point is that FB will find it hard to grow its revenues per user - which is around $4 per year now."

In fact the revenue growth of Facebook is slowing. Its revenues for the first quarter of 2012 stood at $1.06 billion in comparison to $1.13billion in the fourth quarter of 2011. The primary reason for the same is the fact that more and more users are accessing Facebook from their smartphones. And smartsphone screens do not lend themselves well to advertising. Facebook admitted to this in a recent filing with the Securities and Exchange Commission, the stock market regulator in the United States, where it said "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."

Continues on the next page

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by Vivek Kaul

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