The Facebook IPO: What Went Wrong?

It has been a wild ride for Facebook during the past week — and it doesn’t seem to be over yet. The social networking giant — initially valued at $104 billion — held its long-awaited IPO on May 18, only to see its stock barely rise above the opening price of $38. By May 22, the stock had fallen by 18%, closing at $31 — reducing the value of the stocks sold during the $16 billion IPO by more than $2.9 billion. 

Although the stock has bounced back slightly since then, some investors have filed lawsuits over how the company and Wall Street banks handled the IPO. According to media reports, stock market analysts at Morgan Stanley — the investment bank that guided Facebook through the IPO process — and other banks lowered their expectations for the company’s earnings just ahead of the IPO, but only informed select investors.

Facebook had warned in its IPO filing about the challenges it was facing in mobile advertising: As consumers increase their use of mobile applications for sites like Facebook, the firm will need to figure out how to shift its ad sales accordingly to mobile platforms. It also cited growing competition from Google and social networking upstarts such as Pinterest, noting that users could simply migrate to another site.

Risks aside, few would have expected that Facebook, with its seemingly endless growth and strong revenues, would have had such a rocky debut in the market. But according to Wharton faculty and other observers, the problem is fairly clear: No one knows how to value the company’s 901 million users.

“Facebook certainly has a tremendous user base, [which] is more locked in than any social network before,” says Andrea Matwyshyn, a legal studies and business ethics professor at Wharton. Customers stay because the stories of their lives — photos, videos and status updates — are stored on Facebook. And although all of that personal information has value, she notes, advertisers still don’t know how to use it. For now, “valuing companies based on customer data is more art than science.”

What Is All That Data Worth?

Facebook noted in its IPO prospectus that, as of the most recent quarter, it garners $1.21 average revenue per user (ARPU) globally. In the U.S. and Canada, the company has an ARPU of $2.86. For 2011, Facebook reported earnings of $1 billion on revenues of $3.7 billion. For the first quarter of 2012, its earnings were $205 million on revenues of $1.06 billion.

“Facebook is really a data collection mechanism,” Matwyshyn points out. The problem is, however, that much of that data is not useful for calculating value. For example, how do you value “likes” — the recommendation mechanism used on the site? Moreover, she says, the valuation process becomes much more nuanced when you begin to compare one user who has 500 “likes” and 1,000 photos with another who logs on only once a week and doesn’t post. What would each user be worth to advertisers?

To gauge the worth of Facebook’s audience, Wharton finance professor Luke Taylor suggests that it makes sense to value the amount of time users spend on the site. “Facebook is replacing TV and other media as a form of entertainment,” he says. “How much are TV companies worth, and how much of that value can Facebook steal?” According to Taylor, the value of a Facebook user should take into account the total hours spent on Facebook relative to TV, the cost of producing entertainment (almost zero in the case of Facebook) and ad revenues. He adds that Facebook could evolve more like a TV network, with ad rates that vary depending on prime-usage timeslots.

Eric Clemons, an operations and information management professor at Wharton, says that no matter how you value a Facebook user, the numbers don’t add up. “Basically, the valuation [of $104 billion] is indefensible with what we know now,” says Clemons. “Facebook is 1,000 times larger than The New York Times [in terms of users] but its ad revenue is only a third larger” than the latter’s. He adds that the company will be nowhere near as profitable as competitors like Google without a new business model or new technology to better target users.

Wharton marketing professor Peter Fader agrees that valuing a Facebook user is almost impossible under the current circumstances. Unlike a subscriber for a telecommunications or cable company, Facebook users generally are not directly connected to revenue. “Valuing a Facebook user is incredibly difficult. You can’t value a ‘like’ unless there’s a clear link to revenue-producing behavior,” he notes. The challenge for Facebook is that its users don’t appear to be visiting the site for commerce or to view ads. “Facebook has the sheer size of its footprint, and that’s worth something — we’re just not sure how much.”

Room to Grow

The trick for Facebook in the future will be connecting its 901 million users to revenue, says Fader. Facebook’s best opportunity for growth will be by charging people real money, he adds. For instance, the company could launch a premium service that would offer more control, customized content and perhaps an ad-free experience. “The answer for Facebook could be a subscription model,” he notes.

Indeed, Facebook is in the early stages of launching a new offering for “Promoted Page Posts,” which allows organizations that administer Facebook pages to have their posts seen by more of the people who “like” the page than would normally be reached — for a fee ranging from $10 or so up to much larger amounts, depending on the total reach of the post.

Other analysts have argued that Facebook could grow its payments platform, which is called Facebook Credits, by encouraging small transactions among its large user base. Facebook’s commerce system is mainly used for in-game purchases of virtual goods via Zynga, which makes Farmville, Words With Friends and other popular games. In the first quarter of this year, Zynga directly and indirectly accounted for about 15% of Facebook’s revenues, according to Facebook’s regulatory filings. The game maker also accounts for all of Facebook’s Credits revenues. Analysts have noted that the symbiotic relationship with Zynga could become an issue for both firms. Social games aren’t as stable as advertising, because consumers are fickle, notes Wharton legal studies and business ethics professor Kevin Werbach, so it’s dangerous for Facebook to rely on them. For its part, Zynga is starting its own site to diversify away from Facebook. Zynga has said that nearly all of its revenue is based on Facebook distribution.

Pivotal Research analyst Brian Wieser said in a research note that he expects Facebook to diversify eventually into music and film rentals and sales. Wieser predicts that Facebook will have $1.7 billion in media content revenues by 2017. 

But until Facebook develops its business model along those lines, the company is largely dependent on display advertising — and for now, that is the primary challenge facing it. “Facebook has not yet been able to find an ad model to generate revenues commensurate with its valuation,” notes Saikat Chaudhuri, a management professor at Wharton. “Facebook has not articulated a clear mobile strategy in the wake of that platform’s proliferation — especially in fast-growing markets — and users generally appear sensitive to changes. While the potential to harness the user base is huge, it is not clear how exactly that will or can be done.”

Werbach agrees, and says that Facebook’s growth and profits will constantly be compared to Google’s. “Facebook has proven it can monetize social networking” to a certain degree, notes Werbach. “However, it’s far from clear that it’s as defensible as Google’s search advertising business has proven to be.”

Leading up to Facebook’s IPO, investors were rattled after The Wall Street Journal reported that General Motors was pulling $10 million in advertising from the site, saying that the ads had proven to be ineffective. Without state-of-the-art data and ad linkage, Facebook will likely need to plaster its site with advertising to generate more revenue. The risk for Facebook, says Fader, is that it could become another MySpace, a social network littered with ads. Users may then defect to another, less cluttered environment, despite the trouble involved with transporting their personal data.

Can Facebook create a sustainable business model? Definitely, say experts at Wharton. But until the company hones its model, the $100 billion-plus valuation is hard to defend. “I’m more agnostic than skeptic,” notes Fader. “Facebook’s valuation could be right, but there’s a good chance it could be lower.”

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