Facebook versus Google – an Analogy

You must be living under a rock if you haven’t heard that Facebook went public last Friday. That is all most media outlets have been reporting for the last week.

Like most retail investors, I thought about getting some Facebook shares but that is all I did – think of it.

It opened at $38 a share. On the surface, that does not look like much but then consider how the share price of a company is reached. The price reflects how much an investor is willing to pay for the share based on the company’s earnings. Take Apple as an example. If Apple distributed all it’s earnings to all it’s shareholders from the last 4 quarters, each shareholder would get approximately $34 per share. Based on this number, investors decide how much they want to pay for Apple’s shares. Someone will say, I want to pay 5 times it’s earnings because I believe the company is growing. Another would say 10x and yet another 15x. This known as the Price-to-Earnings (P/E) ratio. In reality, Apple trades at about 15x earnings giving it a share price in the $500 range. Google also made about $33/share and trades at a PE ratio of about 16. In the world of investing, a P/E ratio of 15 is seen as cheap, making a company like Apple or Google worth a look.

Now let’s look at Facebook. It’s earnings per share for the last 4 quarters came to about $0.43 a share. At a price of $38, you are giving Facebook a P/E of about 89! Are you prepared to buy Facebook for 89x how it is earnings? Do you believe in the growth of the company that much?

This made me think of Google, a company seen as a direct competitor of Facebook. No one can deny that Google is making money hand over fist. They developed a good concept to make money out of search and it’s working great. Can Facebook do the same?

Which brings me to my story:

Somewhere in Middle America is a city called Net City. Net City is a booming metropolis with jobs, lots of good schools, great restaurants and growing industries. What it lacked 10 years ago was a way to find where anything or anybody was. The libraries were antiquated and the information centers badly staffed. Two young men, Larry and Sarge, decided to open a library/information/search center in Net City. They called it “Findle”. Soon, Findle was where everyone went to find stuff. All the out-ot-towners stopped there first. It was booming. They had devised a way to charge users of Findle for using the services. Since there was nowhere else to go for information, they held a virtual monopoly. Since most of the businesses realized customers could find them through Findle, they bought advertisement space at Findle. Life was good for Larry and Sarge.

Time went by. Net City grew some more. A young man called Mark opened a club where friends could meet, chat, shoot the breeze, gossip, whatever. He called it “The Hook”. It was unlike anything anyone had opened in Net City. The best thing was that it was free to become a member. Soon, everyone in Net City was a member of the Hook. For all it’s popularity and number of members, unlike Findle, it basically made very little money. As the operations grew, Mark got a smart lady called Cheryl to run the show. She convinced a few businesses to start advertising at the Hook. The problem is, most of the members went there to unwind and had very little interest in the commercials. And when they needed to find something, they went to Findle. If they needed to connect with someone, they went to the Hook.

In the mean time, Larry and Sarge opened a club of their own and called it Findle Plus. They wanted Findle to be not only a place you found things but also a place you could connect with others. It looked like they were going to put the Hook out of business but Mark and Cheryl hung on. The membership increased even more. However Mark and Cheryl realized that unless they could find a way to make money off all those members, the business was not going to grow like Findle. They wondered if they could advertise as aggressively to the Hook members as Findle did to it’s users. They wondered if they shouldn’t charge for membership. they wondered if making any dramatic changes would drive members away.

So how does the story end?

Unless Facebook finds a way to monetize the net experience of it’s 900 million users, I don’t see how the company merits the valuation it has.  Can it do that? I have no clue but then who thought social networking will be such a tour de force these days. Growing the company to 900 million members is no small feat. Monetizing their web experience might be an even bigger feat. If you bet on team Zuckerberg and Sandberg to do it, then $38 is a small price to pay.