This is a guest post by Hernan Bruno. Professor Bruno is Assistant Professor of
Marketing at INSEAD, and a marketing modeller who uses tools
from statistics and economics to answer substantative marketing questions and
develop useful marketing and economic methodologies. Currently, he is studying
pricing issues in B2B markets. In particular, he is using actual transactional
databases from industrial companies to understand how prices affect the
long-term relationship between the customer and the selling organization, and
how price perception evolves over time in the context of repeated interactions.
He holds a Master in Research and a PhD from the London Business School.
If you follow financial or technology news,
you’ve probably already read plenty of stories about Facebook going public. You
know about all the Facebook millionaire (or billionaire!) employees, its
financials, its mission to “connect” the world, and the unusual degree of
control that Mark Zuckerberg will hold.
Last week I was teaching customer valuation in an executive
program and the topic of Facebook came up. We were discussing the idea
that relationships to customers could be thought of as assets that provide a
firm with a stream of earnings. For instance, I am a loyal Amazon.com customer
and spend about €500 a year on books and music. If Amazon.com has a gross margin
of 20%, then they can consider me an “asset” that generates about €100 of
earnings each year. We can then compute how much my relationship to Amazon.com
is worth to them in monetary terms. That number can then be used to guide their
customer retention activities, promotions, etc.
Now let’s get to Facebook and allow me to
use approximate numbers. According to the S-1
filing, they have 850
million users. They made $3.7bn in revenue and $1.0bn in profit in 2011.
These numbers mean that the average revenue per user was $4.4 and the average
income per user was $1.2 (I am rounding up, just to be generous to Facebook).
That last number matters. Any marketer worth
her name can estimate the value of a customer who provides a yearly income of
$1.2. Let me show you the easiest way to get a decent approximation of that
value. You will need 2 additional numbers. First, you need an idea of how long
the customer is going to stick around. We often use the retention rate, defined
as the probability that a customer who is active this year, would be active
next year. Companies measure this number by keeping track of the yearly
attrition rate of customers. Second, as in any valuation exercise, you need the
discount rate (e.g. people often approximate this using the Weighted Average Cost
of Capital). The approximate value of that customer assuming nothing changes is
m*r /(1+i-r), where m is the income ($1.2 in our case), r is the retention rate and i is the discount rate (see the Wikipedia entry).
I don’t know the retention rate or the discount rate for Facebook, so I will continue
to be generous and assume that the retention rate is 95% and the discount rate
is 9%. As it turns out, the value of a customer who yields earnings of $1.2 and
remains active year-on-year with 95% probability, discounted at 9% is $8.1. In
other words, the lifetime value of this customer is eight bucks!
The customer base as a whole is worth 850
million X $8.1 = $6.9bn. This is very far from $100 bn.
Maybe you think I am being unfair to
Facebook, because they are building new services, engaging customers, or
monetizing new features, and these will inevitably yield dividends in the long
term. As a result, the revenue and profit per customer will grow. Let’s assume
it does, by 5% a year, and the customer valuation goes up to about 12$. That
leaves the valuation of the entire customer base at $10.4bn, still one-tenth of
the implied valuation.
But I am also forgetting that the mission
of Facebook is to “connect the world”. And the world is much larger than 850
million users. What is the limit? Zuckerberg himself admits that it is unlikely
that they can reach the entire world population and they aim to reach, at best,
about 3 billion users. Let’s believe him, and compute again the valuation of
Facebook, with all our benevolent assumptions plus the assumption that
magically tomorrow they wake up with four times more users. Even this fantastic
scenario leaves Facebook with a valuation well below $50bn. And let us not
forget that the “untapped” market is untapped for a reason, and the next 850
million customers will not join Facebook as quickly as the first 850 million
did. Moreover, it is likely that the marginal customers are not going to be as
profitable and sought after by advertisers.
The point is to make sense of
the current valuation of Facebook in terms of the profits they can make per
user. If the value of the company comes from its discounted cash flows, and
those cash flows come from advertisers who want to reach the users and from
users who pay for specific services, we can easily link the value of the
company to the value of individual customers. I admire Facebook and I expect it
to grow in numbers and margins, but I am sceptical that this growth will be as
phenomenal as the valuation implies.
Admittedly, I left many things outside of
this little valuation exercise. I have not analyzed the value of the brand to
enter other categories (Facebook Phone, anyone?), or the technological
innovation that will come out of the team of millionaire hackers in Facebook’s
basement. Perhaps that is where the remaining $50bn are. In any case, let us
all agree that accepting that Facebook is worth $100bn means accepting that
they will take over the entire social media market very soon as well as grow
the profit per customer fast and consistently.
I don’t know what Facebook’s future looks
like, and I’ll be the first to admit that we should never underestimate great
companies in nascent industries. But I am still trying to link the market
expectations with the basic customer fundamentals. To justify its valuation of
$100 billion, Facebook will need to extract almost 15 times more profit from
each current customer than it does today.
An earlier version of this post appeared on the INSEAD Blog.
Also check out: Should Facebook break itself up? and GAFA: the new face of marketing.
Also check out: Should Facebook break itself up? and GAFA: the new face of marketing.
4 comments:
This is interesting, but even using simple financial measures you can come to the same conclusions. If FB's profit is $1bn, a $100bn valuation implies a P/E Ratio of 100. If the company had the same P/E as Google, say, it would be valued around $21bn. So there is a $79bn premium (over Google) built into the IPO price of its shares. What does that premium represent? And, to the author of this post, what does measuring customer lifetime profitability tell me over and above financial measures about Facebook's overvaluation?
This is a very interesting analysis. I have a reservation however with the approach regarding the retention rate. What makes the value of a service like facebook is not the existing customers who use facebook for marketing campaigns today but the potential business represented by the estimated (by Facebook) 850 users (not customers). The whole challenge for Facebook is to turn them into customers. The valuation should take into account hypothesis on how fast this conversion takes place.
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