Last month, Facebook launched its much hyped Initial Public Offering (IPO) and promptly lost more than 25% of its valuation within only a few weeks of trading. Why was Facebook with revenue of just $ 3.71 billion, valued by the financial markets at $100 billion? What is the business model of Facebook by which can hope to generate enough revenue and profits to justify such an astronomical valuation?
To many observers, the Facebook IPO was like the dot.com bubble, which burst in 2000 and burnt a huge number of small investors. In the case of Facebook, along with the media hype that made Facebook stocks appear like the next big thing, it now emerges there were serious issues violations by the company and the Wall Street giants in promoting the stock.
Before we look at Facebook and its business model, let us look at how the financial markets really function as shown by the Facebook IPO. Facebook IPO makes clear that the primary objective of financial companies such as Goldman & Sachs, Morgan Stanley, JP Morgan, the companies involved in the Facebook IPO are there to create financial bubbles, draw in the small investors through media hype and let their big investors and themselves make a killing. William D. Cohan, the author of “Money and Power: How Goldman Sachs Came to Rule the World,” writes in Bloomberg , “When will small investors finally get the message that investing in IPOs is a fool’s game and that yet again they served as mere grist for Wall Street‘s IPO selling machine? The current IPO market — controlled by Wall Street’s cartel of five or six leading firms — exists only to benefit three groups of constituents.” Cohan identifies the three group as first, the financial companies themselves, the Wall Street sharks like Goldman & Sachs, their big trading partners, who furnish huge trading fees every week and therefore are privy to inside information, the third, the company owners and initial investors of the company being taken public through the IPO. The small investors, according to Cohan, may be the reason for which the stock exchange exists in the first place, but are just sheep waiting to be fleeced.
The Facebook IPO shows all of these characteristics. The hype of Facebook started with Goldman Sachs investing in Facebook and soon after giving it a valuation of $ 50 billion. The final figure fixed for the stock by the lead underwriter, Morgan Stanley was $38, making Facebook worth more than $100 billion. What was not disclosed to the public was that Facebook had already disclosed to its underwriters — Morgan Stanley, Goldman & Sachs, JP Morgan — that the rise in advertisement revenue was not matching the rise in number of users and therefore Facebook’s results for the second successive quarter was going to be less than what had been forecast. The underwriters informed the big private investors about this, who then cooled off on the Facebook IPO, while hiding this information from the public and allowing the small investors to get burnt.
For Goldman & Sachs, this was par for the course — remember how it was unloading toxic housing mortgages it held while still hyping it up for others? Here also, Goldman & Sachs unloaded its stock, which it had acquired even before the IPO. Many of Facebook investors including its management started selling their stocks the minute the IPO went on-line. More stock was unloaded by the insiders than what was on offer as IPO, the IPO being used to create a market for such privately held stock.
The SEC and other bodies are investigating what could be considered violations of security laws in the US. A number of law suits have also been filed by small investors against the underwriters and Facebook.
The financial shenanigans on Wall Street are not unique to Facebook. For anybody familiar with finance capital, this is how it has always operated. Fleecing the small investor or pension funds is the name of the game. When it succeeds, the financial companies make a killing. If it fails, then the tax payers have to bail them out, as they not only will take themselves down but also the economy. This is the new twist to finance capital, “heads we win, tails we still keep our bonuses and you shell out the cash to cover our losses”. This is now the war cry of capital in India also — liberalise, bring in more reforms — all of which transforms into give finance capital more freebies. This is what Manmohan Singh is promising Indian capital, while talking about a return to 9% rate of growth.
The Facebook’s failed IPO makes Mark Zuckerberg, the founder of Facebook, worth $20 billion, even if not $28 billion based on its initial valuation. He and the Wall Street sharks have still made a killing.
What is the business model of Facebook that allows a share value of $31 and a current market capitalisation of $75 billion for Facebook? How does Facebook make its money and how can the investors recover their investments?
Facebook has revenues worth only $ 3.71 billion, and profits of about $ 1 billion. Compare his to Google, which has also about the same number of users and has a revenue of $ 40 billion with about $11 billion of profits. Though it has 10 times the revenue and profits of Facebook, its market value is $200 billion, or only twice that of Facebook. If we do the simple maths, Google is valued at 19 times its revenue, while Facebook was valued for the IPO at 112 times its revenue.
Facebook has only one way of making money — it allows advertisers to target its users; 83% of its revenue came from ads. It is this ad revenue — allowing companies to sell to its 900 million users that provides the business model for Facebook. For Facebook, as it is for Google, its users are the commodity that is being sold to the world. As long as we use Facebook or Google, we are targets for ads, and it is the revenue from ads that sustains – or will sustain these companies.
Here there is one difference between Google and Facebook. In a Google search engine, we put in the search terms, and this allows Google to provide targeted ads based on what we are searching for. For Facebook, the only way to target ads is to use the personal data: what kind of friends we have, their preferences, what they like, etc. that provides the basis for targeting.
It is recognised in the ad world that untargeted ads are much less likely to generate sales, so the importance of targeted ads and the need for Mark Zuckerberg to get personal data of Facebook users. Facebook stores about 800 pages of information on its users — from religion, political views, sexual orientation, IP of every single computer from which you have logged onto Facebook, etc, etc. It even tracks its users after they have logged out to see which sites these users go to and what they read.
One of the ways that Internet companies track users is by introducing various tracking software into your computer when you visit them. They are the invisible spies on your machine which not only monitors what you do but also send this personal information of your activities to their host servers. Wall Street Journal did an analysis of various tracking software introduced by companies and discovered that a huge number of such tracking files are introduced by Internet sites. The simplest are “cookies” that track which sites you go to and your actions, the more complex are “beacons” that not only gather this information but also any text you type.
The other way that personal data of users is gathered is when you download and install apps. Facebook’s great edge has been its apps and allowing app developers’ access to Facebook. According to Wall Street Journal, “Apps are gateways, and when you buy an app, there is a strong chance that you are supplying its developers with one of the most coveted commodities in today’s economy: personal data.”
The Internet world of finance is simple: Facebook and Google, or other similar companies offer services that we do not pay for, except with our personal information. It is this information which is used for targeting us as consumers, and it is this targeted advertisements that rake in the ad revenues. This is the business model of Internet companies. That is why Facebook has to collect personal data of its users; that is its lifeblood.
Many countries have enacted privacy laws that forbid collection of private data. The trouble is that already, companies are collecting this data and using it for a variety of purposes, including selling ads to its users.
The problem with Facebook is that with almost all the Internet users already on it, there is not much room for expansion of its user base. So can its future potential of ad revenue justify such a high valuation?
For me, Facebook is highly overvalued as stock, but that is perhaps not very important except to its investors. However if a major expansion of its ad revenue does take place, it will come at the expense of existing media — print and television. Already, we live in a world starved of choices when we come to views in mainstream media. If such a diversion of revenue does take place, we may end up with only two major media companies — Google and Facebook. What then happens to diversity of views? Or of news which may not go viral such as videos of cute puppies playing with kittens? To regional media?
The Internet has diversified news, made it possible for all of us to be publishers and put a TV station in each house with if you own a video camera and a PC. It is also creating even bigger media monopolies that may drive out even the modicum of diversity we have today.
Yes, the Internet promotes diversity, but its business model does not. If Facebook’s valuation is even half-right, it may portend hard times indeed for existing media. Much as I dislike current mainstream media, this does not appear to be an attractive alternative either.