When Facebook goes public this week, the company will be valued at roughly $100 billion.
It will be the highest valuation ever for an initial public offering of a tech company. Is Facebook really worth this much money?
One way to frame the question is to consider a single fraction.
The number on top of the fraction is the total value of the company. The number on the bottom is the company's profits over the past year. This fraction is called the price-to-earnings ratio. It's widely used by investors in stocks.
Over the past century, the average price-to-earnings ratio for big U.S. companies has been 15, according to Anant Sundaram with the Tuck School of Business at Dartmouth. The ratio for Apple is about 15. The ratio for Google is a bit higher.
One way to think about that: At current levels, it would take the average company 15 years to generate enough profit to pay for itself.
The picture for Facebook is very different. Facebook's price-to-earnings ratio is 100. At current levels, it would take Facebook 100 years to generate enough profits to pay for itself.
"Its price-to-earnings earnings ratio is astronomical," Sundaram says. "Off the charts."
That number is so high is because investors are betting Facebook's profits are going to explode.
Sundaram says judging from this price these investors seem to believe that the company's profits will double, and then double again, and then double again — all within the next few years.
For that to happen, Facebook will need to attract 10 percent of all advertising dollars spent on the planet "across all media – print, billboards, radio, television, Internet," Sundaram says. While this is theoretically possible, Sundaram says it's "an extremely low probability."
Last year, Facebook had just over $3 billion in global ad sales. TV ad sales in the U.S. alone last year were $68 billion.
But Facebook is trying to convince potential investors that it will grow into an incredible platform for ads. There are three key parts to this pitch.
1. Nearly 1 billion people now use Facebook.
2. The company knows a ton about its 1 billion users. If you're on Facebook, there's a good chance the company knows your age, gender, where you went to school, what you like, where you live and who you are dating or married to. That means Facebook should be able to do an incredible job of targeting ads to you.
3. In the long run, Facebook wants to figure out how to use your friends to help sell you stuff. So if your friend buys something — a meat grinder, a seltzer maker, whatever — and raves about it on Facebook, that can become an ad.
That last one — turning word-of-mouth recommendations into a massive new advertising system — is at the core of Facebook's long-term strategy.
Will this be the bomb that explodes advertising as we know it? Do social ads work?
"I don't think they have nailed that exact formula yet," says Rob Leathern, who advises big brands that advertise on Facebook.
Google is the obvious comparison here. The company started as a search engine, but turned into a cash cow when it set up automated auctions for ads that run next to search results. Those ads transformed the whole advertising industry.
Facebook isn't there yet. It doesn't have a cash cow. Leathern thinks the company will get there, but it's not a done deal.
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From NPR News, this is ALL THINGS CONSIDERED. I'm Robert Siegel.
MELISSA BLOCK, HOST:
And I'm Melissa Block. This week, Facebook is planning to raise more than $10 billion from investors by selling a small slice of the company to the public. In filings with the SEC, executives say Facebook could be worth more than $100 billion on its opening day of trading. After trading starts, many on Wall Street expect that number to grow and that could make Facebook more than twice as valuable as Goldman Sachs.
But, as NPR's Steve Henn and Zoe Chace from Planet Money report, such a high valuation comes with a catch. Eventually, investors will demand high profits to match.
STEVE HENN, BYLINE: Zoe, you know what's cool?
ZOE CHACE, BYLINE: A million dollars.
UNIDENTIFIED MAN #1: A million dollars isn't cool. You know what's cool?
UNIDENTIFIED MAN #2: A billion dollars.
HENN: Or, these days, maybe $100 billion.
CHACE: The movie, "The Social Network," was about Facebook just starting out a few years ago and, back then, the company was just worried about getting users. Now, the company's all grown up. One in eight people on Earth are on Facebook and now it wants to make some money.
HENN: Yeah. Again, $100 billion. That's what Facebook is saying the company is worth.
CHACE: And that would be the highest valuation ever for an initial public offering of a tech company. So is Facebook really worth this much money?
HENN: Right. That's the question everybody's asking and there's a way to size up the worth of a public company. Once the company's trading on the stock market, as Facebook is about to be, there's this little number people use to gauge its value.
CHACE: It's basically a fraction. The number on top is total value of the company on the stock market and the number on the bottom is the company's profits over the course of the past year. It's called the price-earnings ratio.
HENN: I talked with a valuation expert, Anant Sundaram, at the Tuck School of Business at Dartmouth, to gauge Facebook's $100 billion promise.
ANANT SUNDARAM: Its price-to-earning ratio is astronomical, off the charts, that are roughly 100 times earnings.
HENN: Apple is under 15.
CHACE: One way to think about that is it means it would take Apple almost 15 years to earn enough cash to buy itself. For Facebook, it would take a bit longer. It would take 100 years.
HENN: That number is so high because investors are betting Facebook's profits are going to explode. Sundaram says, judging from this price, these investors seem to believe that the company's profits will double and then double again and then maybe double again, all within the next few years.
He says to justify the hype, 10 years from now, Facebook will need to attract one of every 10 ad dollars spent anywhere on the planet. That's not just on the Internet. That's the planet.
SUNDARAM: Across all media - print, billboards, radio, television, Internet - and that, to me, seems extremely aggressive. Is it doable? Probably, but at extremely low probability is my guess.
HENN: When it comes to actually selling ads right now, Facebook is really still a baby in this industry. Last year, it sold a little more than $3 billion in ads globally.
CHACE: But television, old-fashioned television, sold $68 billion in ads just in the U.S. alone. It turns out that TV is still by far the biggest ad market and it knows how to spend that money. Every year, all the television networks throw a big party for their advertisers.
JOANNA SAPIENZO: It's their way of saying thank you. It's their way of saying, continue to advertise with us. Continue to - you know, you - we give them money, so they thank us for that.
CHACE: Joanna Sapienzo(ph) is at a party that's being thrown by BBC America. She buys ads on their shows. Internet Ad Auction is not.
JOANNA GATTO: It's like a combination of, like, "Clockwork Orange" and it's like the 1940s.
CHACE: That's Joanna Gatto, sales coordinator for CBS. It's old-fashioned advertising, lavish, but the weird thing is that, even people in television are totally enamored with Facebook.
I sat down with Mark Gall. He's a sales exec at BBC America. And he didn't talk ratings. He talked about Facebook likes.
MARK GALL: Yeah. Facebook is pretty cool and it's helping us.
CHACE: When I asked him about his biggest show, "Top Gear," he didn't talk about its audience or its ratings or how many people watched. Around the world, he says, 15 million people like it on Facebook.
Is that really big?
GALL: Yeah. It's huge for - you know, in the United States, it's probably the number one TV show with a social audience.
CHACE: So he's selling television ads and drinking the Facebook Kool-Aid.
HENN: Facebook couldn't talk with us for this story. They're forbidden to by the SEC because they're about to go public. But the company did make an ad itself last week aimed at investors. The goal was to convince investors that Facebook is going to become this incredible platform for ads and the pitch goes like this.
CHERYL SANDBERG: We offer a compelling value proposition.
HENN: That's Cheryl Sandberg, Facebook's number two in command.
SANDBERG: A unique combination of four things: reach, relevance, engagement and social contacts.
HENN: So, right now, Facebook says it has more than 900 million people and counting. That's its reach. And it knows a ton about these people. If you're on Facebook, they probably know your age, your gender, where you went to school, what you like, where you live, who you're dating or married to and maybe where you are right now so they can target these narrow demographic slices accurately. And it's just the beginning. Facebook's spending a huge amount of time and effort trying to figure out how to bottle up all your friends' likes and interests and hobbies and then use your friends to help sell you stuff.
CHACE: It goes like this. Steve, you're trying to get a meat grinder for your kitchen. Right?
HENN: No, not really.
CHACE: Well, you should because I just got one for myself and it's awesome. I'm going to send you the link and you should get it.
HENN: Capturing interactions like that one on Facebook and selling them as ads is Facebook's biggest pitch to investors.
SANDBERG: This is word of mouth at scale for the very first time.
CHACE: So this brings us to the big question. Right?
HENN: The $100 billion question.
CHACE: Are these Facebook ads - these ads that use your friends as unpaid pitchmen - going to become the bomb that will explode advertising as we know it?
HENN: Do social ads work?
ROB LEATHERN: I don't think they've, you know, nailed that exact formula yet.
HENN: That's Rob Leathern. His business is to help big brands advertise on Facebook. He says, when Google went public, they had this figured out.
LEATHERN: You know, I don't know that Facebook has yet come up with the exact formula the way Google, you know, built a great search experience and then they stumbled upon the ad words - what became ad words and which turned into the big cash cow for them. I don't know that Facebook has found that yet.
HENN: Now, just to be clear, Leathern thinks they will. He's investing all of his time and a lot of his own money building a business around Facebook's success, but he says it's not a done deal.
CHACE: In fact, earlier today, GM announced it was going to stop buying ads on Facebook because it's not convinced the ads work. I'm Zoe Chace in New York.
HENN: Steve Henn, NPR News, Silicon Valley.
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