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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