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Why Facebook's Revenue Growth Won't Justify a $70B Valuation

We need how much?
Facebook's revenue in the first half of 2011 hit $1.6 billion, with almost $500 million in net income, putting it on track for a $3 billion year, according to a Reuters report. Last year, it was $1.2 billion in the first nine months, with $355 million in net income. If the numbers are accurate -- and you don't have to look far for reminders that anything you hear is bunk until a company files its S-1 -- it's an impressive rate of growth that doubles the pace of increase in users.

For Facebook, any business discussion comes in the context of its looming valuation and expectations of an IPO. If you work the numbers and look at the valuation the company has received, you find out that, indeed, Facebook literally could make enough money in a few years to justify the price its shares have seen in private transactions. But only if it got 75 percent market penetration. And that just doesn't seem feasible (although the eventual IPO will still be hugely successful and the venture capital firms will make a killing because, hey, it's Facebook going public).

Keeping track with user growth, at least
To get a sense of the revenue growth, look at the user growth for a moment. Last summer, Facebook had 500 million users. This year, the numbers is 750 million. That's 50 percent growth.

Now consider the revenue growth. The first nine months of 2010 had $1.2 billion in sales. Scale that by two-thirds to estimate $800 million in sales during the first six months. The first six months revenue for 2011 was $1.6 billion. That means Facebook has roughly doubled its revenue pace this year, which is twice the growth in users. Not too shabby.

Everything ends
But there are questions. One is how long the number of users can help fuel the economic expansion. According to Internet World Stats, there are about 2 billion Internet users in the world, or about 30.2 percent of the population. Figure that the easy adoption has occurred and further expansion will be far slower.

Also assume that Facebook could quickly get 100 percent market penetration (a highly unrealistic premise). That would represent a growth factor of 2.67 times. If revenue follows the model it has since last year, Facebook would multiply its current $3 billion pace by 5.3 times -- or $16 billion. That would seem a reasonable upper bound, barring new products or services that could significantly expand the company's earnings.

Facebook will make enough
Of course, 100 percent market penetration is unrealistic. But let's work the problem backwards for a moment. As I've previously pointed out, Facebook would need $12 billion in revenue to justify the $60 billion to $70 billion valuation range it has received, if you assume the same revenue to market cap ratio that Google (GOOG) has.

That $12 billion is roughly 4 times what Facebook will make this year. If the pattern of revenue growth being double user growth continues, the company would need to double its user base to 1.5 billion. Is that realistic?

According to a Pew Internet Project survey, 59 percent of U.S. Internet users were on at least one social network, and 92 percent of them used Facebook. That translates into a 54 percent market penetration into Internet users -- far lower than what Facebook would need.

To keep investors happy past a thin IPO that boosts prices to let the venture capital firms make a good profit, Facebook has to go far beyond the revenue it has been able to make from its relationships with users. How it can do that is the big question.


Image: Flickr user RubyGoes, CC 2.0.
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