Sunday, February 19, 2012 3 comments ++[ CLICK TO COMMENT ]++

Online Social Networks and the Ascent of Facebook

(source: Facebook)


As bizarre as this sounds, one of the most valuable innovations in technology over the last several decades is Facebook's "Like" button. That's what has propelled the company to a galaxy-orbit valuation for its forthcoming initial public offering, filed Wednesday.

This is not only because the word "like" is, like, the identifying word of an entire generation. It's because computing has evolved beyond just taking directions from humans—and instead is cozying up to us and sniffing out our emotions and intent.

— Andy Kessler, Wall Street Journal


Three decades ago, if someone had told you that a company that didn't make any physical products, had existed for less than a decade, and had less than 3,000 employees would be worth $100 billion, would you have believed it?

But here we are, three decades later, and stock market participants appear ready to award a $100 billion valuation to Facebook (FB). Are they crazy? Is this irrational exuberence taken to another level?

Mark Zuckerberg and his team have done an amazing job creating something out of, literally, nothing. Facebook's valuation does appear bubbly and contrarians like me would never buy it at these valuations. However, the company's fundamentals are far more solid than many skeptics claim. 

Facebook is not what it seems; the more I read about it, the more impressive it gets.

What is Social Networking?

Here is a quick recap of social networking through the ages ;):


I never read Time magazine but it was once famous for its Person of the Year award it gives out. I think the significance of that award has been lost, now that politicians and others accomplishing little in the world continuously keep receiving the citation, but, nevertheless, sometimes, it signals major social changes. Time may have been onto something when it named Mark Zuckerberg as Person of the Year in 2010 (Julian Assange of WikiLeaks was more deserving but Zuckerberg was a worthy pick as well). In justifying its choice for the 2010 Person of the Year, Time wrote a fitting description of why social networking has risen to such heights and why there is so much hype around it:

"On or about December 1910, human character changed."
— Virginia Woolf, 1924


She was exaggerating — but only a little. Woolf saw a fundamental shift in human relations taking place at the beginning of the 20th century "between masters and servants, husbands and wives, parents and children." Those changes, she predicted, would bring about transformations in every sphere of life, from religion to politics to human behavior. Few would say she got it wrong.

A century later, we are living through another transition. The way we connect with one another and with the institutions in our lives is evolving. There is an erosion of trust in authority, a decentralizing of power and at the same time, perhaps, a greater faith in one another. Our sense of identity is more variable, while our sense of privacy is expanding. What was once considered intimate is now shared among millions with a keystroke.


***

Evolutionary biologists suggest there is a correlation between the size of the cerebral neocortex and the number of social relationships a primate species can have. Humans have the largest neocortex and the widest social circle — about 150, according to the scientist Robin Dunbar. Dunbar's number — 150 — also happens to mirror the average number of friends people have on Facebook. Because of airplanes and telephones and now social media, human beings touch the lives of vastly more people than did our ancestors, who might have encountered only 150 people in their lifetime. Now the possibility of connection is accelerating at an extraordinary pace. As the great biologist E.O. Wilson says, "We're in uncharted territory."

Online social networks are radically changing the nature of life. One hundread and fifty "friends" may be the optimal number but I think people have many more social contacts when it comes to online social networks. I wonder if humans have permanently expanded our capacity to surpass the Dunbar number. I am having problems with information overload—can't even follow anything on Twitter due to too many tweets; and I don't follow too many tweeters either—but the younger generations seem to be adept at handling it, and keeping in touch with many more people.

I was planning to go into greater length on the importance of online social networks, as well as criticism of them, but this post is very long and I'll save it for another day. As one author once remarked, social networks are a reflection of human elements of nacissicism and voyeurism. Let's save the underpinnings on why they are popular for another day.

It's suffice to say that there are many different types of social networks that are forming. My feeling is that the Internet has magnified some activities that happened in the real world onto the virtual world. These range from mass broadcasting (Twitter), to professional networks (LinkedIn), to photo-scrapbooking (Pinterest), to you-name-it.

Some of the key benefits of online social networks are as follows (some of these are really benefits of the Internet revolution which are being magnified by online social networks):

  • Easily connect with friends, family and relatives: Once upon a time, it was difficult to keep track of friends you haven't seen in a while or who have gone in a different direction in life. Not anymore.
  • Socialize with strangers if you want: Depending on the social network and your nature, you can have a somewhat deep discussion with strangers as easily as with friends. In contrast, in real life, it is rare that you can start a discussion with some stranger, even if they work in your office building or live in an adajcent neighbourhood, without some difficulties.
  • You can observe or participate: Related to the prior bullet, it is more easier to observe things in online social networks and not participate if you don't want to. For instance, I forget the exact number but something like 40% Twitter users don't actively tweet. Similarly, I think  around 20% of Facebook users are responsible for more than 50% of the updates, photo uploads, news feeds, and other actions carried out on a regular basis.
  • Easier collaboration: We haven't seen the power of this yet but once online social networks are established, it's easier to collaborate. Right now, most networks seem primitive with only limited video chats and text communications, but imagine watching movies together with distant friends, or listening to a music mix that is being mixed live by one of your friends. Possibilities are endless.
  • Share interests and hobbies: In the past, people often formed hobby groups or social gatherings for particular interests. If you were in a town with few others who shared your hobby, you were all alone. This has dissipated with online networks.
  • Cheaply save information, photos, favourite lists, etc: Capitalizing on the low-cost, widely-accessible, Internet, mobile telecommunications, and data storage revolutions, online social networks have made it easy—even for people who aren't tech-savvy—to upload pictures, videos, and the like. In fact, in many cases, it is easier to upload photos to a social network than to your home desktop PC or laptop—this would have been unthinkable even 10 years ago!
  • Innovation at the speed of the Internet: Online social networks are mostly driven by software innovations (and less dependence on hardware), and they are able to innovate at the speed of the Internet; whereas the desktop PC and laptop, not to mention corporate computing, are hampered by slow hardware updates and software development cycles.
  • Lower search and transaction costs: Online social networks make it easier to find goods and services that interest you more easily and cheaply than traditional sources. One of the reasons Google feels threatened by companies like Facebook is because, asking your social network to recommend a restaurant, for example, will bypass traditional Internet search. 

This rest of this post will focus on Facebook, which is the strongest and, at least in my mind, the network that encapsulates the greatest benefits (and dangers) of online social networking. I'll primarily look at Facebook as an investor and will ignore issues pertaining to its social impact.

Thoughts on Facebook's Business Model

If rumours and speculations end up being correct, Facebook will end up being priced at ridiculously-high P/E and P/S multiples. I haven't checked the numbers but Anh Hoang at GuruFocus reports that if the market prices Facebook at a market cap of $100 billion, it will be "valued at 100x P/E, 106x free cash flow, 67x operating cash flow and 15.8x its book value."

These are extremely high multiples for a large-cap company but I believe the numbers are a bit misleading and not reflective of the potential, underlying, business characteristics. Facebook's sales and earnings are depressed right now in my eyes. Facebook's revenues is as follows (thanks to SplatF for the graph):

(source: "How Does Facebook Make Money?" SplatF.  February 3, 2012 12:14 pm)

Facebook takes in almost $4 billion but, obviously, this isn't good enough to support a rumoured $100 billion valuation.

Facebook hasn't started monetizing its service and there is lots of room for revenue growth. Facebook has been focused on attracting customers for the last 5 years and now that it has a huge customer base—more than 800 million active users and several hundread in USA alone—it will likely focus on trying to earn money from them.

I see many similarities between Facebook and Youtube in terms of their revenue potential. Readers may be aware that I'm really bullish on Youtube's business prospects. Youtube has something like 500 million viewers but doesn't earn much from them; but it is the in process of trying to monetize their services. Facebook is kind of like that, with it having a huge userbase but very little revenue. (I haven't researched this but it wouldn't surprise me if radio was like this in the very early days: lots of listeners but little revenue and uncertain business model.)

The question for Facebook (and Youtube) is whether they can retain their customers and maintain strong customer relationship as they try to increase revenues. They may lose some customers along the way but I suspect most won't flee (more on this when I talk about its moat).

Tech writer Robert Scoble commented in a post on where future Facebook revenue may come from. The first item he identifies is the potential from mobile devices, such as smartphones. Facebook doesn't really earn anything from mobile right now, even though it is heavily used in mobile phones. This should be the easy fruit for Facebook. Scoble also provides some insightful thoughts on the potential from their partners who use the Facebook platform:
Open Graph is only one way. Companies like Foodspotting push information INTO Facebook, but they don’t get value out. Developers, like Foodspotting, tell me they are hearing rumblings that Facebook is developing a new kind of advertising. One that looks sort of like Ad Sense, but that push ads out to Open Graph partners. Spotify, for instance, has pushed five billion songs INTO Facebook. Imagine when Facebook pushes ads OUT to Spotify!
Not only does Facebook have huge advertising potential, it also will likely earn higher fees since it is more targetted than even what Google offers. As Nicholas Thompson of The New Yorker pointed out,
Precise targeting is the reason for one of the most impressive statistics in the much-ballyhooed I.P.O.: as Facebook sells more ads, it has made more money off of each one. In contrast, across much of the rest of the Web, ad prices keep dropping because inventory keeps soaring.

Unlike many other Internet businesses, Facebook also has great potential in new revenue streams. Many seem to think of Facebook as generating most of its revenues from advertising, and hence tend to compare it to Google. As the chart above shows, advertising has been most of its income over the years, but I suspect that mix could change significantly.

The chart already shows how Facebook is starting to earn revenue from payments and 3rd party activity. I think Facebook will become more of a platform—this seems to be Mark Zuckerberg's vision—and will end up earnining significant revenue from their partners. In article for Fast Company, E.B. Boyd commented on the strategy (as usual, bold highlights by me):
A year ago, at Web 2.0, Zuckerberg explained Facebook’s goals. “Over the next five years, most industries are going to get rethought to be social and designed around people,” he said. Media industries, in particular, he said, “are going to be completely re-thought.”

Facebook didn’t want to do the re-thinking for those companies, Zuckerberg explained. Instead, it wanted to be a platform that those industries could build their new social selves on top of.

“We should play a role in helping to re-form and re-think all those industries,” he said.

The new Timeline that Facebook launched today, and the new class of social apps, is the next phase of implementing that vision. Facebook becomes a platform that allows other applications to build more sharing directly into their own offerings.

And while this certainly conforms to Facebook’s mission to make the world a more open and connected place, it can also conceivably contribute mightily to Facebook’s bottom line.

***

The partners that have decided to join forces with Facebook, like Spotify, Hulu, and Nike, presumably hope that what Zuckerberg says is true--that adding a social dimension to their offerings will lead to more consumption.

Spotify CEO Daniel Ek told the audience at f8 that Facebook users who use Spotify today listen to more music on a weekly basis than non-Facebook users, listen to a wider variety of music, and are twice as likely to pay for music.

“In the old days, we used to go to each other’s houses and browse through each other’s record collections. Until now that hasn’t’ been possible online,” Ek said.
As mentioned in the example above, imagine someone who listens to a song on Internet radio through Facebook and then purchases a song. Facebook could easily earn a chunk of every such transaction. Facebook can essentially become a user's Internet home, fulfilling the dream of Internet architects from the late 90's to build portals and personalized sites:
“Think of Facebook City,” said analyst Tim Bajarin of Creative Strategies Inc. “Ultimately, while they would never create a walled garden, they could create a community where once you come in, you pretty much have all you need there.”

Facebook’s goal, he said, is have more users making purchases, do their banking or even making dinner reservations in the site.
It's not clear how successfully Facebook will execute on some of these ideas. Facebook only has around 3,000 employees—an amazingly low size for a company potentially valued at $100 billion—and it remains to be seen if it can grow without losing its edge.

Customer Base Likely Near Peak

Some in the investment, technology, and media communities seem to be paying a great deal of attention to Facebook's customer growth, but I think this is a flawed approach.

Facebook's customer base is likely near the peak. I don't think the number of Facebook users will grow much further. There will still be increases from population growth and entering new emerging markets but that is likely to be limited. For instance, untapped markets like China will still be out of reach due to privacy issues and the existence of a totalitarian government; similarly, many countries with draconian governments—Middle East, most of Africa, some South American countries, some South Asian countries—will be out of reach of a social network like Facebook where real life names, pictures, etc are shared. My understanding is that anonymous social networks are popular in some of these regions—Facebook clearly isn't based on an anonymous social network business model.

So, Facebook has probably captured most of the Internet users. They can try increasing activity frequency—a customer using Facebook once a week may be converted to someone using it once every couple of days—but that's about it.

Going forward, everything will come down to monetization of existing customers.

To use an online video streaming analogy, Facebook is like Youtube (GOOG) rather than something like Netflix (NFLX). Netflix can still increase its subscriber base because there are still a large number of users who don't use Internet streaming to view movies and television shows. In contrast, Youtube is already being used by almost everyone. Youtube needs to focus on monetizing their existing users and worry less about attracting new users. Similarly. Facebook really can't grow its userbase very much and will spend most of its effort on earning revenue off the existing customers, and ensuring that the customers are retained.

Does Facebook Have a Powerful Moat?

I think so.

But like all moats, they can deteriorate if not maintained.

Successful venture capitalist and blogger at AboveTheCrowd.com, Bill Gurley, rates Facebook on key criteria he has developed as follows:


Bill Gurley is a venture capitalist and is a growth investor, hence, I suspect he focuses on peak (exit) valuations and is short-term-oriented. He is extremely bullish and thinks the company has a strong moat.

You can see how the thought process of growth investors and venture capitalists differs from value investors, who are generally long-term-oriented, by looking at the last factor, growth, in the table above. Bill is concerned that sales growth may be topping out on a quarterly basis. This is important for short-term-oriented growth investors, especially those pricing in huge growth expectations and hence paying high valuations for Facebook.

In contrast, if you were a long-term investor, looking out 10 to 20 years, the sales growth decline in the near-term is not so important. After all, it is a certainty sales will slow down over time as the company grows, regardless of how good your company is—case in point is present day Google, and, I suspect, pretty soon, Apple. What you really care about is the growth rate over the next 10+ years. This rate is not going to average anywhere near the current 88% sales growth in 2011.

I think Bill is way too optimistic with his rating of Facebook on the factors he cited. Nevertheless, I largely agree with his views on the strength of Facebook's moat.

I say it has a moat because user activity and brand loyalty is very strong—so far! Take a look at the type of activities customers use Facebook for, in the following infographic slightly edited by me (go to the original source for the full infographic; data refers to early 2011 figures):

(source: From the article "Obsessed with Facebook," Mashable. January 12, 2011)

I don't know how accurate the sampling in this infographic is but I find it quite amazing. Think about the type of activities: News! Daily status updates from friends! Photos! These are critical elements of one's life. They are all habit-forming!

It's amazing to think how almost half of the youth and young adults rely on Facebook to inform them of news events. As these individuals get more used to the platform, develop a greater dependence, and grow up and age, Facebook's moat is likely to become very strong. Facebook will probably end up having a stronger reputation as a news source than a newspaper website.

How many would leave Facebook if they can't transfer their photos over? Right now, the photos are probably more "fun" and "experimental" than anything meaningful but people will likely cherish these photos as they age. Just check out the following promo video from Facebook showing how the current generation is building memories like the prior generations did with Kodak film and photobooks:


I forget where I read it but I think it was an insurance executive who said that the #1 thing people save from a burning house, apart from living things, is their photobooks. People would rather run into their burning home and grab their photos than their wallets or laptops or their fancy clothes. How many of those people who upload photos to Facebook are going to switch easily to another platform? As long as Facebook stays somewhat close to the latest technologies and makes improvements—for instance, the resolution of pictures on its site is lower than Google's—it will get harder and harder to dislodge.

Based on Bloomberg's compilation of Facebook data, the percentage of users that have visited the site daily versus a monthly basis has increased over the years:
"In last year’s fourth quarter [4Q 2011], 57 percent of users went to Facebook daily. The proportion climbed from a low of 44 percent in the second quarter of 2009."
What this tells me is that people are using Facebook more and more for daily needs, such as the ones cited in the infographic above.

Once you develop a habit at a youthful age, you are likely to stick by it for your entire life. A lot of demographic trends—fashion & style, car purchase preferences, television viewership—tend to depend on what individuals were influenced by when they were young.

The switching costs are going to be enormous pretty soon! As most investors may already know by now, switching costs are a huge barrier to entry. The only other company that comes anywhere near Facebook in terms of high switching costs is probably eBay (a different business). Facebook has a sizeable moat and it may end up being one of the biggest in the Internet space.

Just because you have a moat doesn't mean you can't be dislodged—ask Nokia or RIM about Apple—but as long as Facebook continues to build its moat, it does increase the probability of long-term survivability.

Is Facebook Overvalued?

Based on analysis presented in the following Business Insider chart, Google's revenue from each customer is around $24 per unique user versus Facebook's $4/user (note that these numbers are from early 2011 before Facebook disclosed detailed numbers so they are not the most recent, but this doesn't detract from my analysis).


Although Google and Facebook are not exactly the same business—I tend to think of Google as more of a search or content aggregation company whereas I treat Facebook like a media platform or portal-type company—Google's numbers do give a rough estimate of what Facebook is capable of earning.

An excellent article in Reuters points out the possibilities:
Internet advertising is expected to grow at an annual average rate of 15.9 percent to $113 billion in 2014, from an estimated $84.2 billion this year, according to Zenith Optimedia. That makes the Internet the second-largest ad market behind TV, which by 2014 will reach $215.7 billion.

Facebook currently commands only a sliver of agency ad dollars. In 2011, Sorrell said WPP spent $1.6 billion with Google and just $200 million with Facebook. This year Sorrell, who labeled Google a "frenemy" in 2006, expects to spend $2.3 billion with the search giant and $400 million with Facebook.

Sorrell said the disparity is because of the greater difficulty of monetizing social media. Not to mention that the increased competition with Google in recent years has made it a "friendlier frenemy," Sorrell added with a laugh.

"Facebook is a superb branding medium, but right now it is more about PR than advertising," he said.
The fact that WPP, a leading, global, advertising agency, is doubling its Facebook spend from $200 million to $400 million, shows the strong interest from advertisers. We are not talking about small increases here and there; we are seeing big commitments by serious players.

So, when I say that Facebook's present sales and earnings are depressed, they really are. I would be shocked if Facebook's long-term earnings are at the same level as now.

Aswath Damodaran, Finance Professor at NYU Stern School, has a done a detailed valuation estimate for Facebook so anyone interested in Facebook should check out his blog post. Using an approach that assumes Facebook's growth will mirror (actually slightly best) what Google has seen post-IPO over 8 years, he arrives at the following valuation for operating assets:
Discounting the cash flows back at the cost of capital (with changes over time) results in a value of $71,240 million. To get to equity value, I subtract out the outstanding debt ($1,174 million) and add the current cash balance ($1,512 million)...

Value of equity = $71,240 + $1,512 - $1,174 = $71,578 million
Google's growth trajectory for Facebook looks very aggressive but if you think, like me, that Facebook's sales are severely depressed then this isn't as risky as it seems. You are looking at a potential Golden Goose in, what I believe could be, a winner-takes-all-type market (common in Internet services with strong networking effects, like Ebay or Amazon).

Damodaran went on to produce a graph of valuation distribution based on various factors. As he remarks, "As with my Groupon valuation, I ran a simulation,making assumptions about distributions for my key assumptions (revenue growth, operating margin, cost of capital and reinvestment)":

(source: "The IPO of the decade? My valuation of Facebook," Aswath Damodaran, Musings on Markets. February 16 2012)

Based on the simulation above, it looks like Facebook should be worth between $42.6 billion and $116.7 billion, with the median around $70.9 billion. The highest probability seems to be around $62 billion. (All this based on very aggressive Google-like growth expectations. I haven't seen Damodaran do a business analysis so I'm not sure if he actually believes Facebook will grow like Google or if he is just doing a hypothetical scenario here.)

My Estimate of Facebook's Market Cap

I have pretty much come down to using a crude method to value stocks: the P/E multiple. No wonder my investment returns suck ;) In any case, I like using multiples to value companies because there can be huge errors in estimating detailed growth rates. It's better to just pick a rough long-term profit figure and think about whether the company can sustain that.

One should keep in mind that a lot of Facebook's users are foreign users and their revenue potential is far lower than in rich countries like USA (at least for the next decade or so). Regardless, Facebook should be able to increase their revenue to at least half of Google's per-unique-user figure to arrive at around $12/user. Given Facebook's current userbase is around 800 million, this means that Facebook can probably earn $9.6 billion in revenue eventually, or slightly more than double its current revenue. If the company maintains its competitive positioning, its revenue will surpass this figure eventually (say 20 years and beyond) but it won't grow beyond GDP or Internet adoption rate or something like that.

It's difficult to estimate earnings from the sales figure (since profit margins are more complicated with companies like these; they likely won't scale up linearly due to it being a low-asset service industry) but it wouldn't surprise me if that quardrupled from the current $1 billion or so, to around $4 billion.

Net income of $4 billion on sales of $9.6 billion means that Facebook will have an extremely high profit margin of around 42%. This is very high and usually unsustainable but it is possible in Internet services which tend to have low assets, few employees, and have low marginal cost for each additional customer (it's kind of like the software services industry). Although rare and every entrepreneur and competitor will want a piece of that profit pie, Facebook can probably sustain that as long as it maintains its moat (anyone investing in Facebook needs to make a judgement on whether it can maintain its moat).

If Facebook does maintain a profit margin close to 40% over the next two decades, it will probably have the highest for a large-cap company. For example, assuming Yahoo! Finance numbers are correct, Oracle (ORCL) has a profit margin around 26%, Apple (AAPL) is at 26%, Google (GOOG) is at 26%, and Microsoft (MSFT) is around 33%. If Facebook can execute successfuly on its plans to dominate its market, it'll be like a super-charged baby Microsoft—at least for the next decade.

If we apply a multiple of 15, that pegs Facebook's valuation at $60 billion. I'm using a P/E of 15 because that's the very-long-term market multiple and Facebook likely has a lifespan beyond 30 years. (I did my calculation long before I encountered Damodaran's results and the fact that it is in his ball-park figures gives me some confidence in my number.)

Since conservative investors should buy with a margin of safety, I think the company is attractive around $40 billion to $50 billion. That's not going to happen any time soon and conservative investors likely will be out of the market for a long time (but that's the price you pay for being conservative—the sexy stocks are out of reach until they falter).

Even with these figures, do note that there is a lot of speculation, particularly the growth trajectory, built into the figures above. Facebook needs to execute and it's dangerous to buy companies on the hope that they will—growth investors don't mind doing this but value investors should stay clear. This is why you need to buy the company at, say, $40 billion even if you think it's worth $60 billion.

Key Risks Facing Facebook

Facebook's biggest risk as a public company will involve maintaining strong privacy and customer relationship, while it strives to boost sales. As Reuters reported in a story,
The big question is whether Facebook can further evolve its advertising offerings, which are tempered by privacy laws and the changing parameters around how social networks can mine user data for targeted marketing.

"Their ad product opportunities aren't too robust right now, and the effectiveness is spotty at best," Hayes said.

Facebook has come under criticism for the way it has used member data in the past, including in 2008 when its Beacon advertising product was assailed for disclosing such things as what purchases people were making on Amazon.com to their friends without permission.

Companies have also removed ads from being displayed against offending user or group profiles, not unlike how brands pull commercials on television shows in protest.

Facebook listed the evolving nature of privacy and data protection laws as two risk factors that could impinge future growth in a regulatory filing.

Still, the key for Facebook, according to David Eastman, president of digital at JWT, which is part of the WPP group, is keeping Wall Street at bay while it figures out how to monetize its role as an identity broker.

"I'm worried about how the IPO will affect creative," said Eastman. "I'm worried that the demand for growth and making numbers will get in the way of really evolving the platform to figure out how to monetize influence."
Mark Zuckerberg is setting up Facebook—somewhat like Google and its dual-class shares—to ensure that Wall Street doesn't pressure the company to favour short-term profits at the expense of benefitial long-term strategy. These non-standard corporate governance structures are very anti-democratic and shareholder-unfriendly but if you believe in the key executives running the company, then it is actually a better way of running the company.

On top of numerous other problems, my opinion is that one reason MySpace fell off a cliff was because of the buyout by Rupert Murdoch's News Corporation (NWSA; NWS) completely altered the company and its culture. On top of not understanding the Internet, my guess is that News Corp didn't invest enough in MySpace. It seems unlikely that Facebook will face those problems any time soon but it remains to be seen.

The biggest difficulty for Facebook will come when governments start getting their hands into the business. There is no better way to manipulate the population, not to mention "track down the evil-doers," than to access data from companies like Facebook. I'm curious to see how Facebook, as well as companies like Google, handle these emerging issues. Companies like Amazon and Ebay rolled over dead and didn't challenge the US government (and other governments) when they were pressured by politicians (without court rulings) to cut off funding for WikiLeaks, and I'm curious to see if Facebook will stand up for its users or not. Microsoft, from my impression from some cases in China and Russia, also has a habit of not standing up for its consumers and business users when governments act outside "the law." Unlike all these other companies, Facebook contains way more private data, and if the public loses faith in it, it's all over for the company. In contrast, a company like Amazon can still continue operating as a less-trustworthy online retailer. Facebook won't have that option.

The Future of Facebook

I started off by quoting Andy Kessler's article in The Wall Street Journal, espousing on the innovation of the "Like" button. For those not familiar, the "Like" Facebook button, which you may have seen on many websites, allows Facebook members to indicate articles and products and brands and songs and movies and clothing items and websites and many other items that they support—or like. This enables Facebook to understand the preferences of customers, and build a narrower demographic profile. As Kessler continued in his article,
That's where the Like button comes in. The adage about advertising is that only half of ads are effective, but no one knows which half. So companies will drop $3.5 million to NBC for a 30-second Super Bowl ad. Or run Keystone Light ads on Comedy Central. They may work, but advertising—ask P&G—is an industry ripe for productive innovation. With the Like button, Facebook is like Bob Eubanks on "The Newlywed Game," who promised contestants "a prize chosen especially for you." Advertising's nirvana is an ad chosen especially for you. Of all the players, Facebook is the closest to delivering.
Facebook takes the revolution in advertising to the next level, from the peak reached by Google. As some of you may be aware, Google revolutionized advertising by reaching potential purchasers, just before they were about to make a purchase. I covered this in an earlier post where I quoted the excellent Charles Petersen essay in The New York Review of Books (bolds by me):
Google’s executives realized that ads on search engines reach users at a singularly receptive time: unlike readers browsing through articles on a news website, users of search engines are often looking for something very specific. A user who asks a search engine, for instance, “Where can I find the best car insurance?” would be a more promising potential customer than a visitor to a news website, because by searching for car insurance a user signals that he or she is, at that moment, in the market for car insurance. A car insurance ad programmed to appear next to the results of such a search would allow the advertiser to target its most desirable audience.
Facebook takes it to the next level by allowing advertisers to learn what individuals want before they even purchase something.

It'll be interesting to see if Facebook can successfully navigate the privacy issues that it will face, as advertisers start using its users to make a profit. Will there be a consumer backlash? Will the users feel as if their privacy is being used without any benefit to them?

Or will Facebook consumers actually be happy with advertising that is relevant to them? Instead of sifting through irrelevants ads, as their parents and grand-parents had to do, will they be happy with offers that seem tailored to their tastes?

The newspaper and television industries made a living by successfully selling their customers to advertisers, without incurring a big backlash. It remains to be seen if Facebook, and others like it, will accomplish something similar.

Regardless of how you look at it, Facebook is powerful and likely to stay. Its estimated valuation seems too high but I do think it has a big moat, that can potentially morph into a very big one.

Hope you enjoyed the writing. I'll be revisiting in 9 years when the valuation is much lower ;)

Oh, all this written by someone who isn't on Facebook—yet!—and has no "friends."




Useful References (starred are recommended):

* Facebook Inc. Form S-1 Registration Statement, SEC.

"How Facebook makes money could change" by Benjamin Pimentel, MarketWatch. February 2, 2012.

* "Facebook IPO $100 Billion Valuation Is Not So Overpriced" by Anh Hoang, GuruFocus. February 3, 2012.

"Why Facebook will be worth a half trillion by 2015: the mobile and open graph revenue it’s leaving on the table" by Robert Scoble, Scobleizer blog. February 1, 2012.

* "The IPO of the decade? My valuation of Facebook," Aswath Damodaran, Musings on Markets. February 16 2012.

"Why Facebook Clearly Belongs in the 10X Revenue Club" by Bill Gurley, AboveTheCrowd.com. February 1, 2012.

"As Facebook grows up, it courts Madison Avenue" by Peter Lauria, Reuters. February 5, 2012 8:18pm EST.

"Retailers Shut Facebook Storefonts Amid Apathy" by Ashley Lutz, Bloomberg. February 17, 2012.

"New Facebook Timeline Is All About Discovery And Explosive Revenue Growth" by E.B. Boyd, Fast Company. September 22, 2011.

"Person of the Year 2010 Essays: Only Connect" by Richard Stengel, Time. December 15, 2010.

* "Opinion: The Button That Made Facebook Billions" by Andy Kessler, Wall Street Journal. February 2, 2012.

"News Desk: What Facebook Can Sell" by Nicholas Thompson, The New Yorker. February 2, 2012.

* "In the World of Facebook" by Charles Petersen, New York Review of Books. February 25, 2010. (Book reviews of The Accidental Billionaires: The Founding of Facebook, A Tale of Sex, Money, Genius, and Betrayal by Ben Mezrich; Stealing MySpace: The Battle to Control the Most Popular Website in America by Julia Angwin)

* "Generation Why?" by Zadie Smith, New York Review of Books. November 25, 2010. (Reviews of "The Social Network," a film directed by David Fincher; You Are Not a Gadget: A Manifesto by Jaron Lanier)

"Mind Control & the Internet" by Sue Halpern, New York Review of Books. June 23, 2011. (Book reviews of World Wide Mind: The Coming Integration of Humanity, Machines, and the Internet by Michael Chorost; The Filter Bubble: What the Internet Is Hiding from You by Eli Pariser; You Are Not a Gadget: A Manifesto by Jaron Lanier)

"Small Change - Why the revolution will not be tweeted" by Malcolm Gladwell, The New Yorker. October 4, 2010.

"Ask the Author Live: Malcolm Gladwell on Twitter," The New Yorker. September 29, 2010.

"The Face of Facebook - Mark Zuckerberg opens up" by Jose Antonio Vargas, The New Yorker. September 20, 2010.

"A Woman’s Place - Can Sheryl Sandberg upend Silicon Valley’s male-dominated culture?" by Ken Auletta, The New Yorker. July 11, 2011.

"More Than Half of Facebook Users Need Their Dose Daily: Chart of the Day," Bloomberg

"Tweet Science" by Joe Hagan, New York. Published Oct 2, 2011.

"Influencing People - David Fincher and 'The Social Network.'" by David Denby, The New Yorker. October 4, 2010.

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3 Response to Online Social Networks and the Ascent of Facebook

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March 22, 2013 at 5:14 PM

Its amazing how quickly all of this stuff has happened. It was only in the nineteen eighities that computers started to replace typerighters. It was only around the year 2000 when plain old cell phones started to become really popular. Things that used to take many decades to occur are happening in one decade. Although their are many advantages to some of the new technology. I see this whole thing leading to one big blowup some time in the not to distant furture. And the primary cause of that blowup. The creation of jobs or I should say the very subpare creation of jobs will only worsen over time because technology is increasing enabling companies to grow without adding significantly to their worforces.

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