Breaking Down the Facebook Effect

By Nikhil Shamapant - July 7, 2012 | Tickers: AMZN, FB, GOOG, LNKD | 0 Comments

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With the screwed up IPO and the proceeding freefall, many investors lost money on Facebook (NASDAQ: FB). At current prices, down 20% from the IPO price, Facebook stock looks expensive and speculative at 100x earnings. Regardless, looking at Facebook’s business alone, it’s perfect. It's a service I use everyday, and it's clearly in demand. Peter Lynch says buy businesses that you know, and Facebook fits the bill. So for the everyday investor, what price should you look for to buy Facebook?

First, I want to direct you to this great article by fellow blogger Daniel Ferry. In his article, Daniel asserts Facebook, with all its speculation and hype, is being valued on the basis of its future business rather than its current one. According to the article, if you're worried about buying Facebook too high, the best way to find a "bottom" for Facebook would be to buy at a price that measures the value of the current business. Daniel approximates that value, using a Discounted Cash Flow analysis, to be $19. In his analysis, the only growth Facebook is allowed is that of its user base (still quite significant) and its penetration in international markets.

Another article, by well-known valuation guru Aswath Damodaran, has Facebook valued at $29 per share (his two articles on the subject are here and here).

For potential investors figuring out how to think about Facebook’s business model, I would like to suggest three main comparisons that seemingly have nothing in common with Facebook, but allow you to really understand the power of Facebook’s current position.

1. The Network Effect - Linkedin

Facebook is a lot like its best comparable company, Linkedin (NYSE: LNKD). It’s a rapidly expanding social network, so logically it’s competitive advantage comes from the Network Effect.  The more people Facebook has on board, the more interconnected the community, and the more value a Facebook account has to its users. More connections and people also increases the power of advertising on Facebook and makes it more likely that people won’t abandon it for another network. It’s tough for Google's (NASDAQ: GOOG) Google Plus to catch on because it doesn’t have the critical mass that Facebook has. At this size, it would be tough to stop Facebook from growing.

2. Unstoppable Growth and Unstoppable Trend - Amazon

Facebook is a lot like … Amazon.com (NASDAQ: AMZN). Amazon’s business is growing quickly atop a huge large-scale trend away from traditional retail to online retailing. It has a unbreakable moat in its distribution centers that it is developing out now, and it really looks like the perfect growth stock (High Growth+Competitive Advantage=Long Term Dominance). Facebook is very similar. It sits upon a huge worldwide social shift to social networking, which will quickly defeat email, snail mail, and any other mundane form of communication where you can’t hit the "Like" button. Moreover, it has a competitive advantage over all rivals due to the Network Effect, and its critical mass will keep any other social network from overtaking it or stealing its members. LinkedIn isn’t competition for Facebook because they clearly have completely different markets. No one "friends" their employers, and no one Facebook chats on LinkedIn. Sorry, I meant to say no one chats on LinkedIn, I just don’t really ever use any online chat outside of Facebook. It’s a daily process, recurring service, much like Google.

3. The Inevitable and the Need for Innovation - Google

In fact, the advantage Facebook has in its current position is much greater than that of Amazon for the same reason Google’s moat is so powerful -- it’s a self-strengthening cycle. The more people use Google, the more information is on Google. The more information that’s on Google, the more essential Google becomes to its users. Even Charlie Munger recognized the moat, saying he’s “probably never seen such a wide moat.”

The exact same concept applies for Facebook. Where Amazon has to invest in its competitive advantage, Facebook just has to not mess up. One thing that’s interestingly similar between the three is that they’ve all recognized the inevitable growth of their business models and already have begun to branch out into other businesses, recognizing that their current business is best left on its own. Amazon branched out into the Kindle. Still online retailing, but an aspect that had been left uncovered. Google branched out into practically everything: phones, cloud, email, failed TVs, failed social network, and another now ongoing social network (Google Plus). You can guess how I think that’s going to turn out.

I think looking at Aswath Damodaran’s valuation of Facebook at $29 and Daniel Ferry’s bottom valuation of $19, it’s fairly clear to me that at $31 Facebook isn’t outrageously overvalued anymore. Facebook’s upside now is the same that Google and Amazon are consistently trying to create, and the upside that Apple Inc. has not yet failed to create. Just a few years ago, Apple was overvalued based only on iPhone growth. Suddenly, the iPad appeared and away went those old valuation models. That's the same upside that Facebook has with its potential acquisitions of social gaming and its rumored smart phone entry and its recent Instagram acquisition.

Innovation is definitely something to keep in mind, and I think it’s important that any Facebook investor realize that it’s an inextricable part of the Facebook thesis right now. One day Facebook will be a value tech stock like Google of the present, but for now a bet on Facebook is a bet on Mark Zuckerburg’s imagination.

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