Don't write off Facebook just yet

There is no technology or media company that has suffered the same abuse that Facebook has incurred over the past three months.

“Facebook is a fad” screamed online finance site Seeking Alpha only days ago; a few weeks back there were the claims that 90 per cent of Facebook ad clicks were fraudulent; then there were the claims that 90 million of Facebook's accounts were fraudulent; and back in May the news General Motors was taking its ad spend (albeit a relatively small one) out of Facebook was prominent in media across the globe.

Facebook is an easy target for the media and provides an easy anchor point for when they want to hypothesise about the ‘death of traditional media' and the rise of social media. And right now, Facebook is once again in the media's sites as its share price sits around the $US19 mark, less than 50 per cent of its IPO price and 57 per cent under its $45 high point.

The lazy thing to do is equate the current share price with the health of Facebook's current business. The problem is most are doing this. It's easy to look at the share price alone and not consider that Facebook, even at $19, is trading at a price/earnings ratio of 107.

The big question is how it could have been considered that Facebook at a P/E over 100 could be considered good value. The answer to that lies in two areas, both of which are relatively outside of Facebook itself.

The first area was the bankers involved in the Facebook IPO knew there was heat around the offering and priced according to the heat – which is ultimately what they were engaged to do. Still, Facebook at $38 was just too high based on the industry that provides the overwhelming majority of its revenue – advertising. Advertising is an industry that in a bad year can go backwards by 2-5 per cent and in a good year might increase 5 per cent. It is neither high growth nor stable. It's a rough and tumble, grind it out scrap that is ultimately influenced by factors completely outside its own control.

The second area is the industry that has developed around Facebook – the professional services category dealing in the cloudy, confusing world of social media. Social media, in a business development led whirlwind, has presented itself as the saviour of not just advertising but culture generally. Freedom in Egypt – put that down to social media. The election of Barack Obama? Another social media led success. Liberation in Libya? Say thanks to social media. Cancellation of Everybody Dance Now? Social media, naturally.

The category and its practitioners have spoken with such gusto and forced conviction that people actually started to believe it. And if social media is the future and the redefiner of most modern industry, then Facebook must be at the forefront of not just advertising, but humanity.

The issue is that despite all of the above, Facebook is still an advertising business. In the second quarter advertising accounted for $992 million of its $1.184 million in revenue. However, it's a good advertising business and it's growing. Its second quarter advertising results were up 28 per cent year-on-year, much more than the rest of the digital advertising category, which in display media terms sits around 4-6 per cent year-on-year growth. What's more, the advertising business is still in its infancy, with plenty of new ground for Facebook to farm around targeting, video, news feed advertising and insights.

Putting aside Facebook's second quarter loss of $157 million, which was wholly due to capital investments (the company has reported net income over $129 million each quarter since the second quarter of 2010), Facebook right now is a high growth company that can generate annualised net income in the vicinity of $1 billion off revenues around $4.5 billion annually. Assuming Facebook can grow revenue at 25 per cent per year for the next four years, this is a company that in 2016 could be generating in excess of $10 billion. At $10 billion, Facebook could deliver net profit of anywhere between $3-4 billion assuming costs stay relatively in line of where they presently sit. With that sort of income potential, the current valuation of $40 billion seems expensive but not outrageous.

However, right now Facebook even at $19 is trading at 106x P/E multiple, whilst Google trades at a 19x multiple. The same Google that owns the most lucrative category in all of advertising – search – owns the rapidly growing Google Display Network, is the dominant player in ad-technology with Doubleclick, the dominant player in the fast growing internet video space with YouTube, the major player in developing the mobile advertising landscape, and a dominant player in smart phone OS.

Facebook at a similar, sensible multiple would imply a stock price of somewhere around $10, if Facebook can deliver $1 billion of net profit annually, valuing the company somewhere around $19-20 billion. Not bad, but not $100 billion. But who seriously thought that Facebook was worth $100 billion?

The share price plunge of Facebook is a welcome one. It means the share price and the business are more closely aligned. They are still a long way apart, but it demonstrates that Wall Street now has decided to value Facebook on its performance and potential, not solely its hype. And it is doing the same with other tech companies, including Zynga, Groupon, AOL and Pandora.

Facebook is a great business regardless of what the share price is doing right now. It is growing, it is innovating, and it is generating solid revenue with strong upside potential. It is exciting advertisers and it is seriously worrying competitors. The real thing to focus on over the next few years for Facebook is the product, not the share price. And that's probably just how Facebook likes it.

Ben Shepherd is group commercial director at Dainty Consolidated Entertainment and blogs at Talking Digital.