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Is that reasonable? Suppose that Facebook eventually needs to settle at a P/E of 10:1. Then it needs $5B/year of profits. If Facebook is like Microsoft in that it can maintain a high profit margin due to continuing to successfully exclude any competitors from its market, just as it has so far (in Microsoft's case, through a combination of government-granted monopolies, criminality, and consistently not fucking up; in Facebook's case, perhaps not) then it could have profits like that with as little as $6B/year or so of revenue. Presumably, within a couple of years, the majority of the internet's users will be Facebook users, which is something like two or three billion people.

Is it reasonable to expect Facebook to extract US$2 to US$3 per year per user? It's hard for me to imagine how they could fail to extract several times that. If nothing else, the blackmail value of the data they already have on hand ought to be larger than that. ("Upgrade to Facebook Premium today in order to have the option to keep your past private messages from being visible to all your Facebook friends!" But it probably wouldn't be done in such a public way, in order to dampen backlash.) They can probably also sell preprocessed datasets of people who read subversive literature online to national intelligence agencies: not just the US and UK, but also Egypt, China, Pakistan, Syria, Italy, and Russia. If laundered through some kind of data broker, they could even get plausible deniability.

That would be out of keeping with the kind of privacy invasion Facebook is currently well-known for, though, so it probably wouldn't happen without a change of control of the company first.

So the mere $50B valuation represents an assessment that Facebook's popularity could be short-lived, or that it could become subject to much more intense competition than it is today, driving its revenues down toward their costs.

I hope to God that Goldman is right.




10:1 would be a fairly low P/E anytime soon for Facebook. They might need to settle there when they're a 35 year old company like Microsoft (which is currently at 12:1). Google is at 24:1 right now and Amazon and Netflix are pretty hot at the moment with 66:1 and 72:1 respectively.

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I think 10:1 was the eventual P/E that would have to materialize to justify the $50 billion valuation. I think the historical average is something like 15.

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but they have 30 years to reach that. The historical average is probably brought down by much more mature companies. Most tech corps today are 20+, hell Apple and Oracle have almost same P/E at 20 which might be the new average for tech.

10:1 is low.

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Yeah, I was thinking of the 30-60 year timescale. The higher P/Es you're talking about are either the result of suckers or the result of expectations of continued substantial growth over the next decade or three. The historical average is brought up by companies like Apple and Oracle.

Long-run stable P/Es could rise if the internal rate of return of the economy as a whole fell, so that a good safe investment was one that paid 2% instead of 4% after inflation. That could happen under circumstances like these:

- If the peak-oil doomers turned out to be right, and our economic growth actually does turn out to be contingent on continually increasing fossil-fuel consumption; or

- If much of what we think of today as "profit" was actually destructive extraction of natural resources (e.g. overfishing); or

- If some kind of sustained disaster makes profitability difficult (e.g. the aftermath of global thermonuclear war, widespread coastal flooding destroying coastal cities, widespread Farmville addiction, or the gradual collapse of the Westphalian state system in the face of decentralized guerrilla warfare); or

- If we shift to a less efficient way of allocating productive resources than transparent capital markets, to an even greater extent than currently (e.g. war and other forms of theft, taxation for the benefit of wealthy bankers, insider trading, central government planning for the benefit of the politically well-connected).

I consider these scenarios unlikely.

If, by contrast, we keep inventing and putting into practice ways to produce more and more value for less and less effort and natural resources, and knowhow becomes more easily accessible rather than less, then we can expect that the internal rate of return that stocks must compete with in order to get investment dollars will go up. Which means long-run P/E ratios will go down.

To make this concrete, suppose that in 2029, you have US$20 000 to invest. (I'm speaking in 2011 dollars here to avoid talking about inflation.)

In 2029, Apple has settled down to a share price of $100 with annual earnings of about $10 per share (a P/E of 10:1), and no particular expectation that that is more likely to go either up or down in the next few years. So you could buy 200 shares of Apple and get about $2000 a year out of it, with some risk that Intellectual Ventures Hummer Winblad will get greedy and sue Apple into bankruptcy two years from now.

Alternatively, you can buy solar panels and sell the power back to the grid at the going wholesale rate of $0.015/kWh. In 2029, silicon solar panels have finally been edged out of the market by quantum-dot solar panels, which have an energy payback time of 3 months in a sunny climate. Like silicon solar panels, they're made out of some of the most abundant materials on the planet, and their fabrication is fully automatic, so essentially all of their cost is profit, the cost of the risk capital invested in their manufacture, and the energy dissipated in their manufacture. The energy dissipated is $0.033 per average watt, $0.011 per peak watt, but because of the large investments involved and the rapid expansion of solar panel manufacturing, that's only 10% of the actual purchase price of $0.11 per peak watt.

So instead of buying the Apple stock, you can buy 180 peak kilowatts of solar panels, which will generate 60 kilowatts, averaged over day and night, winter and summer. Instead of earning you $2000 per year, this will earn you $7900 per year, and your only risks are that energy prices fall further or someone steals your solar panels.

Since your objective in this investment is to make money, you buy the solar panels, as does everybody else. People sell their Apple shares in order to carpet the Gobi with solar panels. Consequently Apple's share price falls. Eventually it reaches US$25 per share, at which point its P/E is 2.5:1, and it's competitive with the solar panels again.

As long as there are investments available with rates of return similar to those I've postulated for solar panels above, shares will tend toward that 2.5:1 P/E ratio. They aren't doing it now because there are only very limited investments available with such high rates of return: installing a more efficient furnace in your house, maybe, but how many houses do you have? Solar panels, though, and thorium extraction from seawater, and automating custom manufacturing --- those are scalable investments.

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Why do you assume the price of energy (and solar panels, for that matter) would stay constant as investors flock to blanket the earth with them?

I like your general logic - but I disagree strongly with your prediction that buying solar panels will generate 40% return on investment (in year 1!) in 2029.

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> Why do you assume the price of energy (and solar panels, for that matter) would stay constant as investors flock to blanket the earth with them?

I don't; the energy price I used is about a third to a quarter of today's wholesale electrical price, and the solar-panel price is about a tenth of today's. I assume that those prices will drop rapidly. I think they will probably drop a lot further than that, but it's very difficult to imagine what will happen when some resource drops in cost by more than a factor of ten.

> I like your general logic - but I disagree strongly with your prediction that buying solar panels will generate 40% return on investment (in year 1!) in 2029.

I'd like to disclaim that prediction! It was a scenario, not a forecast.

It doesn't have to be solar panels specifically, but my point is that over time, we may develop capital goods whose internal rate of return is well over the 3% we've become accustomed to. (Solar panels are a plausible candidate because their production is already highly automated, they're made of dirt-cheap raw materials, and they produce energy.) If that happens, whether it's solar panels or automated moon factories, P/E ratios will drop --- at least until the new exponential takeoff hits some resource limit. In the case of solar panels, that will probably be land, until we construct a Dyson sphere.

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I'm curious, why would a company "need to settle" at a certain P/E ratio?

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If a company is not growing anymore, the only reason to own shares is to get dividends. If the P/E ratio is too high, then the amount of annual dividends per dollar of share won't be worth the risk of the company going bust.

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Who even says they would pay dividends? How many tech companies do nowadays?

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Stocks make investors (contrasted with traders) money either by (a) going up in price or (b) paying a dividend every quarter. In order to make your stock price go up, you have to show not just profits, but growing profits. With something like Wal-Mart, this just means either cutting costs or selling more stuff to more customers. However, Facebook is going to (over the next few years) approach market saturation - they hit 500 million users 6 months ago, and there are only two billion internet users world-wide, meaning they can't keep growing at their historical pace forever. As that user growth slows, there are two ways to increase revenues (and profits) - either extract more money from each user or diversify into other products or services. If they can't do that, then they have to reorient into a "own our stock because we pay dividends" slow-growth company like Microsoft.

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A company can also buy its own stock. In the short term this has little impact on the stock price, but as future profits are shared among a smaller pool of investors you can cycle though rising price and splits even with a stable income stream.

PS: This is only really efficient when the P:E hovers around 10:1 but it has great tax implications for long term investors.

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Most tech companies do stock buybacks rather than dividends. From the point of view of shareholders, it is almost the same thing.

Here are the differences. Dividends generate ordinary income, which people may have to pay taxes on. Dividends drop the price of the stock by the amount of the dividend.

By contrast a stock buyback reduces the value of the company and the outstanding stock by the same amount, and therefore leaves the stock price alone to first order effects. Over time this increases the likelihood of incurring long-term capital gains, which are generally better from a taxation purpose.

The never stated difference, which I think is important, is that dividends hurt anyone holding options, while a stock buyback increases volatility which helps anyone holding options. Since tech companies tend to have lots of employees with options, this matters a lot to them.

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Very few, and why does anybody buy their stock? This guy I know has been borrowing more and more money for years and never paid a red cent back, and now you want to lend him your money?

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A company does not need to pay dividends in order to be worth to have a share in it. As long as the assets of the company are stable or growing, owning a piece of it is like having a secure bond. Dividends are either profit sharing when the company can't do anything productive with their extra cash... or attempts by management to keep their valuation afloat in order to collect bonuses.

I'd say that if a company has extra cash, it is better off paying its long term debts rather than dishing it out to the shareholders. Stock valuations rise and fall, but the underlying stability of the company should be worth more.

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A share of a company is in theory optimally priced when it has the same value as the net present value of all future income streams that come from it: that includes both its dividends, and any profits from reselling it. Assuming we're talking about a company that is no longer growing (that's the presumption in the post you are replying to), then owning a share of it has negative value unless its dividends (or moral equivalents, like share buybacks) exceed at least the rate of interest - you can earn more risk-free by putting your money elsewhere.

> I'd say that if a company has extra cash, it is better off paying its long term debts rather than dishing it out to the shareholders.

That kind of blanket statement makes absolutely zero sense to me, and surely if you thought about it for more than 5 seconds, you too can see how silly it is. If the company's return on borrowed money is higher than the interest rate it pays on that borrowed money, paying down the loan would be a waste of money.

Consider a large shop that has a mortgage on its premises. Is it best for it to invest all its profits in paying down its mortgage? Or should it open up a new branch elsewhere instead, borrowing the money for the premises, on the basis that its business model has been proven to have profit that exceeds the cost of finance? Which would make more money? Now consider another scenario: rather than the shop opening up a new branch, what if the investors (i.e. the owners) want to invest in a different or new business, with potential for higher returns in the future?

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Yes, if a company has stopped growing, then its valuation will go down in time (primarily due to inflation), but then giving dividends just hastens the decline. If a company's value is going down, it makes only short-term sense to give out money. It may just mean some unprofitable assets have to be sold off, or the company needs deeper restructuring.

If the company is profitable and its value is growing against inflation (slow growth), then it's worth having a share in it even if it's not paying dividends. (It's actually hard to find something solid that grows against inflation, in the long term).

>If the company's return on borrowed money is higher than the interest rate it pays on that borrowed money, paying down the loan would be a waste of money.

The company's 'returns' on paying dividends is actually negative, all other things equal.

>Now consider another scenario: rather than the shop opening up a new branch, what if the investors (i.e. the owners) want to invest in a different or new business, with potential for higher returns in the future?

If the investors really think they're not getting their money's worth (i.e. the separate assets are worth more or the management is bad), then it makes sense to initiate a takeover.

P.S. please downvote after you have heard a reply.

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You're providing a hypothetical conspiracy theory business model, and assuming that FB has a high profit margin. FB's revenues seem to come primarily from ads. No one knows how much money they're actually making from virtual currency.

Take a look at what FB actually offers its users: core services: photo sharing, video sharing, blogging, micro-blogging, instant messaging, event/group management. non-core services (apps): quizzes, casual games, horoscopes.

Sounds like any other company everyone knows (Yahoo)? The difference is that FB offers all this with a single login, and the (perceived) greater privacy offered for things you post online. Yahoo never even managed to implement a single login across all of its sites and acquisitions.

The problem is that just like Yahoo and Myspace, there's nothing stopping Facebook from losing users to other sites. The business model is to have a lot of visits from a lot of users and serving them ads that don't bring in much profit. That's a lot of risk, and the upside isn't that great.

I don't see FB moving to a paid premium model. Even if it did that, it wouldn't be that different from what AOL had 10 years ago.

There's just not that much value in what FB does, and not much from preventing others from taking that value away from them.

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Why in the world are you talking about Facebook blackmailing users to earn $2/$3 per user? Advertising (and maintaining what's left of their reputation) is clearly fall more lucrative. If each user just clicks on one Facebook ad each year, that's $2/user/year right there.

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If each user just clicks on one Facebook ad each year, that's $2/user/year right there.

CPCs are not 2 dollars on facebook.

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$1.50/user/year? That's what CPC was for my most recent Facebook ad campaign.

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That speaks more to the quality of your Facebook campaigns than Facebook's profitability.

The guys actually spending significant money on Facebook are not paying more than 30-40 cents CPC.

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Two reasons.

First, I continue to not trust advertising as a long-term stable business model. If some piece of information is valuable to somebody, they'll tend to want to pay to get it, and they certainly won't want to be denied it simply because its publisher didn't pay a middleman enough. By contrast, if an advertiser is paying a middleman money to shove their advertising in your face, it suggests that you seeing that information has positive value to the advertiser and negative value to you. In the long run, advertising tends to get trapped in an arms race between ever-more-aggressive advertisers and ever-more-jaded advertisees with mute buttons, fast-forward, and AdBlock Plus.

Of course, in real life, we don't live in a perfectly efficient market. There's lots of friction. There are probably any number of mutually beneficial commercial transactions I would like to engage in right now but can't because I don't know about the possibility, and advertisers paying middlemen to tell me about them is a Pareto improvement. And not everybody will install AdBlock Gold 2015 even if it does benefit them.

Anyway, so that's why I continue to be surprised at the continuing viability of internet advertising, and have been every year for the last 14 years. Maybe one of these days I'll finally learn, or reality will finally catch up with my expectations.

So suppose that cost per click falls to US$0.01 or US$0.001 (what are they now?), and click rates fall to substantially less than one click per user per year.

Second, blackmail could in theory extract the entire discretionary income of all of Facebook's users. If you earn US$100 000 per year, Facebook could very likely get US$20 000 per year out of you with blackmail.

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"If you earn US$100 000 per year, Facebook could very likely get US$20 000 per year out of you with blackmail."

How exactly would that work? People keep their skeletons in their closets, not on Facebook. No one (aside from journalists writing for old people) cares that you have college party photos of you and your favorite beer bong posted on FB.

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Let me know when Facebook has $2 CPCs across the board and I'll agree with this statement

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Given GS's recent history, do they even care about profitability, the long term safety of investors money, or how much the company will earn? All they're betting is that they'll be able to make a short term profit on this.

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If these were $50M and not $50B your analysis would've been correct. But with such enormous amounts, it's not about money anymore, it's about power. And Facebook has the power to understand and influence what ppl think.

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Are you suggesting that people buy Wal-Mart and Microsoft stock not because they expect to make money, but because Wal-Mart and Microsoft use their power to induce them to do so? Perhaps Microsoft will make your PC crash if you don't own enough of their stock? I am skeptical of your theory.

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I'm suggesting GS would buy FB stock even if FB was loosing billions every year and there was no hope for future profits. In the same way GS and company are spending who knows how much on political campaigns and lobbing.

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Can you unpack this a bit more? I'm still not sure who you're claiming has power in this situation, and why that makes GS want to buy FB stock.

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If you look at the market prices of newspapers, radios, TV stations, you'll see that they depend little on their earnings. The buyer pays for influence on the public opinion.

How much do you think will FB support be worth to GS during the next bailout? In understanding what are the common fears, arguments for and against. Even now GS manages many deals, parts of the society don't like - outsourcing, green house options trade, arab and chinese investors, etc.

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I don't know whether your first statement is true, but I'm skeptical. Certainly there are some cases where newspapers continue to operate at a loss over many years, but in those cases we hear rumblings about hostile takeovers.

Regardless, I don't think GS comes close to getting that kind of editorial control or information access with this deal.

Although you do suggest the interesting point that Facebook private messages and even public postings could be a very valuable source of insider trading information.

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GS wants to handle the IPO.

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