The Emperor's new stock (or, why Facebook is so overvalued its actually funny).

I’m a huge fan of Facebook, both as a service and a business.

As a technology it’s truly transformative. Never again will people lose touch with each other (unless they want to), and contrary to the high-pitched tabloid nonsense, it makes people communicate more, not less. It’s also a brilliant business. Profitable by providing a service people want for free, and it seems to grow with almost no pain.

However, at $104bn it is massively overvalued. Here’s why.

According to Facebook’s last reported figures (from Q3 2001), it’s annual revenue is around $3.5bn, with annual growth of around 100%. It makes a healthy margin of around 28%, posting a profit of $714m for the first thing quarters of 2011.

That revenue is almost exclusively from advertising, and the growth primarily due to an increase in Facebook’s user base. At the time of these figures that was estimated by be 750m, and is expected to pass 1 billion shortly.

So, taking some rough figures, Facebook makes just less than $1 per year, per user.  

There are loads of ways to value a business, they all prove the same point so i’ll use just one. As a rule of thumb, a business can be valued at around four times it’s earnings (strictly earnings before interest, tax, depreciation and amortisation).  

At $104bn, Facebook is valued at over 100 times it’s earnings.

So, for stockholders to see value, the business needs to get around 25 times bigger. Is that possible?

Well, there are 6.8bn people on the planet, and that’s going up (and at Facebook’s scale that actually matters). We could be very generous and say that Facebook might, in the medium term, get 50% of a 7bn population using the service (i’m being very generous).

That would, at $1 a user, give us about $3.5bn a year in earnings and a valuation of around $14bn to $20bn. We’re still a multiple of 5 short, and people just aren’t breeding fast enough.

So, to bridge the gap, Facebook would need to increase it’s earnings per user by that factor of 5, to a nice round $5 per user.

Can they do that? Nobody is ever going to pay to use Facebook (although Facebook are trialing it) as they’re too vulnerable to a critical mass of people simply going elsewhere, but they could sell more adverts. Five times as many adverts than now? I doubt it.  Could they charge advertisers 5 times as much? Maybe, but again I doubt it.

Even if Facebook managed to double their earnings per user (which would be an amazing achievement for any business), we’re still only at a valuation in the $28bn to $40bn range, half where we are.

Now of course, nobody is buying stock on the basis of Facebook’s revenue. People are buying into platform that half the developed world is addicted to and is going to be incredibly important in the future. And, for something that big, it would be brave to predict that it was incapable even of what seemed impossible.

However, the Facebook that makes $25bn a year in profit is a very different business to the one people are buying today. The growth process can’t be sustained by recruiting more users, Facebook simply runs out of people to recruit. So instead new and totally different revenue streams, in markets Facebook doesn’t dominate, will have to be established and be very successful. These initial investors are betting the farm on all of this working out.

I wouldn’t bet against a company that has already changed the world in the way Facebook has, but I wouldn’t pay $104bn for it either.