1. How does Facebook make money? What are the value drivers of its business? What is its comparative advantage relative to other social networking companies?
At the time of the IPO, Facebook possessed two revenue streams: advertising ($3.145B in 2011) and payments ($0.555B in 2011). The advertising business delivered ads to Facebooks users. Users uploaded an incredible wealth of information to Facebook, including their authentic identities, interests, and social connections, allowing advertisers to target their ads to an unprecedented degree. Further, all user uploaded information became the property of Facebook, granting them a monopoly on the data. This hyper-focused approach contrasted with those of other major technology driven advertising firms, like Google, whose value proposition is the ability to reach a significant percentage of all consumers using the internet.
Facebook’s other revenue driver, online payments, consisted of in-game purchases of virtual goods for social games. In 2011, all of this revenue was generated via Zynga games. This business relied upon consumers using Facebook as their home for socially-connected online gaming. Given that payments represented a small portion of Facebook’s revenue, and that the advertising business was at the time more developed and predictable, valuing the company as an advertising company rather than a hybrid advertising and payments company seems appropriate.
The comparative advantage of Facebook relative to other social networking companies is primarily driven by network effects. From a user’s perspective, joining a social media site was worthwhile only if friends were participating. Advertisers were drawn to social media sites with large user bases as well, so the network effects were doubly reinforcing. A large, active user base was the key to developing a competitive advantage. In this regard, Facebook’s exponentially increasing user base (~360% CAGR from 2009 to 2012) and increasing portion of daily active users as a percentage of total users were both encouraging signs.

Social Media Company User Base as of 2012
Facebook Twitter LinkedIn Google+ MySpace
900 million 500 million 175 million 100 million 63 illion[1]
All figures from Facebook case unless otherwise specified
However, the recent experience of MySpace offered an instructive cautionary tale. MySpace was the most dominant social networking platform in the world from 2005 to 2008. It allowed users an incredibly amount of flexibility in terms of formatting their profile pages to suit their tastes. However, this lead to a wide divergence in user experience and functionality, as some users cluttered their pages with animations, sounds, and other effects. By standardizing their website, Facebook was able to ensure a consistent, familiar experience to all users. Additionally, Facebook built a sense of exclusivity around its product, limiting access originally to a small group of universities. While these differences allowed Facebook to build a foothold in the social networking space, the speed with which it overtook MySpace speaks to the dangers of depending on consumer taste driven network effects as a comparative advantage. Importantly, this comparative advantage is nearly indefensible, as: a) it is difficult to predict consumer tastes with certainty and b) once a competitor passes the tipping point it very quickly becomes difficult to slow the hemorrhage of users.
2. Why is Facebook going public? What is the planned proceeds from the offering?
Facebook’s stated purpose of going public is to raise funds for working capital and general corporate purposes. Given the precipitous fall of previous competitors, Facebook needs to protect their position aggressively. Maintaining interest and the accompanying growth in their user base requires sufficient capital. Furthermore, acquisitions to both protect Facebook against competition and further differentiate it will be necessary and potentially expensive.
Facebook is issuing 180,000,000 shares at a price of $38.00. This is expected to raise between $6.1 and $6.8 billion.
3. What was going on in the U.S. IPO markets prior to Facebook's offering? What has been the performance of recent IPOs?
The 2012 public equity markets were robust. Prior to the Facebook IPO (5/12/12), 71 companies had completed IPOs raising total proceeds of $26.9 billion, compared with 85 companies that completed IPOs in the first half of 2011 raising $25.8 billion. Second quarter IPOs raised total proceeds of $5.2 billion, at an average value of $200 million per IPO, representing an increase of 53 percent over the first quarter average IPO size of $131 million. Continuing on the positive IPO pricing trends of the first quarter, IPOs in the second quarter produced an un-weighted average return of 8 percent since IPO date, which again exceeded the S&P500 quarterly loss of 6 percent.
4. What is the intrinsic value of a Facebook share? How does this valuation compare to the price talk from the underwriters?
See appendix A for comprehensive analysis.
Value of firm 102,213
Less: Debt 1,088.9
Add: Excess cash 1,512.0
Value of equity 102,637
Less: Cost of equity options (after tax) 3,088.5
Value of common equity 99,548
Number of shares (millions) 2,138.1
Estimated value/share $46.56
Price talk $38.00
Price as % of value 81.6%

Using Aswath Damodaran's DCF provided in Exhibit 11 of the case and refining some of the assumptions resulted in a valuation of $99.5B or $46.56 per share for Facebook as of May 2012. Calculating the CAGR for DAUs, MAUs and Mobile MAUs using the data in Exhibit 3 from Q1 2009 - Q1 2012 resulted in CAGR of 78%, 66%, and 141%, respectively for the 3 year period. Given this vast growth in users as well as the 154% revenue growth in 2010 and 88% revenue growth in 2011, forward looking revenue growth in 2012 was increased from 40% to 60% and to 50% for 2013 before growth was projected to start to stabilize and eventually decline to the risk free rate. Adjusting for this positive revenue growth in the early years drastically increased the estimated valuation of Facebook and caused estimated value/share to be $46.56, well above the $38.00 price talk IPO price. As Facebooks value is driven by future revenue growth, applying comparable multiples to 2011 financial metrics undervalues the company. As such a multiple approach was not deemed to be meaningful.
5. As a potential shareholder, what are your concerns about Facebook or its stock offering?
As potential shareholders, we have three major concerns about Facebook generally and this stock offering in particular.
Threat of mobile. As discussed in the case, at the time of the IPO Facebook could not deliver advertisements to mobile users. Given that the vast majority of Facebook’s revenue resulted from advertisements, this technological limitation posed a major threat to the company. As of December 2011, more than 425 million customers logged onto Facebook via a mobile device, and this figure was growing rapidly. The market for smartphones at the time also posed risks: market research firm IDC projected that new phone shipments would increase to 660 million in 2012 (33% growth relative to 2011) and nearly triple to 1.16 billion units in 2016. Worryingly for Facebook, most of this growth was projected to be in developing countries (where Facebook’s user growth was most robust). For most of these new smartphone and Facebook customers, “the smartphone will be the primary connection to the internet.” Over the long term, a fix for this technological limitation would almost certainly be found. However, in the short term, the lack of mobile advertising revenue coupled with exploding mobile usage could create revenue threats that would depress Facebook’s stock during the holding period for CXTechnology Fund.
Priced on Phenomenal Success. As discussed in the valuation section, Facebook’s shares were being priced on the assumption that the company would experience revenue and profits growth in line with a phenomenal success like Google or Microsoft. Though Facebook appeared to be on that trajectory at the time of the IPO, it could be that growth in users, revenues, or profits could meaningfully underperform expectations. Per the discussion in Q1, MySpace’s experience is a helpful cautionary tale. For a business built on network effects, such as Facebook and MySpace, the moment that the network effects begin to break down, the underlying economics of the business unravel with remarkable speed. Though in our team’s estimation the likelihood of Facebook’s network effects becoming undone within the first few years of the IPO was quite low, there was still nevertheless a chance it could happen. Furthermore, it was nearly impossible to predict when that change would take place or who would be the competitor that provided a better alternative. As a result, we have a concern about the price of shares that CXTechnology would be buying in the IPO; though it would be unusual, a valuation that took into account the slight probability that Facebook’s user base moved to another platform would represent a truer estimate of the company’s value.
Control. Shares typically confer two benefits to their owners: participation in the company’s financial success (via stock appreciation and dividends) and participation in the governance of the company. Facebook’s IPO differs from most in that control is concentrated with its CEO, Mark Zuckerberg. Per the case, Facebook had two classes of shares: Class A, which was entitled to 1 vote per share, and Class B, entitled to 10 votes per share. At the time of the IPO, there would be 635,881,796 Class A shares outstanding and 1,502,203,241 Class B shares outstanding. The IPO would consist exclusively of Class A shares, meaning that even if public shareholders were to buy all shares outstanding, they would control at most 4 percent of the company.
Indeed, as page 20 of the prospectus states: “Mr. Zuckerberg has the ability to control the outcome of matters submitted to our stockholders for approval, including the election of directors and any merger, consolidation, or sale of all or substantially all of our assets. In addition, Mr. Zuckerberg has the ability to control the management and affairs of our company as a result of his position as our CEO and his ability to control the election of our directors.” Because control of the company is so concentrated, Facebook elected to use “the ‘controlled company’ exemption to the corporate governance rules … we are not required to have a majority of our board of directors be independent, nor are we required to have a compensation committee or an independent nominating function.” This means that shareholders are shut out of the governance of the company and denied some aspects of the transparency that typically accompany a company going public. In the event that a shareholder disagrees with the direction of the company or the allocation of its internal resources, the only recourse will be to sell shares. As an institutional investor, CXTechnology Fund might feel that it has the capital and the clout to participate in Facebook’s governance. In the event that this participation is important to the fund, it should seriously consider whether to purchase shares in the IPO.
6. What is your recommendation for the CXTechnology fund?
We would recommend that CXTechnology proceed with the investment in Facebook’s IPO. According to our valuation, the stock is undervalued at its IPO price. The risks the company faces, although concerning, are not substantial enough to risk missing out on the upside potential of such an influential service.
Our valuation estimates a share price of $46.56, which is based on future revenue and income growth. This relies on an estimate of 60% and 50% revenue growth in the years 2012 and 2013 respectively. Given their growth thus far, these estimates are very plausible. In fact, growth much more conservative than this is unlikely. They still have expansion opportunities in countries with quickly expanding internet-using communities and among the demographics that previously considered Facebook to be a place for college students.
The risk to Facebook’s network effect, the main source of its comparative advantage, is of some concern. However, it is possible that it will reach a point of saturation that then cannot be breached. There is an advantage to being the communication tool with access to much more of the population than any other. At some point, Facebook could become a place where you can find somebody you are looking for better than anywhere else. It will be very difficult to unseat it, once it sits in this position.
The control Mark Zuckerberg maintains is only an issue if he makes harmful decisions. His track record thus far is exemplary. Given his limited management background, his performance will likely only improve with time.
Lastly, the threat of mobile use to its business model is really an opportunity. Once, they can present a mobile experience that effectively delivers advertisements, the growth of mobile users will have a direct positive impact on the company’s bottom line.
Overall, Facebook represents a good opportunity to capitalize on an important trend in the economy. We recommend investment.