Investors should be concerned over Facebook debacle

The question for Facebook’s shareholders is how many of the company’s users will decide that their privacy is more important than using the service?

Facebook is under pressure following data scandal. It would not take too many users to leave to have a mjor impact on the firm's financials. Matt Rourke/AP

Facebook's true value resides in its 2.1 billion users, and investors need to worry about what happens if enough of them decide that free social media isn’t worth the cost.

First,  a disclosure: I’ve never used Facebook. I get that it’s an awesome way to keep in touch with family and friends, meet new people and get a personalised online experience. But I value my privacy, and it’s hard to reconcile that with the fact that Facebook is in the business of selling its users’ information.

And it’s a great business. Facebook generated earnings from continuing operations of $15.9 billion in 2017 on revenue of $40.7bn, 98 per cent of which came from advertising.

If it isn’t already obvious that Facebook is a money-making dynamo, consider how it stacks up with digital ad rival Alphabet, the parent of Google. Facebook’s gross margin was 87 per cent last year, and its net income margin was 39 per cent. That compares with 59 per cent and 11 per cent, respectively, for Alphabet.

One obvious takeaway from those numbers is that Facebook’s users’ information is hugely valuable. Less obvious is that the value of Facebook's data trove grows exponentially with additional users. Facebook generated $3.2bn of ad revenue in 2011 with 845 million monthly active users, or $3.79 for each one. In 2017, Facebook scooped up $40bn of ad revenue with 2.1 billion users, or $19.05 for each one.

As Facebook grows, in other words, so does the appetite for its data. It was only a matter of time before that data was wielded in ways that Facebook’s users disliked. I suspect that the Cambridge Analytica debacle is just the first of many revelations to come. Regulators and investors are troubled. The Federal Trade Commission announced on Monday that it is investigating Facebook's privacy practices, and the company' shares continued to slump in an otherwise advancing market, down more than 5 per cent.

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There are also growing concerns that Facebook’s users are giving up more than their privacy. The company has a huge incentive to expand its ranks and to keep them clicking - at a terrible cost to users, according to some observers. Early Facebook investor turned critic Roger McNamee says that Facebook is designed to appeal to users’ fear and anger because it’s an effective way to keep them hooked. That’s a far cry from Facebook’s mission to “bring the world closer together”.

Mr McNamee rightly points out that Facebook could address those concerns by selling subscriptions rather than ads. I, for one, would be more likely to join if Facebook committed to protecting users' information for a fee. But don’t expect Facebook subscriptions any time soon. For one, it’s not easy to sell subscriptions. Just ask newspapers. Or Amazon and Netflix. Despite their success, the combined number of Amazon Prime and Netflix subscribers is about one-tenth the number of Facebook’s users.

More important, selling subscriptions won’t deliver the exponential revenue growth per user that Facebook now enjoys from selling ads. As long as maximising profits is Facebook’s chief priority, its interests will be difficult to reconcile with those of its users.

The question for Facebook’s investors is how many of the company’s users will decide that their privacy is more important. The longer-term danger is clear: If enough users clamour for a subscription-based alternative, enterprising competitors will eventually give them what they want.

The near-term risk is just as sobering, however. Facebook is expected to generate $70bn in revenue in 2019, according to analysts’ estimates compiled by Bloomberg. That translates into a reasonable price-to-earnings ratio of 15.5, or just slightly higher than the S&P 500 Index’s P/E ratio of 15 based on earnings estimates for 2019.

But the flip side of Facebook’s growth model is that its fortunes could turn just as quickly. If Facebook’s historical financials are any guide, a mere 13 per cent decline in the number of users - which would leave it with the same number it had at the end of 2016 - would translate into a 23 per cent decline in ad revenue per user and a 33 per cent decline in revenue. Earnings, in turn, would drop by 43 per cent and its P/E ratio would spike to 45. If that were to happen, Facebook’s stock would have to decline by 65 per cent to reach that reasonable P/E ratio of 15.5.

It would take more than a few defections to bring down Facebook, but investors should bear in mind that the same isn’t necessarily true of its stock.

Bloomberg