Someone who reads
sent me this email:
Even if (Michael Wolff) is overblowing things in his
criticism of Facebook, he poses an interesting idea: that the
value of advertising in general may be falling because
advertising is generally less effective.
This is where I have to disagree with the criticism of
. For me, there is one valid criticism - and only one valid
criticism - of Facebook stock:
It's too expensive
Way too expensive.
Fine. But a lot of stocks are too expensive.
People are talking about the dot-com bubble. This is nothing like
the dot-com bubble. This is like the Nifty Fifty. And it could
end for Facebook investors the way it did for investors who
bought into any of the Nifty Fifty - you'll lose a lot of money
over the next few years - but the company itself will still be a
solid competitive enterprise chugging away many, many years from
That's very different from the dot-com insanity. It's the
difference between speculative businesses and speculative prices.
Facebook is not a speculative business. It's definitely an
investment quality business. There is nothing wrong with a
company like this being offered to the public. (There was a lot
wrong with the companies offered to the public in the late
1990s.) There's nothing wrong with sticking something like
Facebook in a college endowment.
Other than the price.
There is something wrong with the price. But there are two parts
to what makes a stock purchase an intelligent investment:
� The business bought
� The price paid
Facebook is a perfectly good investment if we're talking about
the business you're buying. But it's also a complete speculation
if we're talking about the price paid.
But let's not broaden the discussion into some grander theme. It
really comes down to too high a price for the stock.
Just because an IPO flops, doesn't mean there's something wrong
with the business model.
I don't see any reason why advertising would be less effective in
the future than it has been in the past. Or why it would be less
effective online than offline. If you mean a certain kind of
advertising - yes, a certain
of advertising will be less effective online than offline.
But a certain kind of story has always been less effective on
I live a block from an Angelika theater here in Plano. The movies
I see tend not to play real big in most of the country. Why?
Because they aren't the right
of stories to tell on a big screen where people are going to go
out as a couple or a group and plunk down 10 bucks and spend two
hours in the dark. Seeing old, decrepit English people staying in
an old, decrepit hotel in India; or an old woman looking for her
lost (not especially young) dog; or a mortician killing an old
lady - these are not effective
of movies. The movies themselves may or may not be effective. But
of movie most definitely is less effective in attracting people's
They don't have the right appeal. For one, they are about
characters. And if you want to focus on characters - why not do
that on TV where folks don't need to spend a full two hours with
you, don't have to pay for the experience, and can stick with the
same character week after week.
You get the point.
Some stuff doesn't work that well in movie form. But just because
we can't make American Idol: The Movie doesn't mean movies are an
ineffective medium for telling stories. It just means you can't
put stuff made for free TV into paid theaters and expect the same
The same is true with ads.
Just as what makes an effective TV story may not also make an
effective movie story - an effective offline ad may not make an
effective online ad. And vice versa.
For one thing, I click stuff online. I don't click stuff on my
So, TV has some serious limitations. In fact, it's hard to
imagine a more limited advertising medium than TV. Even
advertising directly in a book would have permanence. I don't
freeze my TV. And yet I also don't give it my undivided
attention. I can and do: change the channel, mute it, walk away
from it and even talk to other people while watching it.
Oh, and I can't interact with it directly - I can't follow a link
to your website on my TV screen. And I usually don't have a pen
on me to write anything down - who would want to advertise on
something like that? Without showing me the same ad half a dozen
times on TV, I won't even remember the ad much less act on it.
These are all valid criticisms of TV advertising. Companies still
There is no reason advertising spending has to be used in a
certain way. Advertising as a percentage of U.S. GDP has not
decreased in any meaningful way in over 90 years. It was
basically the same in 1920 as it was in 2000. And, in that time,
companies have been advertising in everything from:
It has been sold in 30-second spots and 2-minute spots - and in
certain settings even much, much longer. It has been very
targeted, and it has been very general.
Different businesses have used very different ad supported
Newspapers made a huge percentage of their operating profit from
classified ads. Today, there's actual classified sites - that
look much the same as newspaper classified - like Craiglist. And
. Google is essentially a classified ads company.
Google has a way wider moat than local newspapers did though.
Because the habit is more strongly ingrained. It's an active
search. Not passive. It's hard to imagine a better business than
Google. It's a company that stumbled into the marriage of habits
Facebook is a terrific business. Absolutely amazing economics.
Not in the future. Today. Right now. It is already a great
business. Whether or not it is a
great business is another question. But look at its operating
margins. Look at its working capital requirements. Facebook has
the economics of a local TV station. It just happens to have the
potential to reach much of the world.
Facebook's long-term future is entirely a question of two things:
The question of experience is the question of an "experience
curve." I'm not a big fan of that term. But finance people like
using it. So, we'll use it here.
What I mean is that if an army - like the Roman army - gets in
the habit of campaigning every year and marching every day and
building a defendable camp every night - they get good at those
things. Not just any one Roman. But the collected wisdom of the
group - even when they don't know exactly why they do the things
they do - leads them to automatically make somewhat smarter
. And over time, the institution figures out the logistics of
moving tens of thousands of people and keeping them fed and
dysentery free and so on just through doing that day after day
when a lot of other folks are not doing it. And very often a
single academy or one great genius really can't push enough
experience through the whole organization as years of seemingly
mindless practice will.
Well Facebook is going to get a lot of practice. So the issue is
the potential of how much you can make in the kind of advertising
there will be on Facebook - and then how good they will get at
selling that advertising. This is key. Because the advertisers
are going to need help. They evolved in a different ecosystem of
sorts. And they are not well adapted to Facebook. And they have
some old habits that will need to change.
But unless the folks at Facebook are idiots they will soon know
more about advertising to people through social media than anyone
on the planet - much more than any ad agency does now. They will
have a tremendous amount of data on people.
This is one of the big reasons why I think retailers are in a bad
position versus someone like
. Amazon has the potential to assemble the same sort of
advantages - informationally - that every grocery store out there
has and yet it also has a pleasant shopping experience with the
ability to cross sell you things you didn't even know you needed.
That is the trifecta of retail:
� Get all the customer's info
� Sell them stuff they don't know they need
� Have them leave happy
This is very hard to do offline. But it happens all the time at
Amazon. And so I would not want to have to compete with a company
like that. Because the model of an online store is just so
superior to the model of an offline store.
Facebook is theoretically a much, much better way of advertising
than television advertising. Television is one of the world's
worst ways of advertising. The only reason TV advertising became
so important is because TV is one of the best ways of
Advertising goes where people's attention is.
The eyeballs went to TV. Because TV is the best way to entertain
people in their own homes. So if you wanted to sell things to a
mass audience - but talk to one person at a time - TV was the way
to do it.
The article is right of course that Facebook - and let's face it,
Google - are not deriving their economic value from being tech
companies. They are both advertising-supported media companies
from a profit perspective. From an employee perspective it's
different. And that's important to keep in mind. You want to know
how a company sees itself. But you also want to know where it
makes its money. What does it eat? What fuels the business?
It's not tech for either Facebook or Google. They are both pretty
simple media companies in terms of where they make their money.
Facebook is not a tech company. It's a media company. There is a
risk in the company - the same risk is present in Google, but
probably to a much greater extent there - that the folks inside
the company do not have a clear idea of what their golden goose
is and instead will go off and do very stupid things.
According to Facebook's SEC reports, the price paid for its
advertising per user has been increasing rather than decreasing.
Overall, I think the idea that Facebook needs to grow
a lot to justify its valuation gets talked about too much. Growth
in users is not the first thing I would look at when analyzing
Facebook. It is the habitual use of Facebook that is important.
You want to have a product that is used the way a local
newspaper, local morning show, and local even news were once
used. For some people, Facebook is already used that way.
So how much money can Facebook make advertising to each of its
There is a lot of growth potential right there. Even before you
talk about growing the audience.
Maybe because it's an Internet company people think users matter
more than they do. Use matters. The thing I want to know more
about Facebook is how people use it. Not who will be using it in
five years. That really is much less important than some people
are making it out to be. You've got enough valuable folks
spending valuable time on the site now. If they're using it the
right way - it's a very valuable media property.
Let's think about that $100 billion IPO price.
If Facebook ever had 5% of worldwide advertising spending it
would justify the $100 billion IPO valuation.
As a no-growth business Facebook should trade around five times
Look at the company's operating margins. In 2011, Facebook had
revenue of $3.71 billion and operating income of $1.76 billion.
That's a 47% operating margin. At a 35% tax rate, that would put
net margins around 30%. It's pointless to talk about free cash
flow right now because of Facebook's rapid growth. But the owner
earnings picture at Facebook is probably in line with something
Basically every $1 of revenue turns into about 30 cents of
after-tax cash. Divide that 30 cents of owner earnings by 5 and
you get 6 cents. A free cash flow yield of 6% would not be odd
for a big public company. Basically, that's a P/E of 15. So
that's why I say Facebook would be worth five times revenue
without adding any growth premium. (Of course an advertising
supported media business with a wide moat should be able to
manage 5% to 6% growth in nominal terms - basically it should
match GDP over time.)
Every 1% of global advertising spending is $5 billion. So, with
an enterprise value of five times revenue, a company with a 1%
share of global advertising would be valued at $25 billion. This
is only true if you have Facebook's economics. Outside of local
media (most of which is decaying), very few companies have
anything like Facebook's economics. Revenue is worth a lot less
to them. I don't want you to think five times revenue is the
right value for all media companies - it's not.
Facebook doesn't really need working capital. And won't use debt
(media companies don't need debt - they usually just use it when
they buy each other up). So, that's basically $25 billion in
market cap per 1% share of the worldwide ad market you think
Facebook will have.
Facebook went public with a $104 billion market cap. If 1% of
worldwide advertising is worth $25 billion in market cap in the
hands of Facebook, that valuation implies a 4.2% share of
worldwide advertising spending.
In other words, people who bought the stock at its IPO price were
betting Facebook will account for 1 of every 25 dollars spent on
Unless they think Facebook will get profits from someplace else.
From someplace other than advertising.
That required 4% share of worldwide advertising gave no credit to
possibilities of other revenue sources - like payment processing.
Consider all other revenue sources a lottery ticket. Because of
the nature of Facebook there will be more happy accidents than at
other media companies. Revenue sources will appear the company
didn't really plan for. It's a more valuable lottery ticket than
at most companies. There is a much greater possibility of payoff
because of the amount of experimentation that will happen without
the company really having to do much.
As far as the effectiveness of advertising specifically regarding
Facebook - the potential is clearly there for much more effective
organizing via Facebook than any other advertising medium. This
is supported by basic principles of social momentum that have
been proven in research time and again. I have no doubt the
potential exists to get more momentum for an idea, brand, person,
act, etc., on Facebook than through any other medium on which a
company can advertise. Whether this is something companies and
agencies know how to do or want to do is another question.
You had 483 million daily active users when Facebook filed the
original S-1. Of those, probably 80% at least are pure followers
of no great import to advertisers beyond the traditional way you
advertise to folks through TV, etc. In other words, more than 80%
of Facebook users are just worth their eyeballs. Nothing more. It
is not like talking to a crowd. But a small number of Facebook
users - I'm not sure if it's 100 million, 50 million, or 25
million - but it's at least 25 million people are really much
more valuable. Or potentially more valuable. If you know which 25
million people to try to influence you will end up getting a lot
more bang for your buck.
This is one of the big problems advertisers have. Advertisers are
a bad messenger for their own message. The same message delivered
by somebody else would be way more effective than delivered
directly from the company. Advertisers try different ways of
solving this problem. But they can rarely get to the people that
would be most helpful in promoting their brand simply through
advertising. Some companies obviously have a ton of success
influencing the influencers, but this is often through other
means than advertising.
When you are advertising on TV or in a newspaper or even giving
someone a coupon you may know some demographic info and some
buying behavior. But you generally don't know their influencing
behavior. You don't know to what extent they can help you beyond
just getting you one sale. Facebook has that info. They have the
most valuable information about the exercise of influence by
individuals that anyone has anywhere. Whether they know how to
use it, etc., is a different question. Whether they will share it
is a different question. But they have it.
A brief detour about
will explain why this matters.
You leave some behavioral breadcrumbs in your financial life that
FICO can use to predict your likelihood of paying your bills in
full and on time. In fact, your FICO score tells you much more
than that. If anything, FICO and others have downplayed the
predictive value of the FICO score outside of lending for fear of
a public backlash against just what that info tells you. The
truth is that the FICO score is really not just some measure of
creditworthiness. It is a measure of character. It is a measure
of behavior. You could duplicate a lot of the same score - you
could really guess someone's FICO score much better than you
think - by gathering stuff that's (seemingly) totaled unrelated
to borrowing money.
If you knew someone's:
� Driving record
� Sexual history
� Substance (ab)use record
� Criminal record
� Employment record
It wouldn't be very hard to tell if they are more or less likely
to default on a loan. A group of people who present as quite
boring in terms of driving, sex, drugs, crimes and jobs are
people you should lend to.
A group of people who present as quite exciting in terms of
driving, sex, drugs, crimes and jobs are people you shouldn't
This is common sense. But when you can aggregate it and use it on
a large scale it becomes economically meaningful.
It's probably less important than people think which data someone
gathers about your behavior - if it's financial or non-financial.
What matters is the insight into your behavior. Risk taking is
both a basic and pervasive trait. It shows up in all different
actions throughout your life. What FICO can give you is a measure
of risk taking. People with low FICO scores are people who misuse
risk. What credit bureaus have is very valuable because no one is
going to submit to the best way of evaluating creditworthiness
which would be some sort of multi-hour, detailed, taped,
polygraph interrogation of all aspects of your risk taking
history including quite personal questions. No one will do that.
But the credit bureaus' data combined with predictive analytics
(the FICO score) can counterfeit that experience. It's a short
Influence is pervasive too. And it's possible to figure out how
influential somebody is.
Facebook is going to know more about influence than anyone on the
planet over time. And advertising is applied influence. So it
seems to me that if Facebook does reasonably intelligent things
over time it's going to learn more about influence - have more
practical knowledge about how people really influence each other
- than anyone knows now.
That will just be a side effect of the company going about its
business. So, it seems hard to me to believe that a business like
Facebook is going to fail because it can't figure out how to
Charlie Munger says stocks are valued partly like bonds and
partly like Rembrandts.
I tend to think the failure of the Facebook IPO was a failure of
its Rembrandt value. I never buy into IPOs. But on the numbers, I
really can't say Facebook looked especially overvalued as a new
public company. IPOs aren't known for being done at sensible
prices. And certainly not at prices value investors like.
Yes, Facebook was offered at something like five or six times
what the company would be worth if it had no future growth
potential. If it was only going to grown in line with worldwide
GDP. In that case, it's probably worth about 80% less than what
it was offered to the public at.
But Facebook obviously does have
I would not take the bet that the S&P 500 will outperform
Facebook shares over say the next 5 or 10 years. That isn't a bet
I would feel comfortable making.
Facebook's operating margins are much more defensible than those
of the S&P 500 as a whole.
I think value investors have been too dogmatic about Facebook.
I'm not sure most have even seriously looked at the situation.
Thought through the business or the valuation. They've just had
this knee jerk reaction against an IPO and an internet company
and an insanely high P/E ratio.
I'm not especially fond of any of those three things.
But we shouldn't let one bad mark - price - cloud our judgment on
other aspects of the situation.
Facebook is obviously a great business. It has a huge competitive
advantage. If it is a
competitive advantage, Facebook will justify the price at which
it went public - over time.
As far as the idea that digital/web advertising is useless...
If you pitch the right product to the right person in the right
way, you can run an effective ad on the inside of a pudding cup.
Technology will never change that.
I understand when people say the economics of movies will change
in a way that makes a $150 million computer-animated movie
unprofitable to make. That's perfectly valid. But that's not the
same thing as saying stories won't work because of some tech
Ads really are as basic as stories. They work in much the same
You've got to get us interested in getting some sort of info.
Outside of needing to eat and drink and sleep - I'm not sure
there's anything as basic as stories. And I put advertising in
that same category. We may tell ourselves we go about our day
thinking about what we need and don't need - but that's not
exactly true. We go about our day flitting from one thing that
catches our attention - that interests us.
And a good ad will get our interest. It'll catch our attention.
It really isn't medium specific.
I ride a bus every day. And I've seen some very effective
advertising on buses. I don't mean the sides of buses. I mean on
the bus. They have these square cards no bigger than a single
poster. Some of those ads work. And I've seen effective ads run
before a movie in a theater too. And we've all seen TV ads -
probably very expensive TV ads - that don't work at all. I
remember one ad where it took me four viewings to realize they
weren't advertising their competitor's product.
And I can definitely tell you I've seen effective online
advertising - because I know I've made purchases based on online
advertising. Last week I spent $100 because I was exposed to a
display ad for probably five seconds before clicking it.
It was a very effective ad. It singled me out as part of a
special group, told me I'd save money, and that I had a limited
time to act. It worked. And you probably could've run it in print
half a century ago using the same exact appeal and it would've
worked there too.
So I wouldn't worry about the ineffectiveness of online
I would be more worried about some lab testing a pill you pop in
your mouth that tastes great in your brain - bypasses the buds on
your tongue entirely - and nourishes you thus putting Coca-Cola
and Kraft and Chipotle out of business than I would be worried
about ads not working on the net.
(For the record, I'm not especially worried about either. But
food we actually chew has a higher risk of obsolescence than
An ad where you are the target and the aim of the ad is right -
it's very hard not to be intrigued by that.
Now, that doesn't mean advertisers always know the right target,
aim for that target in the right way - or have a good way of
paying for the right advertising.
Probably the best advertising I was ever exposed to in my life
was when a friend said to me - about the movie Memento, which I'd
never even heard of: "
are going to love this." With the emphasis on you. That's the
right appeal. It works better than a trailer, better than a
poster, better than a critic's review. But only a friend can make
I make my living
writing on the Internet. If I can't succeed writing on the
Internet in the future, it won't be technology's fault. It'll be
mine. Writing for any medium is really just about the connection
between the teller's mind and the target's mind.
And that's all advertising is too. I don't see any reason why -
with practice - the tellers can't get good enough to figure
Facebook out. If you've ever seen some of the first stuff that
was written for movies or TV - it's really, really bad.
Astonishingly bad. They basically just threw a play up there. But
then things changed - to the point where 100 years later, most of
what you see on a movie screen is stuff that wouldn't play that
well in other media. Some people may wish it was otherwise. But
the point is that the folks who create movies got better at
knowing specifically what works differently in movies than - say
- on a stage.
Advertisers will go through the same learning process online.
People take time to learn. Facebook will take time to learn its
business. And advertisers will take time to learn how to
advertise on Facebook.
I'm not worried about that.
I'd only be worried about three things at Facebook:
1. User habits
2. Management behavior
Before investing in Facebook, I'd like a lower price. This is a
typical value investor complaint. And it's definitely true here.
Facebook stock is (still) too expensive for me. That doesn't mean
it's overvalued - just that I'm not willing to pay the current
Second, I wouldn't buy any stock in an IPO. That's just a basic
psychological thing. You don't want to buy under the illusion of
time scarcity. So I can't imagine any scenario where I would ever
buy a stock when it is first offered to the public.
But what if the price was right? What if Facebook were trading at
- let's say - 5 or 10 times revenue. That would be cheap enough
that I'd have to really consider the business.
What would I focus on?
User habits are key. I don't use Facebook. So I don't know enough
about this. If I was considering an investment in the company,
I'd spend about 90% of my research time on studying user habits.
Management behavior. I'd like to know more about how Facebook
sees itself. If we're talking about Zuckerberg, this doesn't seem
like a tough task. He's definitely easier to "read" than 99% of
the CEOs you'll come across.
I wouldn't spend much time on this.
There are so many sensationalized secondary sources about
Facebook and Zuckerberg that I think it's pretty hopeless to try
getting info out of a narrative that's become so contaminated by
storytelling by now.
Basically, I'd just focus on the durability of Facebook's moat.
I'll be interested to see when long-term options on Facebook
start trading. In the long-run, you're not going to either make a
little money on Facebook or lose a lot. You'll either lose a lot
(pretty fast) or you'll do well over time. It'll either be
something that blows up in a couple years or is a good buy and
hold forever stock.
It is, however, worth mentioning that this is a stock where
literally everyone knows more about the product than I do. Like I
said, I don't use Facebook. So this is never a stock where I
could never "buy what I know."
The bottom line for value investors is that the stock is way too
expensive - as almost all IPOs are - to consider right now. But I
think the negativity on this stock (especially from value
investors) has been way over done.
One neat thing about an IPO is that you get to read a nice, long
description of the business filed with the SEC. It's called an
S-1. And you can have great fun reading it. It's window shopping
for value investors.
You can find Facebook's S-1 here.
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