Pick The Mature Business – Facebook?

A World Without FANGs

I can imagine a 24 hour period where the FANG’s services did not exist. Some sections of the community would become more productive and developed world birth rates would jump. Imagine if Microsoft products did not exist for 24 hours, only Cupertino would be smiling.

The FANGs have a combined market cap of US$1,694 billion. That is big number for providing non-essential services to the community.

Facebook ($FB) (the product) may provide utility to its users, value to its advertisers but that does not extrapolate to value to the community. I describe $FB as a product that is able to charge a premium to its economic rent.

So what is economic rent and why would it be useful?

Economic Rent

The theoretical price that can be levied for a service based on the value to the community.

We all understand that smoking cigarettes has a cost to the community and has a negative economic rent. Despite this tobacco companies continue to levy a premium for their goods.

Just as I believe in gravity, I believe that no entity can charge above its economic rent indefinitely. Eventually the price must drop to the level of the economic rent or below.

If an entity is charging below its economic rent, it cannot move its price upwards. For example airports cannot charge users a full economic rent. Airports can only earn a return on their capital employed. The airport operator cannot levy a charge based on inbound passenger spend.

Economic rent can be quantified in terms of a unit price or in forward looking market terms, for example, the difference between fair value and current market cap.

Application

Reversion to mean and terminal value are often big drivers in discounted cash flow models. The shape of the reversion to mean curve also weighs heavily on the NPV. At some point in our careers we have all tweaked this and the cost of equity to get the number we were seeking.

The concept of economic rent is an attempt to put a framework around reversion to mean.

How Does This Apply to Facebook?

Facebook’s value to the community could be quantified in terms of the marginal sale made by a client employing $FB’s services. We could also include the productivity gains of the users by posting rather than “emailing all” with photo attachments.

In terms of economic rent, I believe that Facebook has been charging a premium to its economic rent but is now a mature asset.

This statement appears at odds with its relatively small revenue streams. However I do not believe that $FB is capable of fully monetising its user base without losing its user base.

Facebook has reached saturation point in terms of user growth.

Smartphone Penetration

Smartphone Apps

If Facebook cannot monetise its user base, then we should attempt to value $FB as a database of user behaviour.

In terms of economic rent we are going to consider Facebook in terms of fair value versus current market capitalisation.

For this exercise I am only valuing Facebook on its existing assets. $FB, the company, will continue to grow. They are very good at acquisitions.

The following assumptions have been made in order to keep this essay brief.

  • The user base of Facebook and Instagram overlap in terms of value as a database so only $FB users are utilised in the calculations.
  • The Facebook valuation is based on US (214 million) and Western Europe (307 million) users only.
  • The Whatsapp valuation is based on total users (1.3 billion). This is a sufficiently different data set, especially in developing markets (over 200 million users in India).
  • Value per user is US$45. It is close to the value Facebook acquired Whatsapp and this is generally regarded as well priced acquisition
  • Can generate US$40 billion in annual revenue at a 20% NPAT margin (based on current attempts to monetise).

Facebook Market Cap                        US$492.6 billion

less

Facebook users                                 US$23.5 billion

Whatsapp users                                 US$54.6 billion

Existing operations @25X                  US$200.0 billion

Pre-paid Economic Rent                     US$214.5 billion

Whilst we could reduce the above figure with the sale of a number of $FB assets, it is clear that Facebook’s current owners believe it is capable of levying in the order of US$200 billion value somehow.

Facebook (the user service) is at maturity and cannot continue to charge a premium to its economic rent. $FB will continue to add services but this will not necessarily equate to a value uplift to Facebook’s owners.

More importantly for the current owners, it is difficult to envisage how Facebook can justify this US$200 billion pre-payment of economic rent.

Fortunately for the current owners of Facebook, the marginal buyer of $FB shares is not value driven.

Other Points to Explore

Is a company’s economic rent below its customer’s squeal point? If so the competitive moat is wide.

How is the concept of economic rent different to Buffet’s moat? It is difficult to apply Buffet’s moat to first mover or early stage businesses. Economic rent is a variation on the theme that can be applied to any economic entity.

A company that has to accept a discount to its economic rent can only generate growth through factors external to the company.

Through the prism of economic rent we can say that Netflix will revert to mean before Facebook. We will explore Netflix soon.

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