No End in Sight for Facebook’s Free Fall

Illustration by Ed Nacional

It would be all too easy to wager that Facebook’s market meltdown is coming to an end. After all, Mark Zuckerberg’s social network incinerated as much as $50 billion of shareholders’ wealth in just a couple months. To put that in context, since its NASDAQ debut in May, Facebook has lost value nearly equal to Yahoo, AOL, Zynga, Yelp, Pandora, OpenTable, Groupon, LinkedIn, and Angie’s List combined, plus that of the bulk of the publicly traded newspaper industry.

As shocking as this utter failure may be to the nearly 1 billion faithful Facebook users around the world, it’s no surprise to anyone who read the initial public offering prospectus. Worse still, all the red flags that were flying when the company debuted—overpriced shares, shoddy corporate governance, huge challenges to the core business, and a damaged brand—remain at full mast today. Facebook looks like a prime example of what Wall Street calls a falling knife—that is, one that can cost investors their fingers if they try to catch it.

Start with the valuation. To justify a stock price close to the lower end of the projected range in the IPO, say $28 a share, Facebook’s future growth would have needed to match that of Google seven years earlier, according to an analysis by Reuters Breakingviews and Anant Sundaram, a professor at Dartmouth’s Tuck School of Business. That would have required increasing revenue by some 80 percent annually and maintaining high profit margins all the while.

That’s not happening. In the first half of 2012, Facebook reported revenue of $2.24 billion, up 38 percent from the same period in 2011. At the same time, the company’s costs surged to $2.6 billion in the six-month period.

This so-so performance reflects the Achilles’ heel of Facebook’s business model, which the company clearly stated in a list of risk factors associated with its IPO: it hasn’t yet figured out how to advertise effectively on mobile devices. The number of Facebook users accessing the site on their phones surged by 67 percent to 543 million in the last quarter, or more than half its customer base.

Numbers are only part of the problem. The mounting pile of failure creates a negative feedback loop that threatens Facebook’s future in other ways. Indeed, the more Facebook’s disappointment in the market is catalogued, the more Facebook’s image becomes tarnished. Not only does that threaten to rub off on users, it’s bad for recruitment and retention of talented hackers, who are the lifeblood of Zuckerberg’s creation.

Yet the wunderkind CEO can ignore the plaintive wails of his shareholders thanks to the super-voting stock he holds. This Rupert Murdoch–like arrangement also was fully disclosed at the time of the offering. It’s a pity so few investors apparently bothered to do their homework.