Today Inside Facebookposted a brief article about the slowing growth of Facebook. Surely most companies could only dream of having the nearly 700 million users it currently has, and any extra is a bonus. However, with valuations of up to US$70 billion, Facebook has high expectations to live up to. Facebook’s valuation is tied to expectations of its future growth, which I will explain further in this post.

How should we find the right price for a company?

A good way to find a reasonable price for a company is to look at the price to earnings ratio (P/E). If a company is valued at $10 million and the company earns $1 million per year, it has a price to earnings ratio of 10. If you look at the historical averages of the Australian share market (and many other share markets), a P/E of about 17 seems to be the norm. So in most scenarios, a company earning $1 million should be valued at $17 million. Of course this is an average and will change depending on whether the market thinks we are moving into or coming out of a recession.

Tech businesses can generally obtain higher valuations than traditional industries because tech businesses can scale much more quickly. You  need to write the software once, but if your user base increases by 20%, you only need to buy a few more computers. When choosing a company to invest in today, we want to know what it will earn tomorrow, not what it earnt yesterday. So rather than using the price to earnings ratio of prior earnings, investors price companies on future earnings, if they know what they are.

This is where growth becomes important. At a valuation of US$70 billion, you would expect a company to be earning about US$4.1 billion, or in Facebook’s case about $5.80 per user per year (this should take into account the cost of running the service). For the overwhelming majority of users, Facebook earns its money through advertising. That’s a lot of advertising dollars (especially considering that Facebook advertising is significantly lower earning than other display and search advertising).

However the growth rate, not the total number of current users, is what the current valuations of Facebook are based on. Facebook is valued much more highly because investors believe in a year’s time there will be many more people using Facebook than there is right now. My belief is that there are not very many people left in the world who either haven’t heard about Facebook or have heard and will be convinced to join in the future. But belief is one thing and statistics is another. So I used a couple of free online tools to work this out: Google Trends and Alexa.