How Facebook Might Fail Investors (In Its Own Words)

With 845 million users each month and 483 million active each day, it is hard to declare Facebook anything but a smashing success—even if we acknowledge the fuzziness in those numbers.  The challenge for Facebook’s early investors, however, is not Facebook’s business success but whether the company can grow into and beyond its lofty initial valuation.
In a recent Forbes post, Eric Savitz did the math to show that a Facebook valuation of $100 billion (a commonly bandied about number) would imply a P/E of 100x trailing earnings, compared to Apple’s P/E of 10x trailing earnings (minus cash).  Buying into a Facebook valuation in this range would constitute a tremendous vote of confidence in Facebook’s growth potential over the Apple juggernaut.  Savitz also pointed out that in order for investors to double their money, Facebook would have to reach a valuation ($200 billion) that is higher than AT&T, Procter & Gamble and Johnson & Johnson, and be on par with General Electric, Google, or Berkshire Hathaway.
How might Facebook fail to attain and sustain the business growth required to grow into and beyond its frenzied IPO valuation? It will be like walking on the edge of a knife—where any hint of potential slowing will deal a tremendous blow to investors.  Imagine, for example, what a drop of the P/E to “only” 50x trailing earnings would do to early investors?
While there have been no lack of critiques, the most knowledgeable source is Facebook itself—in the form of the risk factors specified in the company’s S1.  Here is the summary, in the company’s own words, of how an early bet on Facebook might turn sour (the categories are mine):

Growth slows — Remember the challenges of starting from such a large base:

If we fail to retain existing users or add new users, or if our users decrease their level of engagement with Facebook, our revenue, financial results, and business may be significantly harmed;

Slowness in translating user traffic into advertising revenue, especially in the context of mobile devices:

We generate a substantial majority of our revenue from advertising. The loss of advertisers, or reduction in spending by advertisers with Facebook, could seriously harm our business;

Growth in use of Facebook through our mobile products, where we do not currently display ads, as a substitute for use on personal computers may negatively affect our revenue and financial results;

Facebook user growth and engagement on mobile devices depend upon effective operation with mobile operating systems, networks, and standards that we do not control;

We may not be successful in our efforts to grow and further monetize the Facebook Platform;

Failing to dominate all the next new things — for both user attention and advertising dollars:

Our business is highly competitive, and competition presents an ongoing threat to the success of our business;

Potential restrictions due privacy breakdowns and concerns, both real and imagined:

Improper access to or disclosure of our users’ information could harm our reputation and adversely affect our business;

Our business is subject to complex and evolving U.S. and foreign laws and regulations regarding privacy, data protection, and other matters. Many of these laws and regulations are subject to change and uncertain interpretation, and could harm our business;

Dependency on a few key individuals:

Our CEO has control over key decision making as a result of his control of a majority of our voting stock;

The loss of Mark Zuckerberg, Sheryl K. Sandberg, or other key personnel could harm our business;

Share price deflated by financial engineering hurdles:

We anticipate that we will expend substantial funds in connection with tax withholding and remittance obligations related to the initial settlement of our restricted stock units (RSUs) approximately six months following our initial public offering

The market price of our Class A common stock may be volatile or may decline, and you may not be able to resell your shares at or above the initial public offering price; and

Substantial blocks of our total outstanding shares may be sold into the market as “lock-up” periods end, as further described in “Shares Eligible for Future Sale.” If there are substantial sales of shares of our common stock, the price of our Class A common stock could decline.

While it is hard to imagine that Facebook, the social network, will stumble any time soon, it is plausible to imagine that Facebook, the investment vehicle, will not reach the comparative heights implied by its IPO numbers. The stock market is, after all, a battle for investors.
There is, of course, a completely different way to look at a potential Facebook investment, which is that early investors “only” have to ride the IPO price up and get out before there are any signs of trouble.  If your strategy is to trade on sentiment rather than fundamentals, you’ll need to pay even more  attention to the early warning signals that these risk factors represent.
Whichever approach you choose to take, caveat emptor!
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Chunka Mui is the co-author of “Unleashing the Killer App” and “Billion-Dollar Lessons.”  Follow him at Forbes or on Twitter @chunkamui