I had the misfortune of missing most of the first Internet bubble. Although I’d got into the Internet before there was a World Wide Web I’d signed my life away to the Royal Navy (in exchange for a great education and generous financial package). Thus I got to spend the two years it took between resigning from the Navy and escaping to the outside watching everybody else do lots of cool things (and in some cases getting rich whilst doing those cool things).

I caught the tail end of the whole thing by joining a .com consultancy firm in early 2000. I remember now clearly the moment that I realised that the Internet had become an investment bubble rather than an economic miracle. It was in the wake of the AOL Time Warner merger, and I was in the pub next door to the office discussing with my colleagues the merits of ‘clicks and mortar’ versus ‘bricks and mortar’. I’d known the web since its birth, and none of this made any sense to me.

I had a similar epiphany the other day when it was reported that Goldman Sachs is investing $450m at a $50Bn valuation. Madness.

Dion Hinchcliffe sums things up perfectly:

There are clearly two things wrong with this picture:

1. User based valuations are relics of the web1.0 bubble, and were contrived for situations when companies weren’t actually making any money by any normal measures[1].
2. How can the average Facebook user possibly have a net present value of $100 to the company?

To be fair it wasn’t really an epiphany. I’ve been short on Facebook and its ecosystem (particularly Zynga[2]) for some time now.

To be fair on Goldman Sachs I don’t think they’re idiots – far from it – though I do think it’s likely that they’ll flip their investment (sooner, whilst the company is still private, or later, after the long awaited IPO[3]).

The main point here is that I use these services. I know people who use these services. I even spend money on these services – just not enough to get into the same order of magnitude as $100.

The other key thing is that I like Facebook less now than I did before. For a while it felt like the school playground – a few rough edges, but fun. Now it feels like a shopping mall – all shiny, superficial and nothing that really captures my interest. Of course my friends are still there, and I can chat to them, but we could do that on Twitter or Gmail or Skype.

‘But what about advertising?’ I hear you cry. Facebook makes its money from advertising just like Google. Google is an (almost) $200Bn company, with revenues of around $28Bn. Facebook has even surpassed Google for page impressions, which is where we find the heart of the problem – Facebook is working a lot harder than Google to make a lot less money. That doesn’t make it worthless, just worth less – somewhere around $14Bn if we think Google is a reliable comparison.

The other thing to worry about is growth. Google is going through that painful transition from being a growth company to a cash cow. From a corporate structure perspective I think life will be easier at Facebook, but for the balance sheet things are less rosy. When you already have most of the world population that could use your service already using your service then that’s not a growth story. Of course the internet will continue to expand its reach, but those new users will be $1 users not $100 users.

So when will the bubble burst? I’d give it 2-3 years if the company stays private, less if an IPO happens in the next year – there’s nothing like having Wall St analysts picking over something to bring on a sudden dose of reality. Do I think an IPO would be a disaster – only for those buying the shares.

[1] Facebook is making real money- revenue of approximately $2 billion, with roughly $400 million in profit. That means it has real value. The problem is simply a disconnect between present cash flows and views on future cash flows.

[2] Who haven’t had a hit since Farmville, and where the miracle of ‘social gaming’ seems to have turned to an advertising symbiosis (deadly embrace?).

[3] One way that many of Facebook’s users could be worth substantially more than $100 each is if they can be persuaded to buy stock ;-)