Depending on who you ask, Facebook has either had a great year or a bad one. Most expected when the company went public that it would immediately become a $75-100 billion company. Today that are worth little less than $60 billion, up from below $40 billion. Facebook was considered a very difficult company to value by Wall Street. But what exactly does the process look like to value a company?

Companies are valued all the time. Public companies are valued constantly. Private companies are valued too, but less often. Depending on who you ask, the way you value a company can happen in a number of ways. It’s a lot like baking and cooking actually. There are recipes but no one agrees on the best method. The best chefs don’t even follow strict recipes or they certainly keep them secret. It’s as much art as it is science. Valuing a company is the same way.

In most instances valuing a company is simply a matter of figuring out how much money they’ll make over the next few years. From there those values are discounted for time and risk. The trick though is in figuring out the right amount of money they’ll make and how much to discount it.

So let’s look at some of the factors that determine how much money Facebook will make. One major factor in Facebook’s revenue model is how much money companies are willing to spend on advertising. A rising tide lifts all boats and if advertisers are expected to spend more Facebook will likely make more.

But it isn’t that simple. Facebook is a new advertising business and so even if spending is falling, Facebook’s could still be growing. For example, Facebook makes a lot of money by offering advertisers the ability to directly target customers. But, for some major ad spenders Facebook still isn’t a good value compared to other online options. If you think Facebook will figure out a way to be more valuable to those advertisers, then Facebook’s revenue may be higher than others project.

This process must be applied to Facebook’s expenses as well. Their costs will rise with revenue, but by how much? What types of taxes will they have to pay? These are all considerations that go into a company’s valuation.

Once you feel good about your own analysis then the discounting math will help you arrive at a value for the company today. It is likely that the current valuation won’t equal your valuation. The more unknowns there are about a company, the more variable the potential value may be. A utility company has a fairly constant revenue stream that’s easier to project. Facebook is more of a wild card.
The numbers are only half the story though. And different people can have different values for the same company.

Most people that professionally value companies do so as a service. So they must make people believe their valuations are correct. This is where your story must back-up the data presented. If you think Facebook’s growth is slower than the market does, then their value is likely less too. But if you see Facebook breaking into a new advertising space and stealing business from others, then it could be worth more. If the story is not compelling, no one will believe the math.

This process is no different than what we do in the kitchen. Food tastes better if it looks better. And it’s easier to sell too. Likewise, there are a lot of ways to make a tasty brownie. And different people prefer them different ways. But ultimately, in a competitive market, you have to make yours stand out if it’s going to sell. If you’re a discerning eater, you’ll want to understand how it was made. If you’re a glutton for punishment, you’ll eat anything that’s thrown at you. This is not much different than the world of valuation.

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categories: business, investing