Question

7. An assessment of the facbook economic moat, including reasons for your conclusions

Answer 1

An economic moat, coined and popularized by Warren Buffett, describes a series of competitive advantages that surrounds any business and defines its long-term ability to maintain profits and strong market presence. This term has been thrown around in almost any situation or industry imaginable in modern literature. The recent IPO of Facebook exemplifies how a strong moat can take precedence over company fundamentals and sound financial valuation and dictated the eventual 100 billion dollar valuation it would receive at its IPO.

Facebook is a challenging company to value. It would be easy to dismiss Facebook as similar to MySpace or other social networks, but Facebook has a compelling network effect that gives it a wide economic moat. It has become a central place for users to communicate and share. People spend a lot of time on Facebook, and although minutes of usage will likely decline over the next couple of years, the likelihood that people will continue using Facebook is very high. There are organizations and groups that communicate only on Facebook, which makes it a functional as well as social platform; that communication approach forces usage. Initially, the market was apprehensive about the threat from mobile devices, particularly in the early days of Facebook. It does not generate any advertising revenue from mobile usage, and that lack of revenue creates an overhang on profits. But our expectation is that the company will eventually resolve the issues relating to mobile usage. Facebook’s attractive valuation is based entirely on our wide-moat rating. It is difficult for people to leave the Facebook network. Valuing that network effect is challenging, but our 10-year projections show Facebook earning excess returns. Furthermore, we believe it is likely to continue earning excess returns on capital beyond those 10 years. Facebook also has the potential to become a compelling advertising exchange, which is another business with network effects.

The strategy at Facebook has been very simple from the start: create an engaging interpersonal relationship through the internet that will build and maintain connections. This engagement of personal connections has been successful and has offered marketers and advertisers a unique combination of reach, relevance, and social context to reach out to potential customers. The reality is that every person’s Facebook experience is unique and completely personalized.