Saturday, July 28, 2012

Loan Sharks, Facebook and the Growth Fetish

Think about the following game. I'm going to let you pick seven or twelve then I'm going to role a pair of dice. If you pick seven you win seven hundred dollars if seven turns up and you lose one hundred if it doesn't. If you pick twelve you win two thousand dollars if twelve turns up and lose one hundred if it doesn't.

I assume everyone who reads this blog would pick seven at this point but what if I added the following detail, there's a loan shark waiting outside with a large gun and he is going to shoot you dead if you don't hand him two thousand dollars.

Suddenly, that twelve is starting to look pretty good.

This example is extreme, of course, but it's not all that unrealistic. There are lots of situations where the value of money follows a nonlinear or even stair-step curve. (ever been a nickel short at the coke machine?). Unfortunately we often make all sorts of assumptions about smoothness and well-behaved functions when talking about finance and economics.

Think about stock options. Let's say you bought a share for one hundred dollars. Furthermore, lets say that the CEO (whose options are also pegged at one hundred) has a choice between two strategies: one has a fifty/fifty chance of a share price off 100 or 105; the other has basically a fifty/fifty chance of lowering the price to 50 or raising it to 110.

Which is the better strategy? That depends on whether we're talking about the point of view of you, the stockholder, or of the CEO.

This is, of course, another toy example, albeit a more realistic toy than the first. For a real and timely example consider this from Marketplace:
Facebook's ad revenue is growing steadily, but not fast enough to justify its stock price.

Williamson: Everybody is going to be looking for is some traction in mobile revenue.

If Facebook's ad sales aren't gaining momentum, the social network could face another problem: share overhang -- meaning, jittery employees could dump shares and the stock plummets. Since the IPO, employees haven't been allowed to sell shares. But starting in August, they will be.

Brian Wieser: If the revenue turns out to be way above expectations, it is possible to alleviate some of the share overhang.

Brian Wieser is an analyst at Pivotal Research Group. But he says if earnings disappoint, employees could stage an ugly sell off.
Other than the marketing analytics aspect (where Facebook is very sharp) I don't have any special expertise here, but to a casual observer, the company appears to be facing a seven/twelve choice.

The seven is to shore up the mobile side of the business, get costs under control,and focus on deepening the relationship with existing customers.This strategy has an excellent chance of paying off handsomely for many years.

The twelve is to try to try to grow fast enough to justify the stock price which is a hell of a long shot (When you're closing in on a billion members, a business plan that assumes further explosive growth may not be realistic). Unfortunately, even having a chance at that goal requires pouring money on the problem and squeezing more cash out of members in ever more annoying ways. This strategy runs the risk of leaving the company cash poor with a tarnished brand and unhappy members.

All of this takes us back to the growth fetish, the tendency to overvalue short term growth even when it may end up reducing the long term returns of a company.