Analysis: Facebook has recently raised around $2bn in new funding from Goldman Sachs and other investors in a deal that values the social networking business at around $50bn. While the company recently reported being “free cashflow positive” (it makes money) for the first time, the valuation reflects a multiple of earnings that is likely to be well into the hundreds, if not thousands.

In a similar vein, the 19th Century saw huge investment in the railroad infrastructure in the US. The real beneficiaries, however, weren’t the shareholders in the rail companies themselves, but businesses who saw new markets and new products open up as a consequence of the new network. Facebook’s capacity to generate long-term profits for its owners will similarly be limited and will make a farce of the current valuation multiple. Businesses who tap the value of the new network capacity will be the real winners.

Shortly after the Santa Fe Railroad arrived at Flagstaff, Arizona in 1882, three brothers from Chicago, Matt, Michael and Tim Riordan, bought a lumber mill there. The new railroad connected the area with distant markets for the local ponderosa pine, and the Riordans’ company also won contracts to provide the railways themselves with wooden railroad ties – 3,000 of them per mile of track. New rail technology enhanced the company’s productivity by extending rail into the mountainous forests where the ponderosa pine thrives.

Railroads were the cornerstone of economic progress in the United States from the end of the Civil War until their heyday in the 1920s. Some great fortunes arose directly from rail: Vanderbilt and Gould for example. At the same time fortunes were lost, as many wannabe railroad companies came and went. But not Riordan. The Riordans made their fortune indirectly, by both supplying the railroads and using rail technology to increase their productivity in a virtuous circle.

The railroads were, at the turn of the twentieth century, what the Internet is today. Both opened markets for new goods and services, and damaged the economics of existing business. The railroads devastated canals and localized agricultural interests. The internet has just about finished off retail video rental and music retail outlets, amongst other things. Both are network business models that were initially funded by over-exuberant capital markets. The mileage of railroad grew at an amazing 15% annual growth rate from 1830 to 1890, to the great advantage of “second-order” winners like the Riordans.

While railroads changed the United States, equity investors had the stuffing knocked out of them over and over. Rapid growth requires capital, and this means additional debt and/or dilutive equity issuance. A capital-intensive industry like rail required large sums to expand. In this instance it was usually better to be a supplier to the railroads than an owner, and the same holds true today.

Just as railroads created insatiable demand for commodities by lowering their cost and expanding supply lines, so have devices like the iPhone created ever-greater demand for data. Companies are beginning to see their data as a core asset.

Wal-Mart, for instance, handles one million transactions per hour. Its database is nearly two hundred times the size of the Library of Congress. All this data “exhaust,” the remnants of consumer choices, is very valuable. In 2004, Wal-Mart probed its database and realized that consumers purchase three things when a hurricane is imminent: flashlights, batteries and Pop-Tarts. The first two items make sense, but Wal-Mart stores in hurricane-prone areas now stockpile the third, as well. Similarly, Best Buy was surprised to find that 7% of its customers represent 43% of sales.

Facebook can commercially serve brands like Walmart and Best-Buy, who want to gain more and better data “exhaust” from their consumers. Managing to do this, however, in a way that doesn’t alienate Facebook users is quite difficult, and forcing brands to pay up in this process is similarly proving tricky.

After throwing around all kinds of ideas on how to generate revenues from this network Mark Zuckerberg seems to have settled on a number of ways to bring in the big bucks. Each of these has their limitations, that make the $50bn valuation pie in the sky.

1. “Self-serve advertising” allows marketing folk to decide precisely who they want to appeal to and buy ads to put in front of users who fit a specific profile. Facebook amalgamates data on users and the ads are served up on their screens accordingly. Sounds great but potentially problematic if Facebook users (as they are demonstrating) backlash against the data mining of their personality traits. Facebook seems eager to pursue a stealth-like approach to collecting data on individuals which is turning some away from using the site. Furthermore the appearance of in your face advertising on your Facebook page may just be a turn-off altogether. Brands can undertake this data mining themselves through a variety of social networks, including Facebook, without actually paying to access that network.
2. Gifts and other virtual property that users can buy and give to each other. This still seems like a crazy idea to some people, but it can prove a profitable business given the right circumstances – virtual goods keep up all kinds of online games afloat, and nobody ever thought ringtones could be so profitable. How much does this generate for Facebook, and how much margin will advertisers pay for the access? How many lunatics actually pay real money to get fake credits to purchase items in online games?
3. “Facebook Deals” is a location based offers service which allows brands to give incentives to users who check in at their venues using “Facebook Places”. When users search for places to “check-in” (i.e. they confirm geographically where they are), those with a live deal will appear with a yellow ticket next to them, to help encourage people to go to that brand’s location.
   
   This service is free for brands to set-up, with no sales commission being taken by the network, but will increase the value of on-site advertising – which is how Facebook aims to get paid. As an example Argos is using the “charity Deals” option, donating £1 to Teenage Cancer Trust for the first 10,000 “check-ins”. That doesn’t seem much like charity to me; the cheapest direct advertising going and no real revenue uptick for Facebook. Furthermore, how many Facebook users want to be wilfully followed from place to place (I certainly don’t).
4. Facebook is known to be working on a micropayments system that will allow it to take a slice of any transaction that takes place through the site. To me this is the most likely area to see significant revenue, but how long would people transact on-site when they can find the deals on-site and transact cheaper direct. The 300mm strong network allows buyers and sellers to come closer, but Facebook’s long-term ability to take some revenue out in the middle is highly questionable.

As one internet blogger points out: “Ultimately, I see Facebook’s financial success strictly bound to its transformation into the institutionalized, business friendly, version of Big Brother (an entity that holds and is entitled to sell, the personal data of everyone). A perspective that, frankly, doesn’t inspire in me any enthusiasm.”

This network, like the railway network, is extremely valuable – just not to the people who own it, but more to those who use it. At a $50bn valuation I know that I won’t be buying shares in the IPO, but I’m sure Goldman Sachs will convince plenty of over-excited pension funds to do so.