Facebook’s Secret Strength

By Matthew Yglesias

Facebook CEO Mark Zuckerberg speaks to the TechCrunch Disrupt SF 2012 conference on Tuesday in San Francisco

Since the May IPO that valued Facebook at $100 billion, nothing much has gone well for the social media giant. The price of shares steadily tumbled through the summer, down to about half their IPO value before a stirring talk by founder and CEO Mark Zuckerberg at the Techcrunch conference in San Franciso yesterday helped give the stock a small bounce.

But as Facebook owners freaked out by the weak share price already know, there’s really nothing they can do to make Zuckerberg do anything about it. That’s because, as I noted when Facebook first filed its IPO paperwork, the company’s corporate governance structure is unusual. Specifically, there is no governance structure to speak of. An absolute majority of voting power is controlled by Zuckerberg personally, and there’s no requirement for members of the board of directors to be “outsiders” to the company. The firm is publicly listed and you can buy and trade its shares on the stock market, but the company is Zuckerberg’s personal fiefdom, at least until he wants to cash out some of his voting shares.

The current crisis in Facebook’s share price shows what a wise decision it was to preserve that personal control.

You can think of a stock price as driven by two separate factors. One is the company’s profits, or “earnings” in accounting-speak. The other is the price-to-earnings ratio—in other words, the total value of the company’s stock divided by its profits. The economy-wide P/E ratio bounces around quite a bit from year-to-year, driven by various manias and panics, but the long-term average tends to hover around 15. But individual companies can diverge quite a bit from this trend. A profitable company in an industry that’s in predictable long-term decline (think newspapers in 1999) or that has limited growth potential (an electrical utility that can’t really move into new markets) might have a lower P/E ratio. Alternatively, a new-ish company that’s poised to grow faster than the corporate sector as a whole may have a high P/E ratio.

So a firm’s share price has two different elements—profits, and what amounts to a prediction about future profits—and only one of them is really under the control of managers.

That’s not to say that managers don’t have influence over actual future profits. This is arguably the most important job they have. But delivering future profits and deliveringoptimism about future profits is a different thing. Ever since the 2008 crash, for example,Apple’s stock has traded at a P/E of around 15 with the markets expecting approximately average growth in profits. Quarter after quarter, Apple beats that—meaning you’ve made a lot of money if you bought Apple stock four years ago—but this hasn’t shaken the overall market’s conviction that the fundamentals for a consumer electronics company that’s lost its charismatic founder has only average prospects. Amazon, by contrast, has seen its P/E ratio soar from an already aggressive 50 to a crazy-high 314.

This kind of shift in sentiment is enormously important to the value of shareholders’ investments. But it’s difficult to change, and counterproductive for managers to focus on it. After all, the optimism level reflects something like average sentiment about the long-term merits of the current business strategy. But if formulating a strategy that leads to explosive long-term growth were easy, everyone would do it. Picking the right strategy and picking the strategy Wall Street and investors think is right are different things. Part of the genius of Facebook’s corporate dictatorship is that it lets Zuckerberg focus on finding the right strategy, rather than focusing on popular opinion about what the best strategy would be.

Even better, it frees Zuckerberg from the need to waste time spinning about issues that are totally out of his hands. Facebook’s financial future depends on many variables that are hard, or even impossible, to predict. One strength of the company is that, in principle, it’s totally global. It works just as well in Florida as in the Philippines. But maps of Facebook usage show weird blank spots, including all of China, where, for political reasons, the service can’t be accessed. Whether that billion-strong market is opened to the company has huge implications for its future. So does the question of whether India’s government gets its act together and lets the world’s second-largest country enjoy a couple of decades of China-style supercharged growth. If those 2-billion-plus people become as lucrative to Facebook as the average American, that’s great for the company. If not, the outlook is a good deal worse. Investor sentiment about the likelihood of these outcomes is an important driver of Facebook’s price, but there’s nothing Zuckerberg can do about it.

And yet, even though much of the uncertainty around Facebook’s future is out of the CEO’s hands, the market’s strong response to Zuckerberg’s talk shows that he can affectperceptions of the future outlook. A Facebook CEO who wants to do right by his shareholders would learn the lesson that he needs to spend less time running the company and more time talking about it. Indeed, the CEO of a normal public company that experienced this kind of share price collapse would essentially have to. He would have to, even though on some level it’s perfectly obvious that shifting focus in this way would be a poor use of his time. Freeing Zuckerberg from that kind of burden is the company’s best hope for navigating what continues to be a challenging environment for any company (Slate and its parent company included) that largely depends on online display advertising for revenue.

Facebook’s unorthodox, shareholder-screwing governance structure gives Zuckerberg precisely that freedom. There’s no guarantee that anything he does will vindicate the company’s once-lofty share price, but the fact that the CEO is able to ignore shareholder interests is one of the best reasons for optimism that he can.