patrick.net

Web companies cost of sales usually includes "traffic acquisition costs". In the case of something like Google's adsense, this is the amount paid to publishers. It also can include things like revenue sharing arrangements.

For instance, there's a revenue sharing arrangement between microsoft and facebook on ads shown in search.

Facebook also only gets a 30% gross margin on facebook credits AFAIK.

I still don't quite get why there are two separate margins.

There's revenue, and there's expenses. So I would think there should just be revenue - expenses = margin

Gross Margin is typcially thought of as:

Revenue / Cost of Goods Sold or Cost of Revenue. It's the direct cost of attaining the revenue. Any business can generate revenue if they give it out for free or essentially free, but it only matters if the revenue has some profit or margin in it.

Revenue / total expense (revnue - COR - SG&A)is the operating margin. Include non-operating item like interest and extraordinany items and it is thought of as profit margin. Most people consider these SG&A (selling, general and Admin) expense or simply overhead. Overhead is mostly thought of as the fixed cost of doing business. Fixed doesn't mean fixed, when a company annouces layoff or hiring plan, It just a part of the company's plans to increase SG&A or reduce SG&A base on the needs of the business. Facebooks's SG&A expanded significanly betweem 2009-2011, which also means they have been hiring quikly in proportion.

Profit margin should be clarified to mean before tax or after tax. In 2011, Facebook achieved a profit margin before tax of about 40% and after tax profit margin of 25% Apparently they have not used some of Googles tax strategy's to get Effective tax rate to around 20%. Facebook is at 40% but we know it's going to be a shareholder demand to fix that soon. 40% profit margin before tax is among the top 1% in the S&P 500. The only company I can think of that has has higher profit margin is BIDU.

Having said that, this is GAAP accounting. An obvious flaw to GAAP profit is stock compensation expense for GAAP purpose vs. reality. Stock compensation expense recongized is based on mostly the black-scholes model and in the case of Facebook, the actual result per the model is nowhere close to reality. I believe it is hidden in the APIC.

Gross margin is important because it tells me the profit potential of the company. Let's say Facebook has a revenue of $100 and achieved gross margin of 80% and SG&A of 40%. (to get to 40% profit margin).

The comany has decided to expand SG&A by 10% to support their business. From $40 to $44

They had a great year and sold $200. (monetized their revenue but only need to expand SG&A by a little)

Gross Margin @ 80% = $160
SG&A 44
Profit Margin = 116 or 58%

Based on this oversimplistic model, doubling their revenue increased their profit margin from 40% to 58% or before tax profit from $40 to $116. A great gross margin leverages each additional dollar to the bottom line. To the extent that Facebook can monetize more revenue, it will be hit profits exponentially. That's what get the financial analyst people excited and support these crazy PE's. Google for the longest time was prices at 100 PE which was supported by fast growing sales flowing to the bottom line and actual cash even faster.

Which loops back to BIDU because it is a great example of the power of gross margins. BIDU had a PE of 500 when it first traded for around $10. Because they had excellent gross margin, that 500 PE ultimately became a ten bagger winner as well. The secret is they were able to monetize achived revenue into essentially all profits. Profit margin went from 25%, 35% 40% and now 50%! They can get to 60%. If you tell me that BIDU was going to be a 50% profit margin in 2008 (and kick Google's ass in China), I would pay 1000 PE easily.

To most, Facebook will appear expensive, but 100 PE can be a bargain if you can visualize this as a 75% growth business with 60% incremental profit margin. Facebook has that potential. Some of the largest private equity buyer who invest hundred of millions see it that way as well. It's 100B for a reason.

I still don't quite get why there are two separate margins.

There's revenue, and there's expenses. So I would think there should just be revenue - expenses = margin

The difference between gross and net margin is a reflection of a company's ability to contain costs. It's much more useful in manufacturing and other industries than it is in industries like software or advertising, where the only real expense is labor.

For many industries, you might as well think of "gross profit" as "revenue".

SFace says

Which loops back to BIDU because it is a great example of the power of gross margins. BIDU had a PE of 500 when it first traded for around $10. Because they had excellent gross margin, that 500 PE ultimately became a ten bagger winner as well. The secret is they were able to monetize achived revenue into essentially all profits. Profit margin went from 25%, 35% 40% and now 50%! They can get to 60%. If you tell me that BIDU was going to be a 50% profit margin in 2008 (and kick Google's ass in China), I would pay 1000 PE easily

You could equally have used Ariba, Commerce One, Agile, Priceline, VerticleNet or the other over-priced stock. They too had the same argument, but it all failed at the end.

If what you said was true, then why didnt we ever .. and I stress the work EVER see, prior IPOs going out at a higher valuation prior to 1995 and Netscape. Since 1995, pretty much nearly 99.99% of the IPOs have tanked. You mention, BIDU and Google.. yet there are countless others that failed badly.

When Cisco went public its valuation was modest and had to earn any stock appreciation based on performance. Its is a complete rip-off to over pay based on some pie in the sky forecast of higher future earnings. THAT WAS THE LESSON we learned from the DOT.COM bust.

thomas,

that person identifies HimSelf with the American Express Black card. You wanna spend your calories arguing with someone like that?

Jeez.

B.A.C.A.H. says

You wanna spend your calories arguing with someone like that?

Arguing burns calories? I need to argue more. It's the most fun exercise I get!

B.A.C.A.H. says

thomas,
that person identifies HimSelf with the American Express Black card. You wanna spend your calories arguing with someone like that?
Jeez.

they wont last long... they never do.

Based on Thomas' logic, Facebook would be massively overpriced when Microsoft valued them @ 15B on a private transaction three years ago. Clearly that is wrong.

High PE can be supported if the profit margin are high and sales are rising. That is the essense of a money generator and the only reason I see Facebook as a worthwhile investment. This has nothing to do with Ariba and Commerce One, or dot com. 99.9% fail rate is not tehnically not correct anyway.

Besides Goog and Bidu, there are plenty of companies that grow into their high PE's on IPO's post 2002 including NFLX, Salesforce, Chipotle, and Lululemon. Obviously, if your reference point is year 2000 and high PE then I get that excess.

The centurian is a tribute to my two mentors, one my boss and one my F-inlaw. That should not offend you. On the other hand, It totally respect your viewpoint as well. I only care about adding value to these message board based on my perspective.

I just read that 12% of facebook income comes from Zygna. That is impressive, they must have dumped a lot of money into facebook over the years.

SFace says

Based on Thomas' logic, Facebook would be massively overpriced when Microsoft valued them @ 15B on a private transaction three years ago. Clearly that is wrong.

That is why im saying FB is overvalued.. The logic was very sound on the part of MSFT.. you may not know what to do with something like FB, but you dont want the competition to get them either. So you inflate it beyond any possible way for FB to get acquired. Its a poison pill designed to backrupt the acquirer.

$300M for say 1.6% share in FB isnt much a material amount for Microsoft to actually lose. They sneeze more that each day.

Now that there is a exit, that investment for everyone else who pitched in has to have a big return.. but its already inflated thanks to MSFT.
And there will be blood...

SFace says

including NFLX, Salesforce, Chipotle, and Lululemon

They came out in dinky valuations.. Sales force went out at 15 and dropped to 11 before reaching 125+ many years later. Same with Netflix..
they were only a mail based DVD rental lighly valued before growint.. there was no way to spin/inflate this business..

The advantage facebook has right now is that it can find new ways of creating revenue. It's like google back in 2000. They came up with a model that made them boat loads of cash. However, over the years, they've figured out how to create reallly big boatloads of cash out of it.

Facebook right now is making money, but the potential there is massive. However, as it stands right now, advertisers are getting very little bang for the buck. The thing with Internet advertising is that you can get exact numbers. Newsprint you can claim for every person who brings in a coupon, 50 others forgot it at home. Who really knows? It's easy to fudge those numbers. Advertising online is far different. It's possible to see exact impacts to your numbers, visitors, how much traction you get, how often they return, etc. Facebook is doing a horrible job in all of those metrics.