Looking At Facebook Through Its Internet Peers

During the spring of 2012 Facebook (FB) underwent its initial public offering, amidst a great amount of media coverage and investor interest. Among the things that make Facebook such an object of fascination is its rivalry with the search engine company Google. If information can be seen as a raw material that can be mined, then you can think of Google (GOOG) as making information more valuable by being able to refine it with more pointed search results. In the cases Facebook and Google both are hired by its users to perform the job of providing information that its users would most like to see. But as the story goes, users on Facebook tend to spend more time on the site than users do using Google’s search and more captive users may prove to be more attractive to advertisers. As a competing method of refining information, Facebook provides value by organizing information through recommendations by your friends rather than a highly logical but more impersonal algorithm.

The Internet is sometimes described as a place for exchange and transfer. But just like any place of exchange, there is often a deal being offered that buyers may not be sure about. Buyers may not be sure whether the party offering the product can be trusted. And what makes them most wary is that they do not have adequate information about the quality of the seller. In other words, the seller has more information about himself than the buyers do—the information among the market participants is therefore said to be asymmetrical. In any market, if this asymmetry of information is pervasive, one negative consequence is that the quality sellers, will be judged to worth less than their true value and feeling undervalued, will be inclined to leave the market. This will leave the market with only the poor quality sellers, or the lemons. This is the famous lemons problem that George Akerlof discovered during the 1970s for which he won the Nobel Prize in economics.

Some solutions to the problem of asymmetrical information in everyday life include the existence of trusted intermediaries who validates the sellers’ quality and worth. For example, if an investor is deciding whether or not to put money into a new but unproven business , it helps the investor if a bank he trusts is providing the new venture with a loan. Similarly, the hiring manager for our recruit may alleviate the lack of knowledge about the candidate somewhat if some trusted person vouches for her qualifications, which is why it is often said that the people that have the best chances of getting an interview are those that have networked most effectively.

When it comes to solving the problem of asymmetry on the Internet, the best Web companies also do so by reducing the informational gap. But rather than act as a trusted verifier, the best Web companies use other tools unique to the Internet, namely its large population of users and the feedback this population often provides. There are a number of examples of this. The quality of Google’s search results is based on a combination of relevance, the number of times the searched for text appears on the page and the amount of times it is cited by another page. Based on this quality, they may be more likely to trust the information that is being offered. On LinkedIn (LNKD), a person’s profile is recommended and a recruiter has little more validation about the profile than one that does not. On YouTube, in addition to listing the number of views in order to validate the quality of the content, there is also a more direct indicator, a like feature, listing the number of likes.

Videos that are more liked and/or most viewed are likely to be of higher quality than those that have few views. On Amazon (AMZN), a product may be offered by an unknown merchant, but there is a star rating system and people are allowed to submit reviews on sellers’ products. And not simply this but even the raters/verifiers are rated with x number of people finding whether this review was helpful. And so on. It stands to reason that any web company that makes information more valuable for its consumers has a better chance of becoming more popular and more valuable. I have named only a few examples, but the Internet is rife with these kinds of quality-validating features. I’m sure you could think of many more if you wanted.

In setting up verifying features that take advantage of participant feedback, these Web companies are simply building on top of content that others have previously voluntarily offered. (Indeed if there is a hallmark of the Internet, I would argue that its success results from its participants voluntary efforts to contribute content and to curate this content.) These Web companies have simply been able to utilize the feedback on this content as a way of improving the quality of this information.

And there are still more novel solutions to the problem of asymmetry occurring. The case of Groupon illustrates a novel attempt to solve the asymmetry problem. The Groupon model as we know offers coupons if there are enough people willing to participate in the sales event. Frequently, these coupons are offered by businesses that are not widely known but who hope to broaden their customer base by introducing prospective customers to their product or service. How this solves the problem of asymmetrical information is that rather than try to verify the unknown product, Groupon simply permits that asymmetry to be priced in at a discounted price. At a lower price enough people may be willing to try anything at least once. And it is hoped that a good experience will lead to a recurring customer.

Finally, there is Facebook, which we opened with. Similar to other Internet companies it derives a great deal of value off of other people’s voluntary efforts. When a friend likes something so that it gets in the news feed, essentially the Internet’s information becomes not active, or even reactive to the user but passive. The value proposition offered to Facebook users: You don’t even have to search to crawl the Web; other people mine the information from the Web and bring it to you.

These examples present new ways of looking at the new value chain for information. But it also presents us with many uncertainties of how to value this new arrangement. How shall we account for all these voluntary contributions that Facebook uses but nevertheless has possession of—as a virtually costless expense; as a costless asset that, as information, depreciates quickly; as a continual source of revenue growth? These are just some the questions that come to mind as we go forward.

Christopher Chiu
Principal of Ralloc Capital LLC, a subadvisor of RCM Wealth Advisors

Disclosure: The author currently has a position in Facebook (FB).

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