A curious thing happened last week. Facebook’s stock, which had seem to have weathered the 2018 controversies, took a beating.
In the Washington Post, Craig Timberg and Elizabeth Dwoskin explained that the stock market drop was representative of a larger wave:
The cost of years of privacy missteps finally caught up with Facebook this week, sending its market value down more than $100 billion Thursday in the largest single-day drop in value in Wall Street history.
Jeff Chester of the Center for Digital Democracy piled on, describing the drop as “a privacy wake-up call that the markets are delivering to Mark Zuckerberg.”
But the downward pressure was driven by more fundamental changes. Simply put, Facebook missed its earnings target. But it is important to peer into why the company didn’t meet those targets.
As Zuckerberg noted in the earning call,
Now, perhaps one of the most important things we’ve done this year to bring people closer together is to shift News Feed to encourage connection with friends and family over passive consumption of content. We’ve launched multiple changes over the last half to News Feed that encourage more interaction and engagement between people, and we plan to keep launching more like this.
Later in the call, Facebook CFO David Wehner signaled total revenue growth rate would decelerate due to the choices made by Zuckerberg,
We plan to grow and promote certain engaging experiences like Stories that currently have lower levels of monetization, and we are also giving people who use our services more choices around data privacy, which may have an impact on our revenue growth.
Moreover, the costs would continue to rise as they also embedded more privacy and security features into the platform:
Turning now to expenses; we continue to expect that full-year 2018 total expenses will grow in the range of 50% to 60% compared to last year. In addition to increases in core product development and infrastructure, this growth is driven by increasing investment in areas like safety and security, AR/VR, marketing, and content acquisition. Looking beyond 2018, we anticipate that total expense growth will exceed revenue growth in 2019.
So, Facebook got hammered because it invested more in privacy and security, while also transitioning to less revenue generating source of content. At first glance, this might seem to signal from the market to not invest in these sort of changes. Indeed, as Blake Reid noted,
They got punished by the market for investing in less-monetized content and spending more on privacy and security. Doesn’t that send a signal to not do that?
Yes and no.
It has been widely accepted that corporations often adopt short term strategies that attempt to maximize earnings. As one well cited survey of financial executive explained, “Because of the severe market reaction to missing an earnings target, we find that firms are willing to sacrifice economic value in order to meet a short-run earnings target.”
This preference for the near term, especially for payoffs in the near term, seems to be a common feature among humans. People tend to prefer small rewards that occur now over much larger rewards that come later. This is known as hyperbolic discounting and it helps to explain why households under-save, why smokers find it tough to quit, and why firms prefer near term earnings.
Pulling together the insights from finance and behavioral psychology, two economists pointed out “that a firm exhibiting hyperbolic discounting preferences faces an underinvestment problem, i.e. there exists another feasible investment plan that improves all periods' present values.” Conversely, a firm exhibiting time invariant preferences would invest, even if it meant a short term hit.
Facebook is probably playing the long game. Zuckerberg has an overwhelming controlling stake in the company and wants to build value in the long term. And if these changes lead to more durability, that is, if users stay on the site longer in the next 5 or 10 years, then it makes sense to take the short term hit. It would be better to do this than have a massive exodus at some point down the road.
In the same kind of way, Amazon has been criticized for years for spending too much money on company investments to the detriment of returns. But, Amazon’s Q2 2018 numbers came in this week and they were double expectations. Bezos' 1997 shareholder letter laid out the strategy, “We believe that a fundamental measure of our success will be the shareholder value we create over the long term.” Bezos is also more concerned with building for the long term.
I’m working on a more formal model of this, but I think there are reasons to believe that Facebook would be especially sensitive to privacy concerns. And Facebook’s missing earnings also point to a real concern about the long term viability of the platform.