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Vitaliy Katsenelson
Vitaliy Katsenelson
Articles (126)  | Author's Website |

Facebook Stock Will Come Down to Earth Hard When Reality Sets In

May 18, 2012 | About:

I was recently on CNBC discussing the Facebook (NASDAQ:FB) valuation, which I believe is priced for out-of-this-world perfection. The easiest way to assess the insanity of Facebook’s valuation is by comparing it to Google’s. Facebook is set to go public at a sweet valuation of $100 billion, and it has estimated revenue for 2012 of about $4 billion.

However, investors are not buying Facebook today because they believe it is fairly valued, so what is the point of the comparison? Bear with me for a moment. Let’s say Facebook investors want to receive 15 percent a year over the next five years. In that case, Facebook’s market capitalization has to double in five years, to $200 billion. Conveniently, $200 billion happens to be Google’s valuation today. Since both companies are in the advertising business and have very similar cost structures, all Facebook has to do over the next five years is achieve Google’s (NASDAQ:GOOG) current sales level, which is a meager $40 billion (for purposes of this discussion, we’ll ignore Google’s $40 billion pile of cash, or about $100 a share, compared with Facebook’s few billion, though that would only further make my point here). For an investor to double his or her money over the next five years, all Facebook has to do is increase its revenues tenfold.

That sounds doable at first glance. When your name defines what social networking means, and when you have 900 million users, nothing seems unconquerable. Still, increasing revenues tenfold may become a difficult undertaking for Facebook. First of all, there is a user fatigue. I find that as the novelty of Facebook wears off, I spend less and less time logged in to my page. (Interestingly, I find that I use Twitter more and more every day, because I strictly use it as part of my research process). One can argue that it may just be me, but a study undertaken by a web research company last fall shows that users are indeed getting Facebook fatigue. In addition, Facebook is a productivity drain, and employers will likely start blocking employee access to Facebook during businesses hours, which will further decrease the time spent on it.

In theory, Facebook is an advertiser’s dream. Since we openly share our age, sex, education, employment, travels, likes, etc., for the first time ever, a retailer can market to an incredibly specific demographic: a 38-year-old male, in Denver, married with children, with a graduate degree, who “likes” Ayn Rand. The precision of target marketing offered by Facebook is simply incredible. But while you can charge a lot more money for delivering a display ad with sniper-rifle precision, this money will be wasted if your precisely selected audience simply ignores your ads. It doesn’t matter whether you deliver ads with a sniper rifle or a 12-gauge shotgun, if users don’t notice them, precision carries little value. It seems our brains have gradually adapted to ignoring display ads — I personally cannot recall a single display ad from Facebook.

By now, you may have heard that GM has pulled its advertising from Facebook because it did not see much benefit to it, while Ford is sticking with it.

To make things worse, there are only so many ads Facebook can deliver per page without trashing the user experience.

Finally, it is hard to maintain your competitive advantages when you don’t know who your competition is. Facebook competition is likely to be nonlinear (e.g., not Google+ or Myspace-like networks). Instead, it will probably be another activity that competes our time away from Facebook. I have no idea what it will be — maybe it’s not even born yet.

Of course, in the short term, it doesn’t really matter what Facebook revenue or cash flows are. Investors are ignoring them. Facebook stock can probably double in the first five trading days, rather than five years. After the company goes public, its shares will trade for a while like a beachfront property that was frequented by Elvis, and little details like cash flow won’t matter. But the honeymoon will eventually end. It always does, and Facebook will then start trading like an unsexy apartment building — based on cash flows. That is when reality will set in and the stock will come down to earth, hard.

About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).

Visit Vitaliy Katsenelson's Website

Rating: 4.2/5 (26 votes)


Paulwitt - 4 years ago    Report SPAM
I just saw on TV, after the IPO was launched, that someone had called Mark Zuckerberg "The One". The last time someone was called "The One" gas prices doubled.

No thanks

Cornelius Chan
Cornelius Chan - 4 years ago    Report SPAM
Conservative investors, as a general rule, avoid investing in new issues.

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