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David G. Dietze, JD, CFA, CFP
David G. Dietze, JD, CFA, CFP
Articles (55)  | Author's Website |

Should You "Friend" the Facebook IPO?

January 30, 2012 | About:

The media hype is starting: Rumors abound that Facebook will soon announce plans to sell shares to the public. Whispers set a $100 billion price tag as a possible valuation for the social media giant; it would be the largest internet initial public offering (IPO) ever, and the fourth largest IPO of any type.

Interest is intense; after all nearly 800 million users spend hours daily on the site, trading pictures, political banter, recipes, reconnecting with old friends and searching for new ones. No website has captured the imagination and time of so many across the globe.

Pundits say we can only imagine the advertising, data mining, and related revenue that could be generated. The value of networks, it's said, rises exponentially with their size. Facebook is a unique property and represents a unique opportunity for investors. But, does it merit your investment dollars?

Bottom Line

Steer clear of this IPO. Profitable investing requires focus on the financial metrics. Tallies of clicks, unique users, and time spent on a website is of little value and can't be analyzed except by the revenues and profits generated. The rumored price tag puts the shares in bubble land, where the downside risks far outweigh any upside hopes.

Growth is sure to slow. Converting from private to public will produce headwinds. Historically, these types of companies have disappointed, while the recent track record of social media IPOs has been anything but inspiring.

Avoid the Bubble Land Valuation

The proposed Facebook IPO pricing would value the company at up to $100 billion. Unfortunately, when analyzed in the context of its recent financial results, that just doesn't make sense.

Facebook is said to have generated $4 billion in revenues last year, with profits of $1.5 billion. That means the price to earnings ratio is nearly 70; absent growth you'd be better off with a ten year Treasury bond, which would yield you $2 billion for every $100 billion invested.

Since growth is expected, compare it to other Internet leaders. Google is valued at nearly $200 billion, but last year generated nearly 10 times the revenues and 6 times the profit. So, if Facebook is really going to be the next Google (NASDAQ:GOOG), its value is closer to $33 billion, one third of projections.

Yahoo, too, is another pure Internet play. It generated more revenue than Facebook in the last 12 months but its market capitalization is just one fifth of Facebook's hoped for $100 billion. Investors will pay more for faster growth. Analysts expect 20% per annum growth out of Google, which gives Google a "PEG ratio" (its price to earnings ratio divided by its growth rate) of about one, given Google's recent price to earnings ratio of 20. But, if you apply a PEG of one to Facebook, it would have to grow earnings nearly 70% annually to justify a 70 price to earnings ratio.

Is that possible? No question, Facebook has done that in the past. But, no company does that for long. That would imply a doubling of the company annually.

A $100 billion valuation incorporates lots of eye popping results, and then some. Your maximum upside is dwarfed by your potential losses should the rosy forecasts not materialize.

Recent Growth Rates Unsustainable; Future Growth May Slow

In recent years, Facebook has doubled in size annually, and that's inspiring the aspirational pricing. As you get bigger, the law of large numbers sets in and percentage rates of growth decline; the low hanging fruit has already been picked. The next 800 million users will be harder to find than the first 800 million users. In effect, to capture another 800 million users Facebook needs to find a region as big as Europe and they all have to sign up for Facebook, no matter their age or even whether they have a computer!

Success breeds competition; Google+, Google's answer to Facebook, has already signed up 90 million users, and has the heft and experience to go head to head with Facebook. Just keeping the 800 million current users will be a challenge, as Twitter, LinkedIn, Google, and undoubtedly guys inventing in garages right now conspire to vie for current Facebookers.

Increasing size invites more scrutiny; if Facebook is viewed as a monopoly regulators here and abroad may want to break it up, like an AT&T (NYSE:T) or a Microsoft (NASDAQ:MSFT). A phalanx of Facebook lawyers trying to navigate the shoals of increased regulation won't help growth.

To maintain growth rates, successful penetration overseas, especially China, is critical. But, that's not easy. Remember Google had to withdraw from China.

Facebook now has $3.5 billion cash on its balance sheet. It aspires to raise $10 billion in its IPO. That could leave it with over $13 billion cash on its balance sheet. Investors don't pay 70 times earnings for cash earning nothing. There'll be tremendous pressure to deploy, but will it be deployed wisely?

Distractions of Being a Public Company May Impede

The most important Facebook metric today is the number of users, estimated at 800 million. After the IPO the stock price may well be the critical number. Will this cause founder Mark Zuckerberg and his team to take their eyes off the ball?

Zuckerberg prides himself on building a business for the long term. Once you're public, unfortunately, Wall Street wants quarterly results. Many lament that this makes long term growth plans far more difficult.

Indeed, Zuckerberg may not want to go public, but probably feels compelled to. It's widely believed that Facebook now has over 500 stockholders, which requires it to file its financial statements publicly before May. This will cause Facebook to lose a major advantage of being private, keeping confidential its financial results.

Once an IPO makes Zuckerberg and his employees billionaires and millionaires, will complacency set in? Will Facebook continue to be the scrappy, hungry startup that laid the groundwork for the success?

Bottom line, don't extrapolate mindlessly into the future Facebook's historical growth rates.

Internet IPOs' Historical Performance Scary

History is littered with internet IPOs that crashed and burned. The examples are legion: The Globe.com was one of the first social media sites; despite soaring 6 fold following its IPO in the late 1990s, it soon was dismembered. But, only after a founder was filmed partying with his girlfriend model, saying "Got the girl. Got the money. Now I'm ready to live a disgusting, frivolous life."

Yahoo joined the S&P as its first Internet name in December 2000, trading well over 100; 11 years later it's down nearly 90%, never having paid a dividend.

Early Facebook investors were mocked because MySpace ruled the roost back in 2005. MySpace was then sold to News Corp for $580 million and by June of 2006 it surpassed Google as the most frequented US website. But, the tides of fortune shift; last year MySpace was ranked 138th by web traffic and was unloaded for a mere $35 million.

It's true that Google has been successful, rising nearly six fold from its IPO debut. But, it came public at a more reasonable $23 billion market cap, just a fourth of the hoped for Facebook number.

This history should serve as a warning to would be buyers of Facebook's IPO.

Recent Performance of Social Media IPOs Disappointing

The social media darling of 2011, Groupon, despite initially soaring, has come back to earth, and now trades nearly exactly at its IPO price. Social media gamer Zynga, which has built its business around Facebook's platform, also remains at its IPO price.

Investors should heed these recent results before piling into the Facebook IPO. Indeed, this may be the reason some are suggesting that Facebook's IPO price will come in as much as 25% lower than implied by the initially touted $100 billion market cap. No one at Facebook wants its shareholders to have a Zynga or Groupon experience.

In sum, enjoy the Facebook pages, but don't friend the shares; the downside risk far outweighs the upside hopes.

About the author:

David G. Dietze, JD, CFA, CFP
David G. Dietze is president and chief investment strategist of Point View Wealth Management Inc., an SEC registered investment advisor, which he founded in 1993.

Visit David G. Dietze, JD, CFA, CFP's Website

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