Facebook's valuation problem

When you want to float your company on the stock exchange, you need to justify the intended share price by demonstrating an ability to earn sufficient money. That's the part Facebook is struggling with.

Let me preface this column by noting that I am neither a financial 'expert' nor a qualified observer. Instead, my thoughts below are my opinion only and are formed from a variety of public sources, some of which are referenced as embedded links.

Contrary to popular opinion, the main intent of a tech IPO is not to bring funds into the company, it is to make the staff and investors rich. This occurs when staff are vested with shares or when early investors buy a significant share of the company (perhaps half to one percent) for a relatively small amount of money.

Previously, I reported that the Facebook stock would launch on Monday May 21st. More recent reports are suggesting that the launch will be Friday 18th, although a Friday launch does seem a little strange. We can only wait and see.

Many commentators are suggesting that very few shares in the IPO will be available for small investors, that the investment bankers with direct access to the float are rationing them to favoured clients.

As the IPO roadshow winds its way around the country, suggestions have been made that the stock will be priced between $28 and $35, raising a little over $10B. A total of 337.42M shares are to be sold - 180M owned by the company and another 157.4M owned by insiders, including 30.2M by Zuckerberg which will be used to pay taxes in relation to previous share allocations.

With all of this in mind, what will happen to the share price ones it is floated?

There are a couple of interesting observations that have been made which suggest the future may not be as bright as Facebook hopes.

Firstly, Facebook's growth is in rapid decline. The most recent three quarters recorded growth of 104%, 55% and 45% respectively. This compares very unfavourably with other recent IPOs, in particular, Google.

Next, we see that Facebook's Price/Earnings ratio is way out of kilter with any other tech company. An Industrial stock (pick any large oil company as a random example) trades with a PE of around 10 - 15x. In other words, their market capitalisation is around 10 - 15 times their yearly earnings. Apple's PE is similar to this, Google's is somewhat higher at 20x.

Facebook earned about $1B in 2011, making the PE calculation easy. If they match Apple's PE, they should be worth about $13B, but if we use Google's PE, that value rises to around $20B.

Adding a degree of generosity, we might say that both Apple and Google are relatively stable companies with limited growth potential and thus their PE is lower than a high-growth company might be. But even if we jack the PE up to 50x, we are still left with a $50B company. Can anyone justify a PE of 100 (to support the $100B valuation)?

In addition, a straw-poll at a well-known share trading site found that just 12% of respondents wanted to buy as soon as possible; 76% said they'd either wait a while or stay right away from it.

So, here's what I think will happen.

In my opinion, the shares will finally be priced at around $40, giving the company an initial valuation of almost $110B. Due to the pent-up demand from (in my opinion, irrational) small investors, the price will be pushed up as high as $55 in launch-day trading.

And that will be the highest it ever trades.

As growth slows, as users drift away to other interests, as the world slowly realises that a valuation of over $200 per active user can never be realised, the share price will enter a steady decline, much like those of Zynga and Groupon which are both trading at a little over half their float price.

Of course the final insult will occur when Facebook returns to the market to raise more capital and is forced to value the shares against a market capitalisation closer to $40B than $100B.

The final thing to remember is that Warren Buffett will take no part in the IPO. He observed, "Anytime you get a truly extraordinary business — and it's obvious it's an extraordinary business — they're the hardest ones to value because the question is, is whether five or 10 years from now that they will be as extraordinary as they are now."

Buffett continued, "I think the worst mistake you can make in stocks is to buy or sell based on current headlines."

Enough said.

I'm happy to be proven wrong in all of this, but I fear I am not. Only time will tell.


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