One More Time on Facebook Investor Psychology and Valuation

The budget should be balanced, the treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance to foreign lands should be curtailed lest Rome become bankrupt.

– Cicero, 55 B.C.

As expected, investors who either did not know what they were doing or refuse to acknowledge that they paid too much, seek to absolve themselves of responsibility and blame others:

Facebook CEO knew about overpriced IPO and dumped shares, new lawsuit claims

Mark Zuckerberg is losing even more friends.

Another group of disgruntled Facebook investors has reportedly sued the the social media guru, saying he made out like a bandit over the site’s botched IPO.

This latest class-action lawsuit claims Zuckerberg knew Facebook was horribly overpriced at $38 per share when trading began last month, TMZ reported today. He used that inside information to quickly unload shares, in a dirty billion-dollar move, the lawsuit claimed. FB closed at $27.72 a share and was down 27 percent since going public this past Friday.

Editor: Surprise! Insiders were selling on an IPO.  Of course, they believe the price is high enough to exchange shares for cash. Investors who do not shoulder their responsibility then lessons are lost and they can’t improve.

 Valuation of Facebook’s Growth

Tweedy Browne did a good job placing Facebook’s (FB) valuation in perspective. Go to i-7 of their annual report: TBFundsAnnualReportMarch2012 and an interview of Tweedy’s principals:VIIFundReprint_033112

As you can see in the above chart, you could buy roughly the same amount of earnings that Facebook produced in 2011 by simply buying Heineken Holdings for $13.5 billion, and you would then have $86.5 billion left over to go shopping for other companies in our Funds’ portfolios. For the remaining $86.5 billion, you could buy Emerson Electric, Devon Energy, G4S PLC, Torchmark, NGK Sparkplug, Daily Mail, and Teleperformance, and still have roughly $700 million in walking around money. When all is said and done, for Facebook’s IPO price, you could purchase the above group of leading companies in their respective fields at a price/earnings ratio of 10.4 times estimated earnings. As a group, these companies produced nearly ten times the earnings of Facebook in 2011, and paid dividends of over $2 billion. According to our calculations, Facebook would have to compound its current earnings at an annual rate of approximately 35% over the next ten years to catch up to the amount of earnings produced by the selected companies held in the Tweedy, Browne Funds, which are compounding their earnings at a more realistic 7% per year.

Now, it might very well turn out that Facebook performs as expected and compounds at even more attractive rates, producing superior returns when compared to the stocks selected above from the Tweedy, Browne Funds’ portfolios, but the stakes are high given the lofty IPO price. Very high expectations are built into stocks that trade at 100 times earnings. If it disappoints, the results for its investors could be disastrous.

Lest we forget, just six years ago, media and tech savvy News Corp., run by Rupert Murdoch, a rather shrewd investor, acquired MySpace, then the most popular social networking site in the US for $580 million, which valued the company at over 100 times earnings. Last summer, after a string of disappointments and corporate losses, News Corp. sold MySpace for $35 million to a company fronted by Justin Timberlake. At the time of the sale, MySpace had approximately 35 million users, which meant a purchase price of roughly $1 per user. Applying that metric to Facebook would give it a valuation of approximately $1 billion instead of the $100 billion, which is anticipated for the red hot IPO. News Corp. experienced a permanent loss of capital on its MySpace investment of 94%. From all indications, few expect Facebook to be such a flash in the pan. After all, it’s hard to question its efficacy at bringing people together, and in some instances it has even been a catalyst for political revolutions such as the Arab Spring. That said, expectations are extraordinary, and anything less than spectacular growth going forward could lead to disappointing stock market performance.

For us, Facebook serves as a convenient reminder that stock market prices can and do at times become significantly delinked from underlying value.

4 responses to “One More Time on Facebook Investor Psychology and Valuation

  1. One interesting thing I thought of about this company yesterday: have you ever seen an ad for Facebook?

    Me neither.

    I’m not saying that justifies the valuation but its strange to find a company that can grow its business and market without advertising.

  2. Lolz. Rupert Murdoch. What was he thinking? I’m not Buffett, but even I could have told him he was wasting his money.

  3. Mark Hulbert Archives | Email alerts

    July 27, 2012, 12:51 a.m. EDT

    Facebook shares still way overvalued
    Commentary: Weakness has brought stock closer to fair valueStories You Might Like
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    By Mark Hulbert, MarketWatch
    CHAPEL HILL, N.C. (MarketWatch) — Facebook Inc. shares today are a lot closer to $13.80 now than in late May.

    That’s when I devoted a column to calculating what a fair price might be for the company’s shares, coming up with $13.80. That column came a week after Facebook /quotes/zigman/9962609/quotes/nls/fb FB -2.51% went public at $38 per share, and when those shares were trading for slight more than $33 per share. ( Read my May 25 column, entitled “Facebook stock should trade for $13.80.” )

    Click to Play Why more heavy selling may be ahead for stocksMarketWatch’s Mark Hulbert explains why he believes the market will not be able to mount a sustainable rally until the Wall of Worry gets rebuilt.

    In after-hours trading Thursday evening, following Facebook’s first earnings announcement as a public company, the shares were trading below $24.

    The reason to revisit my fair-value calculation today: Data in the newly released earnings report allow me to check whether the assumptions I used in that calculation appear to be too generous or too conservative.

    Those assumptions include:

    •Revenue growth. I assumed Facebook’s revenue in five years would be $11.58 billion (versus $3.71 billion in calendar 2011). This estimate was based on a study showing that the revenue of the average company going public between 1996 and 2005 grew by 212% over the five years after its IPO (excluding spinoffs and buyouts).

    •Price-to-sales ratio. I assumed Facebook’s price-to-sales ratio in five years would be the same as Google’s /quotes/zigman/93888/quotes/nls/goog GOOG -0.45% is today — or 5.51-to-1. Given the revenue assumption of $11.58 billion, that translates into a market cap for Facebook in five years of $63.8 billion.

    •Facebook stock’s total return over the next five years. I assumed that this would be 11% annualized.

    The key assumption on which Facebook’s latest earnings report can provide a reality check, of course, is revenue growth. The company reported that its revenue in the second quarter of this year was 32.3% higher than in the second quarter of last year. That’s slightly higher than the 25.6% annualized growth required for Facebook’s revenue to hit the $11.58 billion I assumed in my late-May column.

    So I re-ran my fair value analysis on the assumption that Facebook will be able to keep its revenue growing at this slightly higher rate. On that assumption — which I will argue in a minute is generous — then Facebook’s fair value today would be $17.92 instead of the $13.80 estimate I reached in late May.

    Better than the picture my analysis painted in May, but not a lot better — since this higher estimate is still 25% lower than where the stock currently trades.

    The reason I think it’s overly generous to extrapolate for five years into the future the 32% by which the latest quarterly revenue is above the same year-ago quarter: Facebook’s revenue over the last two quarters has been largely flat. In fact, if I were to base my extrapolation on just the last two quarters, I would find that even my original fair value estimate of $13.80 per share is too high.

    The bottom line?

    I can find nothing in Facebook’s latest earnings report to suggest that a fair-value estimate for the stock of $13.80 needs major revision. No wonder Facebook shares were down so much in the wake of that report.

    Click here to learn more about the Hulbert Financial Digest.
    /quotes/zigman/9962609/quotes/nls/fb Add to portfolio FB Facebook Inc. Cl A US : U.S.: Nasdaq $ 23.11 -0.59 -2.51% Volume: 25.93mJuly 30, 2012 3:49pP/E Ratio75.29Dividend YieldN/AMarket Cap$65.00 billionRev. per Employee$1.35M
    /quotes/zigman/93888/quotes/nls/goog Add to portfolio GOOG Google Inc. Cl A US : U.S.: Nasdaq $ 632.10 -2.86 -0.45% Volume: 1.86mJuly 30, 2012 3:49pP/E Ratio19.60Dividend YieldN/AMarket Cap$209.00 billionRev. per Employee$1.33M
    Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.

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