Facebook fail?

Even using the most optimistic forecasts, Facebook will have to grow earnings spectacularly to justify its current share price.

PORTFOLIO POINT: Facebook’s earnings will need to grow spectacularly in coming years to justify its current share price.

Facebook is now listed and thanks to the underwriters for their opening day support, particularly right on the close in massive volume, the shares appear to reflect a market that agrees with the $US104 billion valuation ascribed to it at the float.

With $US5.4 billion of existing shares sold by incumbent shareholders – Mark Zuckerberg ($US1 billion), Accel Partners ($US1.3 billion), DST Global Ltd ($US0.9 billion) and 'others’, which might include Microsoft ($US2.2 billion) – and an additional $US6.1 billion worth of new shares sold, the IPO makes its founder one of the richest men in the world. Back in 2007, Facebook was generating so much excitement that bloggers were likening Zuckerberg to Steve Jobs and calling Facebook “the next Google”.

But my humble question is will he stay there? Or at least, will the price? Already, Facebook’s price on the Nasdaq has drifted down to $US31 (as of Tuesday, May 22) from $US38 on its first day of trading.

Back in January 2007, the market cap of Facebook was less than $US20 billion (on October 24 2007, Microsoft announced that it had purchased a 1.6% share of Facebook for $US240 million, giving Facebook a total implied value of around $US15 billion). At the depths of the financial crisis, with 200 million active users and $US777 million of revenue, Facebook was trading for less than $US10 billion. And while active users grew to 900 million and revenue to $US3.7 billion, the market cap grew first to $US50 billion in January 2011 and to $US104 billion just 16 months later.

According to some reports, 'investor’ appetite (we’ll use the loosest definition for investor) for Facebook shares was sufficiently buoyant to allow the price – and perhaps most importantly for vendors, the number of shares – to be raised.

My understanding is that many Facebook users (45% of the population of the internet are on Facebook) were not buying shares because of its attractive investment characteristics, but because they wanted to own a piece of history.

Such sentiments do not suggest that the short-term price direction is an efficiently arrived-at reflection of the company’s true value.

Also, it has been widely reported that underwriter Morgan Stanley had to step into the market dramatically during the first day (and tellingly, right into the close) 'in order to maintain order’ – and a share price above $US38.00.

Turning the stockmarket off helps us put the share price aside and think about the value. In valuing any company, it is relatively easy to look like an expert by comparing the company to its peers.

Most analysts would not be criticised for comparing Facebook to other listed goliaths like Apple (for its strong growth profile) or Google (an obvious competitor).

Perhaps unconventionally, I will begin by looking at insider selling. In its IPO, nearly 60% of Facebook shares sold came from insiders. This compares to 37% for Google (GOOG), which went public in 2004. Also shareholder Goldman Sachs (GS) is said to have sold half its stake and according to some reports, far more than the firm initially planned to sell. That’s not a good sign.

A more typical starting point, however, is to look at 12-month trailing price-earnings ratios. In the case of Google, its shares trade at 18-times earnings and Apple at just under 16-times. Facebook listed on a trailing P/E of just under 89-times earnings. Only if one compares it to the 660 price-earnings multiple of LinkedIn does Facebook not seem extreme.

Of course, an element of growth helps to explain high price earnings multiples and for the last three years, Facebook’s earnings have grown by just under 70% per year on a per share basis. Apple’s earnings have grown by 48% per annum over the last five years and Google’s by 17.5% over the last five years. On that basis, it would seem the higher P/E is justified when compared to Apple and Google.

Investing, however, is not done successfully when a rear-view mirror is used. One needs to think about the future. Facebook’s earnings per share are forecast to grow by 6.5% in 2012, thanks to a ramp-up in spending (according to the first quarter numbers in Facebook’s prospectus, earnings fell 18% against pcp), and by 22.5% in 2013, to 60 cents per share. That brings the price-earnings ratio down somewhat, but it is still almost 64-times earnings and well above Google and Apple, which have a demonstrated track record of earning power.

Interestingly, Google is forecast to grow earnings by 45.9% in 2012 and by 16.61% in 2013, while Apple is forecast to grow earnings by 69.76% in 2012 and 14.71% in 2013.

And what about cashflow? The big internet real estate landlords have all raised or generated mountains of the stuff and if you have been reading diligently over the past couple of years, you will know how important cashflow is to our assessment of quality. It’s the reason why Skaffold displays the essential facts that reveal the relationship between stakeholders and cashflow.

For Facebook, a comparison of operating cashflow and price reveals the company to be the most expensive among its peers yet again.

-Price/Operating Cashflow table* ($US)
Operating Cash Flow
OCF Per Share
* 12 month rolling cashflow as at latest quarter.

Many investors reckon Facebook is not expensive and it needs time to prove that current prices are justified. And it is a fact that both Google and Apple were more expensive when they floated.

When Apple listed, it did so with a P/E of 102-times earnings and Google’s P/E of 118.06-times was equally lofty.

But in each case, to justify these heady multiples, each company had to significantly grow earnings and Facebook needs to surprise rather than plod.

In order for Facebook to surprise the market and beat earnings expectations (and justify the apparently nonsense valuation the market has ascribed to it), the company will need to reveal a killer app or game (such as another Zynga, which earned $US705 million in revenue in 2011); a killer product (move over Steve Jobs and Google?); or monetise the clicks, posts and picture uploads 901 million active users make (good luck trying to ask teenagers to pay for something they believe they are entitled to).

It’s all very interesting, but the above 'analysis’ defeats the very purpose of a valuation because it uses price as an input. A valuation must be independent of price for it to be the anchor against which the more tempestuous price can be compared.

There are a couple of ways to do this. One is to look at an expected return and then perhaps see whether the outcome can be or has been adopted by the market.

For a purchaser of Facebook shares today seeking 15% per year over the next five years (doubling their money), the company’s market capitalisation must double to $US200 billion without any additional shares being issued (options to be exercised will put paid to any fairy tale notions about that). Google is valued by the market today at $US200 billion. Both businesses are similar in terms of margins, so arguably Facebook needs to increase its sales tenfold in the next five years to achieve the same valuation as Google today. But keep in mind, Google has about $US40 billion of cash in its accounts. Facebook has nothing like that.

I have a simple-to-understand approach to valuing a company and it’s simply a multiple of book value justified by the profitability of that book value. What we are trying to do is work out what premium over book value is justified by any excess returns being generated.

Facebook currently has a book value of $US4.7 billion or $US2.18 per share. With 2013 forecast earnings of 60 cents per share, the company is generating a return on its equity of 27%. The company stated in its S-1 filing that it will continue to grow by acquisition as well as organically. Assuming earnings grow at 40% and faster than the rate of return on equity – and faster than the above forecasts – then you can expect ROE to rise. Using these optimistic metrics, I still reckon Facebook is worth $US26-$28 billion this year and $US57-$63 billion in 2014 (provided forecasts are met). Neither of those numbers, however, is within a bull’s roar of the current market price.

Therefore, earnings will really have to grow spectacularly to justify the current price. Of course, there are plenty of vested interests (including those that haven’t sold into the IPO) to ensure the company is given the best chance, but already monthly active user growth rates are declining as saturation nears.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.

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