Tuesday, May 22, 2012

Volume 4 Issue 21: Intelligent Investing

Facebook IPO Tanking - Just As Expected?

So, after two days of trading, arguably the hottest IPO of this year has come in line with our expectations. It started off with a short period of euphoria, causing the price to jump to USD42 but then on Monday's trading, it fell back to USD34, way below its IPO price of USD38. (Update: Facebook's price has hit USD31.00 after Tuesday's (22 May 2012) trading)

In the past, I have written about how IPOs are just a bunch of expensive and evil lottery tickets, and this still holds true. If you remember, I also previously showed that 20 out of 25 IPOs in the last two years have tanked.

Even before the Facebook IPO, some analysts have argued that it would be very hard to justify a USD100 billion valuation on Facebook. But as I said, it is difficult to trust analysts sometimes. So let's do a bit of simple calculation on our own. Let us first note that in 2011, Facebook recorded a net income of USD1 billion. For you P/E junkies, simple mathematics would show that the P/E ratio is about 100 times. But as we all know, the Facebook faithful surely believes that the current price that they are paying is for Facebook's future earnings.

So let us now satisfy the thirst of the Facebook faithfuls. I am going to assume that Facebook's net income will grow at 50% for the next four years, and 30% for another four years, and eventually at 15% after that. I think this is by every means a very generous growth rate, which I would be more than happy to get for any investment I own. But what we are trying to figure out now is, is this kind of earnings growth worth the price tag of USD100 billion. (P/S: For those of you who caught me using net income instead of free cashflow, I am just trying to prove a point and I don't want to go into the intricacies of depreciation, amortization, capital expenditure etc.). Take a look at the Chart 1.

Chart 1
So the blue bar shows the cumulative net income in each year after the IPO. The orange line marks the USD100 billion that you would pay for Facebook if you bought the whole company straight up. I am just going to ignore the Mark Zuckerberg premium because there is no way I know how to value that. As you can see, it would take you about 10+ years for your investment to break even. In other words, it would take you more than 10 years before you begin to start making profits for your investment. Now, from an investor's standpoint, you have to ask yourself, is there a better way for you to get better returns for the next 10 years?

Those of you who are more observant would have noticed that I did not use the net present value of the net income. Assuming that I use a discount rate of 5% per year, the discounted payback period (the smart people's term for breakeven point) would be almost 13 years. Of course, the 5% that I am using is arbitrary. It varies from person to person, but it should be based on your required rate of return or at least, be based on the possible return of your next best alternative.

I will not pretend to know how to value a company like Facebook. Some of you may claim that the growth rates that I have assumed are too conservative. Facebook's potential is much larger that I think. Maybe, maybe not. Nonetheless, you must realize that I have assumed that in the next 10 years or so, there will be no recessions. This is very unlikely, and as we all know, recessions lead to lower advertising revenue for Facebook. The second point is, we have all seen the death of Friendster and Myspace. Now, maybe Mark Zuckerberg is much smarter than the people at those other social networking sites, but honestly, who knows?

I suppose only time will tell.

Disclaimer: All company analyses, including the paper portfolio that appear in this newsletter are derived from facts gathered from various sources and the contributors' personal opinions and for education purposes. It is NOT an invitation to deal in securities, and especially not a recommendation for buying or selling any stock. The contributor(s) do not guarantee the accuracy of the facts being presented. The accuracy of such facts are only as reliable as the sources that they are obtained from. Please consult your investment advisers before acting on any information provided by the analyses here. The authors most likely have interests in the stocks that are discussed in this website.