Why Investors Should Avoid the Facebook IPO

The Facebook IPO continues to garner an outsized amount of attention in the financial press, but how does it stack up as an investment?

Even though the company is going public at a lofty $104B valuation, investor demand for shares of the social networking darling is already beginning to reach the stratosphere.  The company recently upped the size of the IPO by 25% on Tuesday, citing increased investor demand.  Retail investors, institutional investors, technology luminaries, and even amateur investors are piling in en masse.

When Facebook goes public tomorrow, the sprawling social network is poised to break several records:

    • Largest venture-backed IPO in history – Facebook’s dizzying $104B valuation is 4 times larger than Google’s 2004 IPO.

 

    • Largest venture-backed company in the United States – taking in a total of $2.2B in venture funding.  For reference, Twitter has only raised $1.1B to date.

 

    • Largest pre-IPO acquirer – Facebook has acquired 13 other startups, including their most recent $1B deal for photo-sharing site Instagram

 

In total, the company is expected to raise a whopping $18B from this historic IPO.  While these numbers are impressive and the hype surrounding Facebook’s IPO is palpable, is all this buzz really justified?

I could write several articles talking about how great of an innovator Facebook is and how they completely changed the social media world, but that has little to no bearing on how the stock will perform in the coming months.  In the end, investing all comes down to price and what fair value is for ownership in a certain company.

From a valuation perspective, Facebook has one of the richest valuations that I’ve come across in my 10 years of analyzing tech stocks.  It’s even more perplexing when you consider what that the valuation will invariably increase when shares of Facebook open up on their first trading day.

Price is price – and Facebook’s lavish valuation is based on pre-tense of future growth and future profits.

Obviously, digital advertising is an integral component behind Facebook’s business model and potential investors are banking on continued growth in that segment.  But is their advertising business as thriving as investors make it out to be?  The numbers say otherwise.


In Facebook’s recent Q1 2012 report, advertising revenue only grew by a pedestrian 37% year-over-year, which isn’t all that impressive for a high growth company. Analysts talk about how Facebook could blow past Google and re-invent the ad display market, but the numbers just don’t tell that story at all.  Yet.

The biggest thing that jumps out at me is the extreme level of optimism towards future profits.  Facebook’s future will not be determined by their next earnings report, but by their ability to innovate and find new revenue streams in the future.

It is pretty clear that investors at paying upfront for potential when it comes to Facebook.  It’s not too different than an NFL team who drafts a top-rated quarterback straight from the college ranks and hands him a $20M+ contract before he steps into training camp.  A calculated risk? Sure, but a risk nonetheless.

When you look at the valuation from a price to earnings perspective, using Facebook’s reported $1B in net income for 2011, it equates to a 104X multiple.

You must also consider that this valuation is just a starting point and unprecedented investor demand will likely drive it up to $130-150B, which translates to a multiple of 130x-150x.

Considering their critical-mass of users, treasure trove of data, and steady history of enhancements, Facebook is well-positioned to be a mainstay on the web for many years to come.  Mark Zuckerberg is undoubtedly a genius when it comes to building social platforms on the web, but that doesn’t always translate into profits for shareholders.  For example, Facebook has over 425,000,000 mobile users, but the company has still yet to earn any advertising revenues from mobile.

But even though the company has built a great platform that should continue to grow, I am still not sold it from an investment perspective.  The valuation is “priced for perfection”, which means that one bad earnings report or misstep could be very costly for Facebook shareholders.

When companies carry such a premium valuation, the margin of error is just so slim.  In the last year, high P/E “darling” stocks like Netflix ($NFLX) and Green Mountain Coffee Roasters ($GMCR) learned this lesson the hard way.  I’m not saying that Facebook is next on that list, but the risk is always there with such a high valuation.

For investors who are looking to gain exposure into social media, I think there are better alternatives out there like LinkedIn ($LNKD) or Jive Software ($JIVE).  Both of these social media companies are trading at much more reasonable valuations than Facebook.

I traded LinkedIn on their opening day and generated a nice rate-of-return in doing so, but I am definitely sitting out this Facebook IPO.  Will I be looking to get in if the stock dips to $80-90B or so?  Absolutely.

Facebook will continue to be one of the most admired technology companies for years to come and I certainly want to add it to my portfolio eventually, but for now price is price.


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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