By Andy Obermueller
While the mainstream financial media chases every conceivable Facebook (FB) angle ahead of its initial public offering (IPO), which is expected sometime in May, it's important not to get lost in the frenzy.
About $5 billion worth of shares will be sold, though the deal values the entire enterprise at between $75 billion and $100 billion. Only a little more than two dozen U.S. companies have a market cap that size. Remember, all stock trades are ultimately a matter of valuation, and valuation is always a matter of perspective.
Perspective almost always needs to be checked; certainly so with the level of hype that is surrounding this IPO.
So is Facebook's underlying business worth owning?
To figure this out, I recommend keeping several things in mind...
1. You should be interested in "What's next." Facebook is "What's now."
Everyone already has a Facebook account. How much can it grow from here? That's not a rhetorical question: It's a quantifiable one.
Right now, Facebook's business generates revenue of $3.7 billion and nets 26.9%, or $1 billion. The company grew 77.8% from 2007 to 2008. In the next three years, it grew 185%, 154% and 89%, respectively.
The trend is clear: Facebook's growth is waning.
The best comparison here is Google (Nasdaq: GOOG). Google had four strong years of growth in excess of 30%, then growth waned. Facebook is at that point now.
Now, Google, it has to be said, grew into its valuation. It ended 2004 at $192.79 a share and shot up 235% to its current market cap, which works out to 19.6 times earnings. But it is unlikely that Facebook will be able to accomplish the same feat.
To be worth $100 billion in market cap, at 19.6 times earnings, Facebook needs to have $5.1 billion in earnings. At its current net earnings margin of 26.9%, that implies top-line revenue of $19.3 billion, which is 421.3% above 2011 levels. This means Facebook has to double revenue and earnings in 2012, then double it again in 2013, then start to have 30% a year growth. If it does that -- which would be an incredible business feat -- it would be worth the top end of its IPO price range.
After 36 months, Facebook's business has grown, but it would be fairly valued -- without having generated any upside.
2. Myth: Facebook will be something different than it is today.
There is this idea that Facebook is going to be something other than what it is, that the personal information it has on its scads of users somehow makes it more valuable than just the sum of its parts.
I want to be clear: I totally disregard this notion.
Facebook is what it is. It's a social-networking site. It's nothing more than that. Facebook is a business and it must be judged by its business results.
If it had some magical profitability formula up its sleeve, it would have unleashed it long ago and generated the cash it needs that way rather than raising it from investors. Certainly, Facebook is enviably profitable, it can grow in some ways, and it will change over time. I'm not suggesting any of those things is impossible. To the contrary: They are eventually inevitable. But Facebook will always be the company whose mainline business is operating a social-networking site. That's what you own if you buy shares, and investors can't forget that.
3. "The market is initially a voting booth, but over the long term, it is always a scale."
That's an old Warren Buffett line, and I think it's his most important, especially when one considers how long he's been saying it and how long he's been right.
In the short term, the market will cheer a company just for coming to the market. Traders want to see the company take off and its share price rally because that portends a market ready to buy. That's always good for people who make their living by trading or appearing on TV.
Wall Street gets in this gleeful mood -- former Federal Reserve Chairman Alan Greenspan famously called it "irrational exuberance" -- and begins to do the worst thing it can do: It starts to buy its own B.S. And when they start getting sold on their own deal, an IPO takes on an energy that is completely disconnected from reality.
You see, the market at a certain point stops thinking about anything but results. The idea that a stock price can only move skyward just evaporates. When it eventually does, a company's value will always be compared to its ability to generate cash earnings.
So take a careful look at what Facebook actually makes, at what it earns, and ask yourself what you'd pay to own a piece of that business. At 30% growth a year through the end of 2014, Facebook would have $8.1 billion in revenue and earn $2.2 billion. That level of growth would thrill any reasonable business owner. But at 19.6 times earnings, it means Facebook is worth $43 billion, or 57% less than the top end of its offering price.
4. Assume a Reed Hastings moment.
Everyone likes to talk about what a genius Mark Zuckerberg is. He well may be. But even the greatest tech visionaries make mistakes, and they can be very costly.
Assume the best-case scenario, which is where online movie rental outfit Netflix (Nasdaq: NFLX) found itself. Investors had been lulled by consistently good numbers, profitability and sunny outlooks. Then, reality intervened. A mistake was made. And Wall Street remembered that the genius at the helm is fallible, that the company isn't bulletproof, and that all the gains priced into a coveted stock can be erased in the blink of an eye.
This is a Reed Hastings moment.
Hastings is the CEO of Netflix, and he tried to reorganize his company, rebrand it and also raise its prices. It was too much: Subscribers bolted. And shares of Netflix, one of the Internet's great stock-market success stories, tumbled from $300 in July 2011 to about $62 six months later. Now, the good news is that the shares have come back -- they're up more than 100% from their low. But will they gain another $180 a share and retake the heights they once held? Not a chance. Those gains are gone forever. Netflix came back to a diminished reality.
It has to be assumed that the same could happen to Facebook.
So, after all that, what do I think of the IPO? I think it is a bad long-term investment. I think Zuckerberg wants to sell at a point when it looks like he can grow forever, even though Facebook cannot possibly sustain its rate of growth and in fact is already seeing growth wane. I will be sitting out this IPO. In future issues, I will follow these shares and assess strategies that investors can use to profit from a long-term bleed-out in Facebook's valuation.
Disclosure: Andy Obermueller does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of GOOG in one or more if its “real money” portfolios.