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Unless you have been living under a rock, you probably know that Facebook (FB) has filed for listing on the stock exchanges and plans to raise $5 billion through its IPO, which is rumored to value the firm at $100 billion. I have several issues with the IPO, starting with the fact that Mark Zuckerberg (who I greatly respect) will dominate the company and the shareholders will have little control over the happenings at Facebook. I plan on discussing the management issues in a separate article. In this article, I will perform a discounted cash flow analysis of FB and determine the fair value for the company.

I began my analysis by reviewing the historical financials provided by FB in its S-1 filing. Some important financial information from the last 3 years is shown below.

2009

2010

2011

Revenue

$777

$1,974

$3,711

EBIT

$254

$1,008

$1,695

Net Income

$229

$606

$1,000

In addition, FB had $3.9 billion in cash and equivalents and no debt on the balance sheet. The company increased its revenue by 88% and net income by 65% in the last financial year.

To estimate my projected growth rate for the next 10 years, I evaluated the growth trajectories of Google (GOOG) and Baidu (BIDU). Google, in 2004, reported revenue of $3.18 billion. Last year, GOOG revenues had ballooned to $37.9 billion - an average growth rate of 42% annually. Baidu on the other hand grew its earnings at an annual rate of 65% over the last 3 years with its revenues increasing from $3.19 billion to $14.489 billion. Based on growth rates of GOOG and BIDU, I project FB to grow its earnings at an average annual rate of 50% during the next 5 years, followed by an average 15% growth rate in subsequent 5 years. My model assumes a terminal growth rate of 2%.

FB currently sports a very impressive operating margin of 46%. I find it highly unlikely that the firm will be able to maintain these impressive margins over its life. I have modeled a gradual decline in margins over the next 10 years with a margin of 30% in the tenth year. Capital expenditure needs were estimated by comparing the sales to capital ratios of the advertising and software services industries (Sales / Cap = 2).

Finally, FB reports that proceeds from the sale of Class A shares will not be received by the company. Mr. Zuckerberg plans on using the proceeds to pay taxes arising from option grants. I have assumed that $3.3 billion of the $5 billion will reach the company's treasury.

The important inputs of the model and the resulting valuation are shown below:

FB

Bottom-Up Beta

1.75

Risk Free Rate

2%

Equity Risk Premium

8.0%

Cost of Equity - High Growth Phase

16%

Cost of Equity - Stable Growth Phase

10%

Average Growth Rate (Years 1-5)

50%

Average Growth Rate (Years 6-10)

15%

Stable Growth Rate

2%

Present Value of FCFE in High Growth Period (Billions)

$15.72

Present Value of Terminal Value of Firm (Billions)

$33.35

Cash and Equivalents (Billions)

$3.91

Cash from IPO (Billions)

$3.30

Market Value of Equity (Billions)

$56.28

As shown in the table above, I project fair value of $56.28 billion for FB. This calculation does not include the impact of employee stock options. Based on my rough estimate, the options would reduce the company's fair value by about $3 billion.

If the rumors are true and FB is indeed offered to the public at valuations closer to $100 billion, I recommend avoiding the IPO. I would wait for the first week bounce and then consider shorting the stock.

Disclaimer: Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision.

Source: Fair Value For Facebook Is Closer To $56B: Avoid IPO, Short The Stock