Why Investors Should Stay Away From Facebook Shares

May. 8.12 | About: Facebook (FB)

I have received an email from a reader asking me about whether he should buy Facebook (NASDAQ:FB) once it becomes available in the public market. To me, this opens the discussion again whether an investor should pursue a value or growth style.

First the numbers: It was reported in February that FB earned $1 billion on sales of $3.71 billion, equating to an EPS of $0.43 per share. The pricing range for FB's IPO is set to be between $28-35. Based on the hype around social networking companies, it is likely that the final price for FB shares hits $35 - with all of the shares being placed with institutional clients. Paying $35 a share means paying 80x earnings. Even when considering that current earnings have increased, the multiple investors pay is just insane. And that is just the placement multiple the institutions pay. The first trading day will probably lead to an even higher, much more insane, valuation when FB doubles due to unrestricted buying from retail investors to which institutional investors will happily sell.

I personally would never consider, no matter how exciting an investment is, to pay that kind of multiple. I do not much believe in hyped companies which are confronted with immense expectations and that somewhere down the road will have to be disappointed. And the cheerleading of FB that reminds me of 1999, has already started. By coincidence, as I was researching FB valuation metrics, I also stumbled over an outperformance rating from Wedbush that caught my attention:

Michael Pachter at Wedbush has put a $44 target and an 'Outperform' rating on Facebook.

We are initiating coverage of privately held Facebook, Inc. with an OUTPERFORM rating and a 12-month price target of $44.

Our 12-month price target of $44 reflects 22x our 2015 EPS estimate of $2.00. Facebook's underwriters have indicated a preliminary pricing range of $28-35. At these prices, demand for Facebook shares will likely outstrip supply, and we expect the shares to trade up. We think that given the huge upside potential for revenue and earnings growth, a $44 target price is warranted.

Firstly, I consider it tremendously difficult to forecast earnings and the multiple for such an unpredictable company three years out. Secondly, if the analyst used a multiple approach, instead of a DCF, I am not even sure how he can derive the 2013 target price with the 2015 EPS (if anybody can enlighten me please drop me a message). Wall Street will continue to follow the cycle and present the investor higher target prices when we are in an up market and lower target prices when we are in a down market without really caring about its clients. Thirdly, to my knowledge, FB comprises about 900 million users. User growth is very limited from such a high level. Instead, FB will have to convince investors and present tangible results as to how it is going to monetize its existing customer base to justify such a high valuation.

Conclusion: The pricing is extreme and retail investors will probably be exploited by institutional investors to drop highly overpriced shares on them. The IPO range prices in extreme expectations, which leads me to conclude that the risk/reward trade-off is out of balance and tilted toward existing shareholders who capitalize on the average investor. Highly priced & hyped IPOs as well as private equity-led IPOs should be avoided.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.