Facebook Valuation Should Be Compared To Google

May.22.12 | About: Facebook (FB)

Facebook (NASDAQ:FB) is one of the most difficult stocks to value on the market. One has to look at it both on a value basis and on a growth basis. Long-term investors should ignore the short-term trading action, based on Facebook's botched IPO and focus instead on its future valuation.

The company needs to be compared to other very large-cap internet companies and the only one that offers a reasonable comparison is Google (NASDAQ:GOOG). The other publicly traded internet companies are either too small, or have a different business model focused on selling goods or services.

Both Google and Facebook have so many users that they run into the law of large numbers. Facebook has over 900 million users. This is almost half of all the people on the planet plugged into the internet. Facebook cannot grow by adding multiples of non-users. It can only double the number of users if it captures everyone on the internet.

Another key challenge for Facebook is many internet users are migrating from personal computers as their main way to access the web to mobile devices with smaller interfaces. Facebook needs to keep these users by providing a comparable experience for users on mobile devices, or else they run the risk that someone else will.

Social media is not a fad as some say, rather it is a new and improved way to communicate with people. Facebook will need to stay at the forefront of social media innovation to keep challengers from turning Facebook into the nest MySpace.

To understand Facebook's valuation based on value metrics, one must first examine Google's valuation metrics. Google has a current marketcap of approximately $200 billion. Google has trailing 12 month revenue of almost $40 billion. So one metric values Google at 5 times current sales.

Google had almost $11 billion in net profit after tax and trades for less than 20 times earnings. Based on its assumed growth rate Google trades at a reasonable price to earnings ratio compared to other large companies in the S&P 500. For example, Coca-Cola (NYSE:KO) trades at a PE of 19. Google also has an excellent balance sheet with close to $50 billion in cash, which is almost 20% of its marketcap.

Facebook has a current marketcap of close to $100 billion. Facebook has trailing 12 month revenue of a little over $4 billion. This values Facebook at 25 times revenue compared to Google at 5 times revenue. Facebook has almost $700 million in after tax profits and trades for well over 100 times earnings. Compare this to Google that trades at less than 20 times earnings.

Facebook sold 180 million shares in the IPO and the insiders sold the rest. After the IPO, Facebook should have close to $11 billion in cash. On this metric, Facebook is trading at less than 10 times cash whereas Google trades for 5 times cash. Clearly, if one only uses value metrics, Facebook is trading at a very rich valuation compared to Google and other large cap companies.

But Facebook is a new concept that has demonstrated rapid growth in only a few years. Therefore, Facebook should also be looked at as a growth stock just like Google. At this point, the market considers Google a more mature company without the potential for torrid growth, hence the PE of less than 20.

So what type of growth can Facebook achieve considering it already has half of all the internet users signed up with user accounts? That is the $64,000 question and one must consider what is possible and what is probable. Here investors should understand that this is Mark Zuckerberg's company and a belief in Facebook's growth potential must start with a belief in Zuckerberg. So far one must acknowledged that he has achieved amazing growth in a short amount of time.

But since Facebook is constrained on its potential growth in users, the only way Facebook justifies its lofty marketcap is if Facebook can increase revenues per user. This is where Facebook looks interesting from a growth investment perspective. Currently, Facebook is generating less than $5 in revenue per user per year. Google, by comparison, generates $30 in revenue per user per year. So if Facebook could achieve Google's revenue per user, then all of a sudden it would be valued in line with Google using value metrics like revenue per share and earnings per share.

If Facebook can get to $5 per user per month rather than per year, then it would have $60 per user, which is double what Google currently has. Over the next several years, Wall Street will be focused on revenue growth per user when attempting to value Facebook. The stock trades at a premium today because Wall Street is already factoring in revenue growth per user. The debate is over how much, how fast, and whether or not Facebook is a fad.

So what can Facebook management do to grow revenues per customer? For starters, it can generate a lot more revenue from advertising than it currently does. Facebook has almost half of the main consumers in the world and yet currently receives less than 1/2 of 1% of advertising dollars. Facebook can more than double revenues just by getting 1% of worldwide advertising dollars. It can quadruple revenues if it can get 2% of advertising dollars.

What additional businesses can Facebook get into to monetize its users? Certainly, it can do things like compete directly with Google with its own search engine. It could also create its own version of YouTube. It could compete with traditional media companies by creating a Facebook channel. It could compete with banks by creating an online banking company. It could compete with internet retailers. It could certainly compete with internet travel companies.

But we can all come up with ideas it can copy. The real key to understanding Facebook's potential is understanding whether or not it can continue to create things people weren't expecting. Is Mark Zuckerberg and his team people who had one good idea that caught on and they were just lucky to be in the right place at the right time? Or are he and his team like Steve Job, people that can keep creating new things that are original rather than copied?

The answer to this question is the key to understanding Facebook's potential and right now the jury is still out. Facebook can and should grow revenues over the next several years. But to be a committed long-term investor, one must believe Facebook will continue to innovate.

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