Few sectors are as alluring to invest in as the social media and networking sector. However, it is important to keep fundamentals in mind. Many of the IPO's in this sector, especially that of Facebook (FB), serve as a stark reminder that fundamentals and valuations should not be ignored in long-term investment planning and selection.
Many investors wished to buy into the IPO of Facebook, only to watch their investments lose a good deal of value in just a few short weeks. As of this writing, Facebook shares are priced at $26.91, a drop of 29.44% from their IPO price of $38. Investors who bought the stock on the day it began trading have clearly been burned, and assuming that they are still own shares, it will take a good deal of time and patience for Facebook stock to recover to those levels.
But what about perspective investors, those who have stayed out of the stock? With Facebook trading below $27, it is time to jump in? As with many things in investing, it depends. We will know provide a quick examination of Facebook's financials and consensus estimates for the company.
Based on the company's trailing 12-month EPS of $0.43, Facebook trades at 62.58 times earnings, hardly something you would call cheap. However, the company is set to grow, with 2013 EPS set to come it at 65 cents.
And analysts see upside to the stock, with the Reuters consensus price target coming in at $38.75 (little consolation to those who bought on the day of the IPO, but of importance to those considering the stock). At current prices, that represents upside of 44%. Just today, JMP initiated coverage of Facebook with a market outperform rating and a $37 price target. Furthermore, these analyst estimates do not include Facebook's underwriters, which may imply that they are more trustworthy (there are some in the investment world who believe that underwriter estimates should not be trusted).
The question of what is Facebook's true value has not yet been answered? Is it worth $38? Or $30? Or $20? JMP's Mark Harding writes that "While the valuation appears high by almost any metric, we stress that investors should not underestimate FB's highly creative management team, its large user base, the virtuous circle created by its size to attract more users, and the attractiveness of such a large user base to advertisers and companies looking to sell online services through its platform." Harding also says that his DCF model for Facebook, even under the worst assumptions, calculates a value for Facebook of $27 per share. With Facebook stock trading below that, it may be tempting to jump in and initiate a position, and for investors bullish on Facebook's future, that is probably the best move for them. But what if you would like to own Facebook stock, but are more cautious? Enter cash secured puts.
Cash secured puts allow an investor to collect premium income while obligating themselves to be assigned shares at the stated strike price anytime before expiration date, if the put holder chooses to exercise their right to sell. And with Facebook's options trading at high levels of implied volatility, there are rich premiums to be collected, depending on the expiration date selected. Selling cash secured puts on Facebook allows an investor to possibly purchase the stock at a more attractive price. However, there is a caveat. For this trade to work properly, an investor must not only want to own Facebook, but be prepared to not own it as well if their puts expire without being assigned.
This trade can be executed with a variety of different strike prices and expiration dates. We have picked the one that in our opinion, strikes a balance between premium income and time commitment: the September 22, $20 put, which can be sold for $1.05 as of this writing. If Facebook stays above $20 per share until September 22, this put will expire worthless, and investors will be able to keep the premium. But should it fall below 20, the stock will be assigned at a net purchase price of $18.95.
Could Facebook fall below $20? We think that is unlikely. Even though at $38 Facebook may have been overvalued, at $20 it is a whole different stock. To determine the likelihood of a fall to $20, we looked at past poorly-performing social media and networking IPO's. Groupon (GRPN), which priced its IPO at $20 per share, fell as far as $8.80 in the months after, before bouncing back to close on June 6 at $10.63. At its post-IPO low, Groupon fell 56%. For Facebook to fall 56% from its IPO price, the stock would have to go to $16.72, something we think is unlikely. While Facebook is certainly not free of controversy, it has nowhere near the amount of baggage that Groupon has. In addition, Facebook is solidly profitable, whereas Groupon is set to reach GAAP profitability this year. Zynga (ZNGA) serves as another point of reference. That company's IPO priced at $10, and the stock sunk as low as $5.51 in the months after it, before rebounding to close at $6.16 on June 6. Zynga fell 44.9% after its IPO before bottoming. Facebook would have to fall to $20.94 to reach that same result.
While the Facebook IPO may have been overpriced, the company is still worth at least $20 per share in our opinion, and this put trade reflects that view. For the stock to be assigned to you, Facebook must fall an additional 25.4%. And even Business Insider's Henry Blodget, one of the harshest critics when it comes to Facebook's valuation, thinks the stock is worth $16-$24. $20 is right in the middle of Blodget's target valuation range for the company.
For investors with a desire to own Facebook, but hesitant about its price action, cash secured puts allow them to collect premium income and still have the option of ending up with shares of the company. At $20, Facebook is far different than at $38, or even the $26-$27 range. While we think the September $20 put is optimal, investors can adjust strike prices and expiration dates to fit their individual needs.
Additional disclosure: We are long shares of GRPN and ZNGA via our holdings of GSV Capital, an investment fund that includes both companies in its portfolio.