If you can't explain your decision in terms a reasonably intelligent 10th grader would understand, you probably need to rethink your decision. - Anonymous
The above saying seems to get lost in the investing community. We investors often tend to think we're a little more sophisticated or well-informed than the general populace, and perhaps we are. Yet in throwing around PEG ratios and operating margins and technical chart patterns, we sometimes forget that there are other equally valid ways of analyzing a potential investment. I am going to use an alternative valuation metric to examine just how overpriced Facebook (FB) (and Zynga (ZNGA)) stock is, using an argument a 15-year-old could understand.
What Can I Get With My Money? Devising An Alternate Valuation Metric
One of the first lessons kids learn when they have a little money to spend is that buying one thing often means you can't buy another. If a little boy wants the newest video game console, he may not be have enough cash to buy that BB gun he's been dreaming about. We learn (or rather, should learn) pretty early on that we only have a finite amount of resources, and we should utilize them in a way that maximizes utility/return. (If I opt for the less expensive car, I can take my family on a vacation AND put away some money for my daughter's college, so on and so forth.)
Warren Buffett used this sort of "finite capital" analysis to explain why he didn't like gold as an investment. According to Buffett's reasoning, with a certain sum of money, he could either buy all the gold in the world—and it would just sit there—or he could buy Exxon-Mobil a bunch of times over, buy up all the arable land in America, and still have a trillions of "walking around" money. Buffett's argument is that maximum utility is achieved by buying things that aren't gold.
Gold's potential merit as an investment aside, this seems to be a valid valuation metric to me—after all, it fits in quite nicely with our real-world experience of choosing what to spend our money on. It's a great tool to explain to the layman why Facebook and friends are overvalued. (And you have no idea how many of my non-investor friends wanted to buy Facebook right after the IPO. So they're the ones who I had to explain this to in lay terms.)
As of the time of this writing, Facebook's market cap is $68.82B. In "common man" terms, this means that if you wanted to buy all of Facebook, you'd have to spend $68.82 billion. (Please note that as Facebook's stock price is jumpier than my neighbor's terrier, the market cap may have changed by the time you read this. However, the general point/conclusions should still hold.)
We'll throw in Zynga's $3.82B market cap as well, since Zynga is inextricably linked to Facebook.
Let's now examine what ELSE you could buy for $72.64 billion, then see if Facebook (+ Zynga) is really worth buying. It's especially important to keep in mind that Facebook's future is unknown—it could grow and grow and grow, or it could be replaced by another social network. (Interesting note: Facebook's users are declining.)
What Else You Could Buy
1: J.M. Smucker Company (SJM)
Market Cap: $8.29B
This is the company behind Smucker's Jam, JIF Peanut Butter, Crisco, Folgers, and a bunch of other consumer brands.
2: Hanesbrands Inc. (HBI)
Market Cap: $2.85B
Unless the world is overtaken by nudists, I feel it's a pretty safe bet that we will continue using socks and underwear.
3: The Hershey Company (HSY)
Market Cap: $16.24B
Chocolate and candy. Does anything more need to be said?
4: Clorox Corporation (CLX)
Market Cap: $9.41B
Bleach and stuff.
5: Kellogg Company (K)
Market Cap: $17.4B
Cornflakes and stuff.
6: H. J. Heinz Company (HNZ)
Market Cap: $17.58B
Ketchup and stuff.
Net Income Analysis
Facebook's Q1 net income was $205M, down from $233M a year ago. Let's be generous and give Facebook a yearly income of $1B. So if we spent $72.64 billion on Facebook, we'd be entitled to a yearly income of $1B now, and theoretically more as Facebook grows. Zynga's net income is $182M/yr, excluding stock compensation costs. Again, we'll be generous and call it $250M/yr, for a total income of $1.25B plus growth in the future.
Now let's look at the net income of the other six companies we could have bought.
Click to enlarge
Buying these six companies would entitle us to immediate net income of 1.223B + 923M + 668M + 536M + 455M + 191M for a total of $3.996 B, or roughly $4B of immediate income.
Let's say that over time, these six companies grow income at a very conservative 2%. Let's also say Facebook/Zynga grow earnings at a very rapid 25% annual clip. How long does it take Facebook to catch up to these six companies' earnings?
numbers in billions
While Facebook and Zynga start to earn more after Year 7, they don't give us more total return until Year 11. Of course, this is assuming that Facebook and Zynga are able to maintain 25% income growth—as I previously noted, Facebook's income dropped in Q1.
Another factor the "retail investor" should consider is concentration risk. If you choose to invest a certain amount of capital in Facebook, what happens if Facebook users start leaving? (The all-important teen demographic is already starting to.) Obviously, it will be difficult for Facebook to maintain income in such a scenario. On the other hand, it's fairly easy to predict that over the next 10 years, people will still be eating PB&Js and buying bleach to get stains out of their socks.
Further Analysis and Conclusions
The argument scales down - buying all of Facebook + Zynga is equal to buying all of the companies mentioned, so buying 1/10th of Facebook is equal to buying 1/10th of all the companies mentioned, and so on. So whatever "stake" you have in Facebook could be used to buy an equivalent "stake" in each company mentioned.
I believe this argument I've constructed is fairly easy for the average layman to understand: you can either buy X, or you can buy A, B, and C. Taking it one step further, buying A, B, and C enables you to collect more income than buying X. Also, you know that A, B, and C will have a fairly stable customer base, while you can't predict what will happen to X's customer base.
Presented with the data above and a $72 billion bank account, I think a reasonably intelligent 15-year-old would choose to buy A, B, and C rather than X.
In conclusion, Facebook might make a good "speculative" play for investors with cash to burn, but it should not be a core portfolio holding for retail investors with smaller bank balances. Why? Simply put, you have to take on a lot more risk (sacrificing immediate income) for the possibility of future returns that may never materialize.
So if you really want to buy Facebook, sure, buy a dozen or so shares. But don't invest more than you feel comfortable losing.
For more analysis on Facebook, see Facebook and the Email Snafu: A Troubling Trend?
Disclaimer: I am an individual investor, not a licensed investment advisor or broker dealer. Investors are cautioned to perform their own due diligence. All information contained within this report is presented as-is and has been derived from public sources and management. Always contact a financial professional before making any major financial decisions. All investments have an inherent degree of risk. The future is uncertain, and actual results may be materially different from those expected. Past performance is no guarantee of future results. All views expressed herein are my own, and cannot be interpreted as the views of my employer(s) or any organizations I am affiliated with. Presentation of information does not necessarily constitute a recommendation to buy or sell. Never make any investment without conducting your own research and reading multiple points of view.