There are not many tried and true philosophies to investing that have held up throughout the years, yet an investor can always count on one thing - a stratospheric P/E, P/Book or whatever other multiple for that matter can only be maintained for a finite period. Sentiment will eventually turn and revert to its mean or that of the industry.
I have compiled numerous historical studies of high P/E firms, which show that the majority of companies lose steam within a year. While this is true, it doesn't necessarily mean that one can generate a guaranteed short profit and the stock may indeed serve as a viable long term investment. If you doubt this fact, review a 10 year P/E chart for Apple (AAPL) and Google (GOOG). Such is the predicament that Facebook (FB) investors are faced with currently as even with a lackluster IPO the stock currently trades at a very high 75x P/E. I've decided to take a look at how much revenue Facebook must eventually generate per monthly active user (MAU) to achieve the growth rates of some well known innovative companies with historically high P/Es.
Previous High Flyers
Before I get into my projections, I believe it's important to understand the interplay of multiples on stock prices by reviewing what has happened to other firms previously. Historically, for a stock with an abnormally high multiple, the probability of a profit is skewed toward the short investor. AAPL and GOOG are the outliers, but there are 20 Netflix's (NFLX) and Green Mountain Coffee Roasters' (GMCR) for every success story where stocks grew from net income growth rather than multiple expansion.
One of my favorite stories is that of a known hedge fund manager who was short NFLX throughout its 2010-2011 run-up. His main thesis for being short was its high P/E multiple which ran to around 80x in 2011. His rationale made its way through the headlines to the CEO of NFLX who then was kind enough to write a letter to the hedge fund manager. Don't quote me on the exact words, yet it essentially stated that if the hedge fund manager desired to keep giving so much of his money to charity, as he had done so frequently, then it would be best to close out his short position in NFLX. We all knew that NFLX would come down eventually yet the stock rallied, the hedge fund manager closed out with an enormous loss, and then it tanked within months as the P/E declined. This demonstrates the difficulty in profiting from such a high probability event. The profit is not so much a factor of the multiple declining, but timing the decline which is not a predictable event.
Facebook investors undoubtedly have a tough road ahead, either as a result of uncertainty in revenue prospects or from a deterioration in investor sentiment through a lower P/E. Many analysts are currently focusing on MAUs and revenue per user (RPU) to quantify how the company has performed. This is a relevant method to gather an understanding of how much Facebook must grow its RPU to achieve a long-term profit for its shareholders. Further muddying the outlook, it has come to light that the reported MAU numbers don't truly represent its true revenue base as 87 million accounts are duplicates or undesirables. This brings the number to an adjusted 868 million MAUs as of Q2 2012. Since revenue for the TTM has been $4.3bn, we see that Facebook has been generating a more realistic RPU of $4.98. Worth noting, my RPU formula is a different calculation than the one supplied in its quarterly report measuring average revenue per user ($1.21 2Q12).
Facebook Needs to Grow RP's by 412%
My analysis compares the growth of Apple, Baidu (BIDU) and Google over the past five years to ascertain how much RPU Facebook must generate to achieve similar returns over the forward five years. I have also utilized LinkedIn's (LNKD) IPO as a gauge as well. Averaging out the growth achieved by the four reference companies, Facebook needs to increase its RPU to $25 from $5 currently - certainly a daunting task. I've included the results of my analysis below with some of my assumptions. I assumed that the P/E multiple will compress to the average of the four reference companies. It would be unjust to assume that Facebook will still command such a high multiple by 2017 as investor sentiment wanes and its business model is more concrete. The "Req'd RPU" column explains the RPU growth Facebook needs to achieve to grow its stock price similar to the reference company.
|MAU Growth Rate||41%||10%|
|Net Profit Margin||-62%||30%|
|Company||Date||Price||Current Price||Gain||Req'd RPU||RPU Growth|
The Road Ahead
This is a daunting task to achieve a 421% change in RPU for a company that has not yet cemented its business model. This is not to say that the potential to do so is impossible. Rather, it is quite possible that Facebook could achieve this goal. The thing that AAPL, GOOG, LNKD and BIDU have in common is that they are complete game changers and redefined how companies do business. For Facebook, it will take time for companies to learn how they can leverage access to data on 868 million people globally. This is an astounding reach that many platforms have historically been unable to tap. Facebook truly is one of the most innovative game changers out there today.
We must remember that while Google was a more established company at its IPO date than Facebook, its potential uses and market breadth were unclear. Nowadays, Google's platforms are well understood with large and small companies reaping the benefits. Mark Zuckerberg mentioned on the recent 2Q call that there is the potential for Facebook to help small business owners, yet the model for doing so is not in place currently. Zuckerberg also commented on the new sponsored news service which has promising results. They have rolled it out slowly in a manner that attempts not to disrupt the experience for users. I believe this service to be too early in its infancy to support an increase in RPUs in line with my analysis and we also have to question how greatly the experience would be affected if it were rolled out aggressively. That aside, there is the potential for Facebook to leverage its reach for the benefit of a wide array of businesses without harming the user experience.
Buy Shares? That's A Good Question
Well, I must admit, I am not considering a purchase of Facebook shares until the company can persuade me that it has a business model to support the growth we have seen in other game-changing companies. By that time, the stock may be higher, but if it lives up to expectations, there will be plenty of upside to enter at that point. My thesis is not entry price based, rather it is business model confirmation based. Buying Facebook for the long-term is no more than an educated guess backed by some hope that such an innovative company can change the advertising landscape - assuming the company even focuses on advertising as its core competency in the future. That is not out of the realm of possibility for a company whose goal is to make the world more socially connected by accessing 1/7 of the its population.