I Told You So: Facebook's Ugly IPO Debut

| About: Facebook (FB)
This article is now exclusive for PRO subscribers.

Earlier, I wrote that Facebook's (NASDAQ:FB) IPO is becoming a sucker's bet. On its IPO debut, Facebook started at $42, hit a high of $45 for a brief moment, and then turned south quickly. It hovered around the round number psychological price of $40, and went directly to $38 at approximately 11:50 EDT. $38, Facebook's official IPO price, provides the second psychological barrier that sustained through the day. Its price bounced back from there and stay above $38 for most of the rest of the day. The fact that $38 has been hit multiple times during the day makes it a very ugly IPO.

Once $38 is penetrated, the bottom for Facebook's stock price can be pretty deep.

By midday, many Facebook related plays went down in sympathy: Zynga (NASDAQ:ZNGA) was down 13.3% and its trade was halted. Renren (NYSE:RENN), the Chinese equivalent of Facebook, was down 9.4%. GSV Capital (NASDAQ:GSVC) and Firsthand Technology Value Fund (NASDAQ:SVVC), two funds heavily vested in Facebook were down 12.4% and 18.6%, respectively. Pandora (NYSE:P) was down 6%. Groupon (NASDAQ:GRPN) was down 4.9%.

Why did the market give Facebook such a lukewarm response? It is too expensive. The expected return for shareholders who purchased at the IPO price of $38 is not very rich, even under the most optimistic scenario.

We can use a very simple calculation to value Facebook's IPO. The goal is to find a price that can give investors a reasonable return in the next five years.

First we gauge Facebook's approximate terminal valuation five years from now. Given its recent growth trend (around 100% in 2010 but dropped to only 37% during Q1 2012), we use what I believe to be a fairly generous 50% year-on-year revenue growth over the next five years. That would give Facebook approximately $28 billion in revenue five years from now. Using Google's (NASDAQ:GOOG) profit margin of 25%, this method predicts Facebook makes $7 billion in profit in 2017. Using a P/E ratio of 20 (again with Google as the benchmark -- this is higher than Google's current level), this predicts that Facebook may have a market cap of $140 billion five years from now.

Without considering likely dilution due to stock options as compensation and stock issuance for acquisition purposes, the following table provides Facebook's annual return for different possible IPO market cap:

IPO Market Cap
IPO Price Market Cap in 2017
Annual Return
$ 70.00 $ 25.55 $ 140 15%
$ 80.00 $ 29.20 $ 140 12%
$ 90.00 $ 32.85 $ 140 9%
$ 100.00 $ 36.50 $ 140 7%
$ 110.00 $ 40.15 $ 140 5%

If Facebook's IPO price were $25.55, the expected five-year return is only 15%. At $38, Facebook's five-year return is about 6%. That is below S&P 500's index's long term return of above 9%.

This gives a gross yet clear picture of why Facebook had such an unenthusiastic IPO day. At $38, it is way too expensive. With all the hype in this stock, it could stay overvalued for some time. Yet, even if it drops another 30%, with 15% annual return, it is still not that appealing considering the risk of Facebook not being able to grow its revenue at an average of 50% annually over the next five years.

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