Should You Double Down On Facebook?

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

Speaking at a tech conference on Tuesday, Mark Zuckerberg stated that he was not happy to see Facebook (NASDAQ:FB) shares plummet. But the young CEO also stated he would love to be underestimated because it would allow the company to be more aggressive going forward. According to Zuckerberg, some disappointed employees might defect, but he hopes most will stay and double down on the company's future. But the question remains, should investors do the same?

Zuckerberg stated "I think it is really easy to for folks to underestimate how really fundamentally good mobile is for us", and maintained the view that Facebook would figure out numerous ways to profit from the more than 955 million worldwide users.

The mobile strategy has been one of the issues that has knocked down Facebook's stock, with many questioning how Facebook will make money off it. The main problem is described in the section below, taken from the above linked article.

"Zuckerberg shouldered some of the blame for the misperceptions about Facebook's mobile prospects, saying he made a mistake by initially relying on a computer coding called HTML 5 so the company's applications could run on a multitude of different mobile operating systems without making a lot of changes. That resulted in sub-par experiences for many users, Zuckerberg acknowledged, prompting Facebook to use more customization tools to account for the differences in the software that run different devices such as the iPhone and Android phones."

Zuckerberg seemed to maintain that a Facebook phone isn't in the works. However, the big news appeared to be when Zuckerberg stated that Facebook could start taking on Google (NASDAQ:GOOG) in the search business, stating that Facebook processes a billion search requests a day, and that they aren't even really trying. Just yesterday, I described the current transformation at Google. Should Facebook enter the search business, it would really change things at Google, and not for the better.

Jumping into search is something that many have called Facebook to get into. Just look at some of these stats the just linked to article provides on the opportunity in this space. They might surprise you. For reference purposes, Facebook is expected to do $4.93 billion in revenues this year and $6.32 billion next year.

Yahoo (YHOO) still generates nearly $2 billion a year from search revenue. And it's mostly all profit.

AOL (NYSE:AOL) generates almost $500 million in search revenues a year. Again, it's almost all profit.

Microsoft (NASDAQ:MSFT) generates about $2 billion a year in search revenues. Microsoft has been losing money on its search business, but Facebook wouldn't necessarily see the same losses.

I don't think Facebook would be looking to acquire Yahoo, although AOL would be an interesting idea. Another idea that was floated was the possibility of Facebook purchasing Bing from Microsoft. Apparently Microsoft floated the idea to Facebook last year, but Facebook said no at the time because they were too preoccupied with other matters. Maybe they think about it again?

Facebook shares rallied strongly Wednesday after Zuckerberg's comments, which were after Tuesday's close. Facebook shares ended up $1.50, or 7.73%, to $20.93. This was the highest close since August 15th for Facebook. Facebook shares have seemed to find a nice short term bottom, after hitting a post-IPO low of $17.55 just last week.

Now, Facebook was due for a rally at some point, even if it is just some short covering. However, as I recently detailed, Facebook analysts are becoming less positive on the name. Analysts have been cutting revenue forecasts and price targets constantly, and even since my article just a week ago, the average price target has come down by another $0.44. That doesn't seem like much, but the average target has now come down $6 since June 25th. If it keeps coming down, it will eventually be at where Facebook is trading at.

So to answer the question I asked at the beginning of the article, investors need to decide what they are comfortable paying for this company. I stated that based on current forecasts, I would be willing to pay 25 to 30 times forward (2013) earnings, and the current analyst estimate for next year is $0.63. The midpoint of that range is approximately $17.33, so that's what I would pay right now. Now, if Facebook were to enter the search business tomorrow, that would change my thought process completely. They also could change the valuation argument next month if they post a good quarter and analysts raise their forecasts.

Why is the valuation argument important? Let's say you are willing to pay 20 times Facebook earnings over the long run. For argument's sake, let's say Facebook should do $1.50 in earnings in 2015. That gives you a price target of $30 by 2015. With shares now at $21, You would have $9 of upside and Facebook seems like a buy now. But that's just one person's opinion, and Facebook could easily go lower before it starts heading much higher.

So in the end, you should only double down on Facebook if you believe that this company can grow earnings and maintain a decent valuation going forward. Prospective investors should also consider other issues, like the 1.7 billion shares that are locked up currently, that investors may wish to sell once they can get the chance. Also, if Facebook disappoints with its third quarter earnings, the valuation range will be lowered. Zuckerberg states that you should double down on Facebook now. Personally, I would disagree, and would wait until after the lockups expire, or there is some game changing news, like an entrance into the search business. This name might have bounced nearly $3.50 off its lows recently, but that doesn't mean Facebook is out of the woods just yet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.