Market Overview

Don't Buy Into The Facebook IPO Hype


Yesterday, Facebook filed its much anticipated initial public offering. The company is seeking to raise $5 billion and could be given a valuation as high as $100 billion. The deal will be the largest U.S. tech IPO since Google (NASDAQ: GOOG) went public in 2004. Unfortunately, new investors are extremely unlikely to get a bargain in the deal - unless of course you have a way to buy in at the IPO price, which is unlikely.

Since Facebook is only selling $5 billion in stock, and around 90% of that is likely to go to large institutional investors who happen to be the underwriters' best clients, most individual investors are extremely unlikely to be allotted shares.

If you are an individual investor who is hoping to buy stock at the IPO price, you better be lucky, very rich, and a favored client of your broker. Those who are able to buy in at the deal price might be able to make some quick money by flipping their shares into the initial hype when FB begins trading publicly, but even that is not a guarantee - Zynga (NASDAQ: ZNGA) for example, actually fell on its first day of trading last December despite it being a very highly anticipated IPO.

In fact, many of 2011's most hyped IPOs have logged relatively disappointing returns since hitting the public markets. This list would include companies such as Groupon (NASDAQ: GRPN), LinkedIn (NYSE: LNKD) and Pandora Media (NYSE: P). If you bought any of these stocks on their first day of trading and held on, you have lost money.

While plenty of people are sure to get rich when FB goes public, it isn't going to be you or me. Instead, the company's IPO is going to be a windfall for early investors and the bankers underwriting the deal. That is not to say, however, that Facebook might not turn out to be a great long-term investment like Google (GOOG) has been.

It very well could be - but in light of the numbers being thrown around - I wouldn't make that bet right away. According to Facebook's filing documents, the company determined that the fair value of a share of FB stock as of December 31, was $29.73. Based on the current share count, this implies a valuation of around $60 billion for the company.

Given the hype and buzz surrounding this deal, however, and expectations for extremely high demand, it is likely that the IPO will be priced well above the company's most recent fair value estimate. The valuation number that is being talked about most frequently is $100 billion. If, in fact, FB shares are priced at a level which gives the company a $100 billion market value in the IPO, I would stay away from the stock for at least a year.

The numbers simply don't add up. In its prospectus, Facebook lists its primary competitors as Google (NASDAQ: GOOG) and Microsoft (NASDAQ: MSFT). In particular, Google is the company that investors should be looking at in order to determine at what valuation FB might be a good investment - and its not $100 billion. At this level, Facebook would command a valuation more than five times higher than Google's on an earnings basis.

According to Bloomberg, the company would trade at 26.9 times 2011 sales if it was given a $100 billion valuation. This compares to Google, which currently trades at around 5 times sales. Furthermore, Facebook would trade at around 100 times its 2011 net income versus a current P/E ratio for Google of 20.

The numbers look even more out of whack if you compare them to Google's valuation when it went public in 2004. At that time, the company raised $1.9 billion at a valuation of $23 billion. This equated to around 10 times sales, or half of what Facebook could be initially valued at on a price/sales basis.

While Google has been a terrific long-term investment, rising eight-fold since going public, it is less likely that Facebook shareholders will realize similar gains because of the sheer size of the company already, as well as the rich valuation metrics. The largest company in the world is Apple (NASDAQ: AAPL), which trades at 4 times sales or 20% of what FB's price/sales ratio may be, with a market cap of $424 billion.

If Facebook goes public and were to put up Google-like returns over the next 8 years, it would have a valuation of roughly $800 billion by 2020, or nearly twice Apple's current market cap. I don't think that is going to happen. In order to further examine the numbers that are being thrown around with relation to Facebook, lets look at Groupon's (NASDAQ: GRPN) recent IPO.

The company came public at a price/sales ratio of 10 times and was valued at $12.8 billion. Groupon is a much less mature company than Facebook and a strong argument could be made that the company has a more favorable forward-looking growth profile than FB. If Facebook is indeed valued at $100 billion, I would argue that Groupon would look considerably more attractive on a risk/reward basis.

It is also important to address the fickle nature of Facebook's business, which is based on advertising revenue. As Paul La Monica notes in a CNN article questioning Facebook's potential valuation, former Wall Street darling Yahoo (NASDAQ: YHOO) has struggled mightily in recent years with a similar model.

Another question that investors need to consider is how fast Facebook will be able to grow its already massive 845 million person user base? While it will certainly continue to grow over time, the hyper-growth phase is over. "If Facebook can make more money from their existing platform, they are golden," said Tim Loughran, a finance professor at the University of Notre Dame. "But Facebook is much more mature than Google was in 2004. Where's the user growth going to come from?"

In addition to questions about valuation, the business model, and future growth trends, there is also a strong argument to be made that Google is a better company, with a superior model, which will hurt Facebook over time. On a subjective level, I think that this is true. I personally would attach significantly more value to Google's services in the context of my day to day life than I would to Facebook's.

I don't even like Facebook that much - while the service is of clear value in the context of keeping in touch with family and friends and sharing certain aspects of our lives in an interactive and convenient way - it can also be viewed as an annoying procrastination tool.

Google, on the other hand, is the favored portal to the internet and its services are extremely utilitarian. Furthermore, the company is making strong inroads into social networking with the launch of Google+, which by itself, is a real threat to Facebook's growth and user metrics.

The bottom line is that when you add it all up, at a valuation of $100 billion, Facebook just doesn't make good investing sense. Investors who want to make a long-term bet on the company should at the very least wait for the hype, and hopefully the price tag, to come down before jumping into FB shares.


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