Thursday, 24 May 2012

The Facebook Flop

I know I'm probably late to the party in terms of ripping the Facebook (FB) valuation to pieces but I wanted to see where the stock traded during the first couple of days of trading before declaring that we were back to the same valuation silliness that we saw during the Tech boom / bust.  Given FB's tragically poor performance during the first few days of trading I'm happy that the stock has plummeted because it shows me that the market is not going crazy again. 

I confess that the valuations surrounding the whole list of social networking stocks (including Facebook, LinkedIn and RenRen to name a few) has never made a whole lot of sense to me.  The idea of valuing a stock on a 'number of users' is akin to the old 2000s methodology of valuing a stock using 'number of eyeballs'.   While there should be different techniques to valuing stocks in different industries, valuations should always come down to the earnings of a company. 

Traditionally 'new industry' companies have been valued at much higher multiples than their industrial / resources / financials counterparts because of the 'blue sky' factor.  That is the potential for these companies seems limitless and given that the price of the company should be the future value of its cashflows almost any valuation can be justified with enough imagination.  The problem all to often is execution.   Although some companies are able to execute on these visions and justify their huge IPO multiples (Google particularly comes to mind) most are never able to live up to the expectations.

For facebook to be worth the ~100x LTM (last 12 months) P/E multiple it either needed to get a whole lot more users at the same revenue per user OR find a way to monetise the site better.  Given that Google trades on a P/E of under 18 it would need to increase its earnings fivefold before it got to the same point Google is at now.  Given that Facebook already has close to 1 billion users and China blocks it there is not a whole lot of growth to be had in terms of users so it comes down to monetisation.  While it is entirely possible that Facebook will be able to monetise these users in the same way that Google has - there is no way of knowing whether this will come off or not.  For investors this means that they should demand a higher return for taking the risk that Facebook will not pull off this monetisation.  The real problem is therefore that Facebook's IPO valuation already priced in this upside potential so there was nothing left for the new investors making it a terrible investment.

Why the shares were ever in short supply is a mystery to me.  The valuation proposition never stacked up.  I think that perhaps people were hoping to make stag profits on the shares and so didn't care too much what the underlying fundamentals are.  This only works if most people in the market are dumber than you which is always a losing strategy.  I think FB was always a flawed investment and it needs to show that it can effectively monetise it's users before it can ever be considered a good investment.  How people can buy into FB before Google (which actually makes money) is a mystery to me.

Disclaimer: I do not own either Facebook or Google.

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