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1 Big Number That Will Burn Facebook Investors

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On Wednesday, Facebook shares changed hands on a private market at an implied valuation in excess of $100 billion. That's wonderful news for Facebook's employees and venture backers -- the only constituencies Mark Zuckerberg is concerned with in the impending initial public offering (the prospectus is explicit on this point). But if you're considering buying shares when the company goes public, it's awful news: The higher the pre-IPO valuation gets, the lower your expected share returns.

I stand by my prediction
At the end of last June, I predicted that Facebook would close its first day of trading with a market capitalization in excess of $150 billion. The private market value at the time was $70 billion. At the company's current valuation, my prediction is beginning to look conservative. And yet there are plenty of excellent reasons to remain skeptical regarding this IPO.

At the beginning of February, I argued that high-profile companies that go public with a low float (the percentage of shares being offered) have a poor track record in terms of shareholder returns. Facebook certainly falls under "high profile" -- I can't think of any IPO that has generated as much hype (Blackstone and Google came close).

Tom Gardner weighs in
Motley Fool CEO Tom Gardner countered that, in light of the expected dollar size of Facebook's issue ($5 billion-$10 billion), the float percentage is irrelevant -- that is, given the absolute dollar amount of supply, a squeeze that would produce an overpricing is unlikely.

That argument has merit, in theory, but my guess is that the pent-up demand for these shares is such that the issue will be heavily oversubscribed. I'm expecting that the market will gobble it up before going to Mark Zuckerberg, basin and spoon in hand, to ask: "Please, sir, I want some more." There is already anecdotal evidence of ravenous demand for the shares, with qualified investors going to great lengths to obtain shares in private markets.

Paying a premium on top of the premium
Let's imagine that the current $100 billion private market valuation holds until the IPO. The offer price will be set at a premium to that valuation. Once the shares hit the secondary market, the stallion is out of the gate -- who knows how far or how fast it will run? If LinkedIn (NYSE: LNKD  ) shares can double on their first day of trading, who'll be foolish enough to argue that Facebook shares can't gain 30%, 40% or 50%?

Still, the number $150 billion holds no specific significance. There is no law that says a company can't go on to produce decent returns from that level and, if any company can, I can't think of many better candidates than Facebook (but that doesn't mean I think it's likely). It's a big starting number, but it must be possible -- Apple's market value has increased by over $100 billion since the beginning of the year! Of course, Apple generated over $10 billion in cash flow last quarter.

Facebook vs. Google
I'll admit I thought Google (Nasdaq: GOOG  ) looked very pricey when it came public in 2004 and the company subsequently proved me wrong, delivering superb operating results and share performance. However, while the situations share some similarities, there are a couple of important differences between the two flotations:

  • Google went public earlier in its growth cycle.
  • The valuation multiples we are currently juggling for Facebook are significantly higher than Google's were.

You can't ignore size as a limiting factor. With 800 million users there is natural ceiling on the growth Facebook can still achieve and that ceiling may not be all that far off, as the total number of Internet users globally at the end of 2011 is estimated at 2.3 billion (of course, that number is growing also). Proponents will argue that the company has merely scratched the surface in terms of monetizing its existing user base, let alone its future user base, and that argument isn't without merit.

I couldn't imagine how Google was going to monetize my web searches, either, but sure enough, I did end up using the search engine to find certain products. I use Facebook every day, but I find the ads deeply irritating (and poorly targeted, for the most part). I've never even considered buying anything. As for spending time and money growing virtual vegetable patches or rubbing out Mafia rivals, either we are on the brink of a new Dark Age or Zynga's (Nasdaq: ZNGA  ) games are the Cabbage Patch Kid of the digital age (maybe I'm just too old to understand).

Explain this to me like I'm a 6-year-old
If you're impatient to buy into Facebook's IPO, I invite you to tell me why I'm wrong in the comments section below. I don't wish for investors to suffer the same fate as those who invested in the Cowen Group -- another IPO I panned several years ago -- but I fear the odds of disappointment are climbing with every uptick in Facebook's private-market share price.

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of LinkedIn and Google. Motley Fool newsletter services have recommended buying shares of Google and LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (23) | Recommend This Article (42)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 03, 2012, at 12:30 AM, awallejr wrote:

    Wow we are on the same side for once. Personally I am of the opinion that Mark Zuckerberg has no idea how to monetize his creation. It won't matter to him, of course, since he is destined to make billions.

    Google is a search engine. People go there to find things. Facebook is a social network, People go there to socialize, not to buy things. At best I can see it as a way to engage in demographics, which means trying to recoup data on its users.

    And with such a small percentage being IPO'd, which shares will probably skyrocket, but not on fundamentals, only the holders of the non-public shares will benefit since they can now peg their private shares on an unrealistic public valuation. It is a suckers' purchase in the end.

  • Report this Comment On March 03, 2012, at 1:36 AM, dferry01 wrote:

    Here are 2 small numbers that could redeem a facebook investor: 4 and 30. Specifically, $4 in revenue per user for facebook in 2011, and $30 in revenue per user for Google. Even Yahoo! managed to make $7, and facebook is one of the most visited pieces of virtual real estate on the web.

    You mention that the ads are poorly targeted and irritating: yup, they are. That's why facebook's revenue per user is so low. But they don't *have to be.* Zuckerberg has stated before that he has been more focused on growing the user base than monetizing users, and it shows. There's nothing wrong with facebook's revenue model that better management couldn't fix. If facebook went public and shareholders demanded a little more attention paid to its advertising segment, it's really not hard to imagine facebook's top-line revenue matching or even exceeding Google's per-user figures. If they kept their expenses down and you assume an aggressive but reasonable P/E, let's say 20, you get a company that's fairly-valued at around $160 billion.

    I think a higher P/E would be justified because facebook has good prospects of generating returns by becoming a content distributors. Their partnership with Spotify for music and various newspapers for news content have already been promising: as content providers continue to raise the pay-wall around their content, they face the problem of how to give potential buyers enough of a taste of their product to get them to commit their cash. Facebook fills that gap. By sharing something on facebook, you can let your friends see it, but ONLY that portion of the content. And a potential customer's friends know better than the content creator which particular bit of content will entice the customer. If facebook does a little more work of making an integrated payment system part of its platform, it's very easy to imagine people buying music, news, maybe even shows and movies through facebook, with facebook taking a neat commission.

    It's also got the potential to go multi-bagger in a relatively short amount of time by stealing massive market share from Google virtually overnight.

    How? Two words: social search.

    What facebook has been attempting to figure out is how to use the massive array of data it has about its users, and its users' friends, to create a new way to surf the web. Instead of Google's PageRank algorithm system, which returns websites that have certain linguistic and structural features its bots have identified, Facebook would return the search results most likely to be interesting or relevant to you *based on what your friends found interesting or relevant.* This is obviously not an easy task to pull off and get right, but if done correctly it would absolutely revolutionize internet search. That opens facebook up to an entirely new market.

    Of course, all of these arguments require that management execute very well and focus on monetizing user base, and that doesn't seem to be something Zuckerberg has any interest or talent in doing. So because of management concerns, I'm not buying facebook because I don't want to invest in the speculation that Zuckerberg will either shape up or ship out. But he might, though. . .

    So don't short it.

  • Report this Comment On March 03, 2012, at 7:13 AM, steveat wrote:

    I agree with the earlier poster about the fact that Zuckerberg doesn't know how to monetize facebook and THAT is the reason investors should hold back until they perfected that technique..IF they perfect that technique.

    Right now, they have it wrong. Yeah, they are making money from paid advertising, but when you have that many users, you are bound to get quite a few clicks. Like a person who has never worked out before and just starts at a gym.of course they will lose eight and see exponential improvement within the first month or 2..then it tapers off.

    The problem is that everyone is looking at FB as an ecommerce sell products and services which it is NOT! It has a social market. Facebook needs to move more towards a "Second Life" type model for monetization as opposed to a "Google" model of paid ads.

    I find this as a problem with FB apps as well. the developers haven't a clue how to monetize..actually, I would go insofar as saying the devs can't think outside the box. What do people want to do when socializing with friends..buying stuff is certainly part of it, but a very small part. The whole idea is to generate income for both the devs AND the users. FB can make a load of cash paying users to fill out surveys. App devs can make a load of cash paying people to get their friends to join (ie affiliate srvices). FB should be a vehicle for outside companies to either gain valuable info OR build a userbase for their products and services.

    IF FB acquires Second life AND Skype, we are in business and they could build a model to go head to head with Apple.

    "The Median IS the Message"

  • Report this Comment On March 03, 2012, at 11:11 AM, raonanduri wrote:

    The moral basis of the data management by Facebook has to be resolved before I look at the shares to buy.

    How is Facebook going to convince me and others that what it says is what it will in fact do with all the info that hundreds of millions of users place at its disposal?

    I will stay away from the IPO, share purchase now or in future until I see the usual metrics that make Facebook a good investment vehicle. I will only have myself to blame if I make others rich!

    Rao Nanduri

  • Report this Comment On March 03, 2012, at 11:36 AM, payaso1 wrote:

    Don't forget about Sheryl Sandberg. Hired as COO in 2008 got Facebook to profitability by 2010. I think Zuckerberg made a good decision when he hired her to grow his "cool" site into a profitable business.

  • Report this Comment On March 03, 2012, at 4:19 PM, TMFAleph1 wrote:

    Thanks for these interesting comments, which contribute to helping me understand how Facebook *might* make good on a $150 billion valuation (although I continue to think it unlikely.)

    raonanduri highlights a reputational risk that is dogging Facebook. I know that I trust Google *much* more than Facebook when it comes to their use of customer data.

  • Report this Comment On March 04, 2012, at 1:56 AM, TMFAleph1 wrote:

    "The medium is the message."

  • Report this Comment On March 04, 2012, at 4:12 AM, RandomName83 wrote:

    I won't be buying Facebook at predicted IPO valuations. Nonetheless, I definitely won't be shorting the stock. Facebook has the potential for huge growth. If the company capitalizes on its 800 million users and is able to make similar per user advertising revenue as Google (or even half that of Google's), Facebook will be a huge success. However, the risks don't justify the rewards.

    I might short the stock here on CAPS. I definitely won't be betting against Facebook with my real life portfolio.

  • Report this Comment On March 04, 2012, at 1:41 PM, steveat wrote:

    Thanks for the correction. Was my typo fault. TMFAleph1

  • Report this Comment On March 04, 2012, at 1:43 PM, earlyseller wrote:

    I am NOT NOW nor have I ever been nor will I ever be a FaceBook or a Linkedln participant.

    NOR do I consider Tweeting by Twits an advance in communications technology.

    Ditto for other social crap, of Texting, MySpace, FAXing and twitterers.

    Therefore I can not nor will not ever enjoy/suffer the slings and arrows of those same idioticies

    including Texting on cell phones.

    YES! I am a convert to Luddite and all its isms.

    Sincerely and Anti-Spammedly yours,

    Jack the computer antique since 1964 from punched card devices at IBM to airline res systems and on-line banking.

  • Report this Comment On March 05, 2012, at 5:41 PM, hbofbyu wrote:

    There is a lot of hype that has been going around in marketing circles that say my friends will influence my purchases. I disagree. I value the product user reviews on Amazon much more than the opinions of many of my friends - they are my friends but it doesn't mean we have the same taste in music, cars, food, books.

    Social marketing is good for getting the initial word out on a new product or fad or eccentric items. But it doesn't work for most things you are looking to buy (IMO).

    Facebook's has an intrinsic value in that it can no longer be touched by other social sites in size and scope. They need to keep building the mote. The golden goose application probably won't come along for another 5 to 10 years, but when it does I predict it will be huge and they will blow well past their current valuations. Maybe it will be along the lines of gaming or virtual reality.

  • Report this Comment On March 05, 2012, at 6:01 PM, hiddenflem wrote:

    I for one can't wait for facebook to go public so I don't have to keep on hearing about how much it's going to be worth. let them cash in and let's move on to the next big thing which will no doubt be a heck of a lot more interesting than facebook is.

  • Report this Comment On March 05, 2012, at 6:53 PM, sikiliza wrote:

    "Never underestimate the power of stupid people in large numbers". - Homer Simpson.....

    The 800MM number that is bandied around includes the "likes" that people click on other sites - I would say those vastly outnumber the actual visitors to the FB site and therefore lessen the potentially 'monetizable' eyeballs.

    FB has the potential to make money but that pool of advertising dollars is finite and is being targeted by a large number of ad-based business models meaning that sooner or later everyone gets a diminishing share of the pie.

    I expect that FB will end up like YouTube - 3BB in video views a day and $3BB in revenues a year. Large numbers fail to scale because of the way online advertising is set up - they usually sell ad campaigns at a fixed cost e.g. a $1MM Toyota campaign that is then spread over targeted content, users or fan pages. It's not the other way round where it's a price per view - the ads sold this way are the extremely low CPM ads that tend to be annoying and that no one clicks on. If these are sold on a price per click/action (CPC/CPA) basis and the clickthrough rate is low, then FB's return on inventory gets very low - and remember, views are immediately perishable goods - they cannot be stored.

    One bright spot on FB's horizon is that it can position itself as a platform on which others can build very successful business models, Zynga being a prime example.

  • Report this Comment On March 05, 2012, at 7:17 PM, MichaelHamilton wrote:

    I bearly have time for facebook and also don't see it being monetized any time soon. It could be but I wouldn't be convinced until I see some strategic shift in that direction. Mostly facebook is fairly boring and not worth spending money on. the ads are largely ignored. I think I have a filter that just filters out ads in general.

  • Report this Comment On March 05, 2012, at 8:41 PM, Merton123 wrote:

    A lot of companies use facebook as their website. A lot of people use facebook as the platform so that their friends can keep in touch. I have read several articles on the WallStreet Journal talking about how several companies advertise their products on facebook.

    With all that stated most IPO tend to drop in price a few weeks after the initial offering. Does facebook make sense from a value investment perspective criteria? I agree with everyone above that the answer is no. How about from a growth investors perspective? The current valuation is at nose bleed territory. If earnings growth suffers any setbacks - ouch.

  • Report this Comment On March 06, 2012, at 8:49 AM, import2udirect wrote:

    what would happen if fb added premium account features for 1usd a month and called it fb pro and only half of its 2.3 users signed up for pro? 1.15 billion a month in positive cash flow thats what would happen

  • Report this Comment On March 06, 2012, at 11:28 AM, consolcwby wrote:

    I really believe Facebook will launch it's IPO as a monster, speculators will drive up the price to unbelievable numbers. But over the long haul, I can't see any way it can sustain. In fact, I'll take the contrarian view - I believe to see this in the pink sheets within 12yrs or under.

    TL;DR: IMO - Bullish speculation but bearish value.

  • Report this Comment On March 06, 2012, at 12:05 PM, mikecart1 wrote:

    Facebook has done nothing but ruin the internet. It would be one thing if Facebook just ruined itself. But that is not the case. On nearly every website worth going to, from sports, to news, to games, to stores, to shopping, to videos, to blogs, to reviews, to research, to just info, there is a Facebook application on that page. It is ridiculous. The internet used to be a lot faster than it is today. But it isn't when you have Facebook and Twitter on every site. Even this article has Twitter on the top! C'Mon man!

    Instead of the options of thumbs up or thumbs down on a webpage that links it to my Facebook account, how about giving me a third option - the middle finger.

  • Report this Comment On March 06, 2012, at 3:16 PM, TMFAleph1 wrote:

    <<what would happen if fb added premium account features for 1usd a month and called it fb pro and only half of its 2.3 users signed up for pro? 1.15 billion a month in positive cash flow thats what would happen>>

    Yes, if Facebook *had* 2.3 billion users; their current base is roughly 800 million.

  • Report this Comment On March 06, 2012, at 4:57 PM, racchole wrote:

    Facebook, buy EBay. Host a social network with an e-commerce marketplace. Bam, synergy. Until then, Facebook will be as flat as the Serengeti.

  • Report this Comment On March 06, 2012, at 11:05 PM, srini12 wrote:

    These kinda valuations are only gonna make Facebook more vulnerable to making stupid mistakes and start the journey south . .My thoughts on this @

  • Report this Comment On March 09, 2012, at 12:28 PM, mard46 wrote:

    "Never underestimate the power of stupid people in large numbers". - Homer Simpson.....

    The median is the message.

    That was no typo.

  • Report this Comment On May 15, 2012, at 6:26 PM, ronel327 wrote:

    I am a fellow fool for about a year now.I try to deal

    with facts that I usually have to dig for.

    In march 2011 FIDELITY bought $151,000,000

    of FACEBOOK @ $25.00 a share.

    GOLDMAN SACHS likewise bought an obscene

    amount of FACEBOOK.(usually a good indicator)

    The big player list goes on and on...

    I joined FACEBOOK because it was the only way I

    could participate in a football pool at work. THATS

    IT! And by the way, I have never seen an adver-

    tisement on my home page or any other page.

    Not much revenue there, or maybe I just have a

    good computer protection system.

    I'm not sure who stole the FACEBOOK idea from whom but most of them are selling a boatload of stock as soon as it goes public!

    Most of the successful IPO's I have seen have

    some pedigree but,don't see it here.

    These youngsters are smart ,with master degrees from OXFORD and STANFORD and so on but networking is nothing new.

    I don't believe there will be much left after the

    money is divided up for a small invester like me.

    I wonder if he will pay off his student loans be-

    fore he discards his citizenship. Does not seem

    very grateful to America but then they do teach

    GREED these days don't they.........


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