Facebook Through Peter Lynch's Eyes

One of these days I'd love to sit down with super-investor Peter Lynch and find out just how annoyed he is that an stellar career as an investor and educator of individual investors has been boiled down to the cliché "buy what you know."

With the Facebook (Nasdaq: FB  ) bonanza we've had yet another run-in with the public's misunderstanding of Lynch's wisdom. "Buy what you know" is now popularly interpreted as "if you're familiar with it and like it, it must be a good investment." That garbled message helped retail investors -- with plenty of help from the media -- get worked up into a frothy frenzy over the possibility of buying shares of the pop-culture icon that is Facebook.

But it hasn't worked out at all so far. For somebody that sunk $40,000 into the stock at the IPO price, the loss so far tallies to more than $10,000.

A Lynchian look at Facebook
Peter Lynch did indeed counsel investors to buy what they know. However, the lesson wasn't "anything that you know is worth buying" but, rather, more of an admonition against buying what you don't know.

Further, if Lynch's One Up on Wall Street was nothing more than advising investors to "buy what you know" it'd be a darn short book. But if you dig into the rest of what Lynch has to say, Facebook, though familiar to many investors, doesn't end up looking like a very Lynch-worthy investment.

In the final chapter of the section titled "Picking Winners," Lynch presents his "Final Checklist." Let's see how Facebook stacks up.

First, there are checklist items for "stocks in general:"

Lynch: "The p/e ratio. Is it high or low for this particular company and for similar companies in the industry."

Me: At more than 70, Facebook's p/e ratio is high, high, high. On an absolute basis it's high and compared to similar companies it's high. Google (Nasdaq: GOOG  ) trades at a p/e of 17.8 while Apple (Nasdaq: AAPL  ) has a p/e of 14.1.

Lynch: "The percentage of institutional ownership. The lower the better."

Me: Facebook gets a checkmark here -- insiders still own a lot of the shares.

Lynch: "Whether insiders are buying and whether the company itself is buying back its own shares. Both are positive signs."

Me: Nope! Through the IPO both insiders and the company were selling shares.

Lynch: "The record of earnings growth to date and whether the earnings are sporadic or consistent."

Me: Facebook's growth has been blazing fast, but with a very short history, it's hard to know how fast the company can consistently grow.

Lynch: "Whether the company has a strong balance sheet."

Me: Facebook has a very strong balance sheet. Though it's notable -- as my fellow Fool Morgan Housel pointed out -- that the financial strength has mostly come via outside investments in the company rather than the company's performance.

Lynch also offers criteria specific for growth companies like Facebook. Let's take a look at a few of those as well.

Lynch: "What the growth rate in earnings has been in recent years. (My favorites are the ones in the 20 to 25 percent range. I'm wary of companies that seem to be growing faster than 25 percent. Those 50 percenters usually are found in hot industries, and you know what that means.)"

Me: Uh oh! Facebook's earnings growth from 2009 -- its first year of profits -- to 2011 averaged more than 100% per year. It's certainly a fast grower, but as a social networking company it also would fall into that "hot industries" category that would make Lynch skeptical.

Lynch: "That the company still has room to grow."

Me: The simple answer is "yes." However, that growth will only come if Facebook figures out how to consistently monetize its users.

Lynch: "Whether expansion is speeding up ... or slowing down."

Me: From 2010 to 2011, revenue grew 88% and profits were up 65%. For the quarter ended in March, year-over-year revenue growth was 45% and net income fell 12%. And let's not forget all of the grumblings over Facebook's admission that its business on mobile phones is lackluster.

The final jab
Lynch doesn't have a whole lot to say about IPOs in One Up on Wall Street, but when he does bring them up, he doesn't exactly sound enthusiastic:

IPOs of brand-new enterprises are very risky because there's so little to go on. Though I've bought some that have done very well over time ... I'd say that three out of four have been long-term disappointments.

Fed up with Facebook and ready for some better ideas? Think big and check out these three companies that my fellow Fools think are set to "dominate the world."

The Motley Fool owns shares of Apple. The Fool owns shares of Google. Motley Fool newsletter services have recommended buying shares of Google and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (7) | Recommend This Article (10)

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 May 31, 2012, at 6:37 PM, funspirit wrote:

    I like the logic here, and the points, though simple that were made.

    here's a good column evaluating Facebook's stock at the time of the IPO-

    seems to have been pretty spot on, so far at least

    http://www.richmakesyourich.com/2012/05/investors-facebook-q...

    cheers

  • Report this Comment On May 31, 2012, at 7:06 PM, cbglobal wrote:

    Why don't you call up Lynch and ask him? I would bet he would talk to you. Instead we get your opinion dressed up to make it look like it was Peter's.

    I call that fraud in the inducement.

  • Report this Comment On May 31, 2012, at 7:24 PM, SimchaStein wrote:

    What we're seeing (not in this column) is the 'stupidity of crowds'. Firstly, all the exchanges were overwhelmed with sell orders at IPO, because tons of IPO buyers were looking for a quick pop - and out. That's a stupid reason to buy a stock. Then, when that failed, we're seeing panic sellers. So why are they selling? Did they never believe the valuation? Are they spooked by the next quarter forecast? Again all these are stupid reasons for a stock that was obviously valued at long term potential.

  • Report this Comment On May 31, 2012, at 9:40 PM, srwm4 wrote:

    I would warn against suggesting that Lynch would classify selling via IPO a bad indication. I recall him discussing how he was leery about La Quinta because an insider had sold a significant portion of his holdings in the company. Lynch later learned that the insider was selling because he had >90% of his net worth invested in the company's stock, and he needed to diversify.

    I'm pretty sure darn near 100% of Zuckerberg et al.'s net worth was in Facebook stock, so selling to get a bit of diversification shouldn't raise any red flags at all. It's not like the management team haven't retained a significant portion of the company - Zuck still has majority control, after all - so I doubt that one could really be worried about him losing his shareholder alignment anytime soon.

  • Report this Comment On June 02, 2012, at 1:58 PM, mountain8 wrote:

    cbglobal,

    Opinions are all you will ever read. Even Lynch gave you opinions. I see a lot in this article that is interesting and informative. I will have to pull out my copy of one up on wallstreet and review.

    I'm assuming you lost a bit on Facebook. I didn't.

  • Report this Comment On June 02, 2012, at 5:46 PM, earledouglas wrote:

    This piece would have carried more weight if it had been published *before* the IPO. Your hindsight is rated 20:20.

  • Report this Comment On June 04, 2012, at 1:03 AM, lowmaple wrote:

    Not certain if Mattwas a friend or foe of FB before the IPO. However there were many voices on the foe side. I did not even consider buying FB seeing how hard they campaigned in New York. Looked like a political rally to me. We know how well we can trust those.

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