Facebook Shares Could Fall Another 50%

With such a short history, the release of Facebook's (Nasdaq: FB  ) second-quarter earnings is an important opportunity to review the valuation in light of new data. Prior to the company's May IPO, I warned investors to steer well clear of the shares. While the near-40% decline the shares have suffered since the offering may tempt investors into believing they can now secure an attractive entry point, after consideration, my advice is unchanged today.

Facebook falls short
In an article published just after the IPO, I used a graph similar to the one below to show that Facebook's growth path was far outstripped by Google's (Nasdaq: GOOG  ) . The graph matches up annual revenues for both companies over five-year periods: 2000 through 2004 for Google versus 2007 through 2011 for Facebook:

Source: Company filings, S&P Capital IQ.

The trend is very clear and it suggests that in the following year, Google's revenue would surpass Facebook's. And that's exactly what is happening. Although we don't have Facebook's full-year results for 2012, we can add trailing-12-month revenue through June 30, 2011, instead. This is what an updated graph looks like:

Source: Company filings, S&P Capital IQ.

Google overtakes Facebook, with 12-month revenues of $4.48 billion vs. $4.33 billion! But that doesn't properly convey the gap in growth rates between the two companies. In the second quarter, Facebook's revenue grew by 32% year-on-year; the equivalent figure for Google during the second quarter of 2005 was 98% (in fact, in the second quarter of this year, Google's revenue ex-acquisitions increased 21%, which is remarkable for a company with trailing-12-month revenues that are now 10 times Facebook's.)

On July 22, 2005, the first full trading day after Google announced its results, shares closed at $302.40, with a price-to-earnings (P/E) ratio of 88.7. Google shares have roughly doubled since then, for an annualized gain of 11.1%. Based on last Friday's closing price, S&P Capital IQ has Facebook's P/E at 82.2.

A high-risk bet just to earn the historic average equity return
What are the implications for investors? Let's assume that Google shares are currently fairly valued (or at least not significantly undervalued). In that case, if you're willing to bet that Facebook can achieve over the next seven years what Google has achieved over the past seven, then you can reasonably expect an annual return of 11%-12%. That looks -- to me -- like a very risky bet to achieve nothing better than decent returns. After all, we've already observed that Facebook is on a lower growth path than Google's. If I'm going to take punt on a long shot, I want to get paid in full if it comes in, and I don't mean 11% per year!

Another model I have referred to previously is that of econo-physicists Didier Sornette and Peter Cauwels (hereafter S&C), who valued the shares in a paper for the Journal of Portfolio Management, based on the following assumptions:

  • Revenue per user per year is stable at $3.50.
  • Profit margins remain stable at 29%, for an annual profit of $1 per user.
  • Annual profits are discounted using an equity risk premium of 5%.

Based on these assumptions, S&C came up with a range of values for Facebook conditional on three scenarios for the maximum number of users the social network ultimately attracts ("base case," "high growth," and "extreme growth"). Under their extreme growth scenario, users top out at 1.8 billion (roughly twice the current number) and the company is worth $32.9 billion.

Facebook's value: The hard numbers
On the release of Facebook's offering prospectus, S&C updated their model with new assumptions in terms of profitability (they increased expected annual profit per user to $1.20) and user numbers. Under the new assumptions, the valuation associated with the base case and high growth scenarios increased, but the extreme growth scenario -- investors' best-case outcome -- yielded a lower value than previously, due to lower expected user numbers (S&C are now forecasting that Facebook's monthly active user base will stop growing in April 2013):

 

Base Case

High Growth

Extreme Growth

Number of users

1.01 billion

1.11 billion

1.37 billion

Company value

$21.6 billion

$23.6 billion

$29.2 billion

Source: Facebook IPO, Updated valuation and user forecasting, Cauwels & Sornette, May 2012.

With last Thursday's quarterly earnings release, we have yet more data with which we can compare S&C's results.

  • With regard to the ultimate number of total users, Facebook looks likely to surpass the base case scenario, since it is already at 955 million.
  • With regard to annual profit per user, the revised assumption is holding up. Over the trailing-12-month period ending June 30, Facebook achieved a profit per user of $1.24. Although we've got a very short history, this metric looks pretty stable -- it was $1.36 in 2011 and $1.24 in 2010.

A 55% haircut
Facebook could well exceed S&C's base case valuation, but even S&C's most aggressive user growth assumptions produce a current value for the company of $29.2 billion at the time of writing, or $10.66 per share -- a better than 55% discount to Friday's closing price of $23.70.

The nightmare isn't over
Facebook's IPO was botched, yes, but the shares have performed so poorly because they began trading at an outrageously inflated valuation. It's no more complicated than that. The same is true for Zynga (Nasdaq: ZNGA  ) , which came to market without a hitch. In that context, Facebook shareholders should consider that horrific past performance does not mean their downside is now capped. While Facebook may increase its business value over time, shareholders will continue to suffer underperformance consistent with the shares' current overvaluation.

One of the Fool's top analysts took time to give his assessment of Facebook's long-term prospects in our brand-new premium research report. If you want to deepen your understanding of the social networking giant, you need only click here for the full analysis and 12 months of free updates.

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 @longrunreturns. The Motley Fool owns shares of Google and Facebook. Motley Fool newsletter services have recommended buying shares of Google and Facebook. The Motley Fool has a disclosure policy.

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.


Read/Post Comments (22) | Recommend This Article (47)

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 July 31, 2012, at 5:02 PM, josephavellino wrote:

    I believe that this stock has a lot more to go than down another 50%. I've been calling for a price of $7 within 18 months of the IPO. But if we're in the $10 range based on your estimates, we're not that far off.

    Sadly for the billions and billions lost, Zuckerberg has already cashed out so it doesn't matter from this point on for those who already created their wealth. From Steve Case with the AOL debacle to Mark Cuban with the bust of Broadcast.com and now with Zuckerberg, the masses just never get it.

  • Report this Comment On July 31, 2012, at 5:19 PM, Puckplayr4 wrote:

    I heard that employees can't sell their stocks until August...so I expect a huge drop then as everyone cashes out. After that...it will do whatever its going to do, but if I was thinking of a rebound, I'd buy in August. But no...I probably won't be buying in August.

  • Report this Comment On July 31, 2012, at 5:21 PM, user5701 wrote:

    From the article:

    "I warned investors to steer well clear of the shares" - Alex Dumortier, referring to Facebook.

    At the end of the article:

    "The Motley Fool owns shares of ... Facebook. Motley Fool newsletter services have recommended buying shares of ... Facebook"

    It sucks when the company you work for isn't even listening to you. As always, TMF remains ambiguous at best, be careful with what advice you follow, fellow readers.

  • Report this Comment On July 31, 2012, at 5:34 PM, MyPortfolioGuide wrote:

    Hopefully not too many people are using this forum as investment guidance or think it's tailored to them. Geesh!

    Facebook is one company that clearly was overhyped and I couldn't be more glad that I told my clients to look elsewhere. I rarely pound the table or want to be so stubborn against buying a stock but this one was fairly obvious to me. If anyone liked it at $45 and banged on the door to get it....it's certainly cheaper now. Has anything truly changed with the company since then? No....again...

    People are emotional and follow shiny objects.

    Eventually this could get cheap enough to look at but for now I'm not touching it.

  • Report this Comment On July 31, 2012, at 5:50 PM, EquityBull wrote:

    I got 400 on the IPO and sold out earlier today to offset some gains I had so thanks to the taxman my total loss cut by a lot as I would have been paying full tax on them.

    I went in to FB as a flyer knowing it was overvalued but figured the ponzi buying public would run it up nicely and I would dump on the open. When that failed to happen I held on figuring we might catch a bounce if they had decent financials.

    Well after seeing the financials and extrapolating out I saw more downside and decided to sell and offset some gains from last Friday when I did some rebalancing of my portfolio.

    I could see FB maybe earning 50 cents this year and 65 cents next year. Put a 30x on that to be nice and you get about 20/share next year. If the market is not so nice on the multiple it goes much lower. Time will tell. For now it is one less position I have to follow. I'll redeploy the remaining funds into something more promising like Apple with the upcoming iPhone 5, ipods, iTV. Also Windows 8 debacle should provide incredible catalyst for Mac sales and all things apple. I should make up the loss within a year on the Big A.

    http://www.oracleofjersey.com

  • Report this Comment On July 31, 2012, at 5:53 PM, TMFAleph1 wrote:

    <<In that context, Facebook shareholders should consider that horrific past performance does not mean their downside is now capped.>>

    Just to clarify: Their downside is capped. Assuming they aren't leveraged, their maximum loss can't exceed 100%. ;-)

  • Report this Comment On July 31, 2012, at 6:01 PM, pauldelang wrote:

    The Sheeple has been Zuckered into believing that there will be lot of money left on the table after the IPO. Not only did they take all the money on the table at the IPO, they also took the table and the tent leaving the speculators with stars in their eyes exposed to the ugly element of reality. Suddenly the emperor had no hoody but not only that, the emperor was a skinny ugly guy with not meat on his bones.

    But hey - who cares about speculators getting burned. They were In it only for a quick buck anyway, and it could also have turned out the other way were their more optimist Zuckers around.

  • Report this Comment On July 31, 2012, at 6:13 PM, topbeancounter wrote:

    The day after it went public, my business partner asked if I bought any. I told him the pricing was a joke and I wouldn't even think about until it reached $20. He suggested it would go far lower. I like the fellow that suggested $7. I like that.

  • Report this Comment On July 31, 2012, at 6:38 PM, mikecart1 wrote:

    Mark Zuckerberg will be the first person to be on the cover of Time Magazine for being the Best CEO in the World to the Worst. I can't wait to see Facebook turn to dust. It is like a disease on the internet these days, slowing down everything, and eating up my life.

  • Report this Comment On July 31, 2012, at 6:47 PM, SaraW946 wrote:

    Before I buy stock, I do my DD and the main question I ask is this: what does the company I am considering sell? As in sell something tangible. If I have a hard time answering this question, then I pass. I'm glad I passed on Facebook and truly consider it a fad. Sorry.... :)

  • Report this Comment On July 31, 2012, at 8:46 PM, cire333 wrote:

    Just a few small points:

    1. Facebook has a pile of cash at their disposal (some where around $16 bn I don't really recall but its a lot of cash), and to think they can't earn a return on that by either growing the facebook brand or doing something else might be a little short sighted.

    2. Its just a matter of time before they figure out how to capitalize on their mobile platform.

    3. Facebook stock was trading in private markets the day before the IPO at $41.37, so the choice to have the public offering start at $38 really doesn't seem that far off.

    I agree that the stock will probably continue to go down options traders seem to thing $15 is a pretty good target. At some point I think there will be some money to be made on the upside.

  • Report this Comment On July 31, 2012, at 10:07 PM, kmarkt2 wrote:

    Zuckerberg, because of the special voting rights share, will want to buy up more of those falling shares - after all, its not his cash, that's burning.

    The IPO runners and investment bankers should be sued for their poor due diligence, then the circus could go round and meet Zuckerberg and he can have his day in court.

  • Report this Comment On July 31, 2012, at 11:07 PM, BMFPitt wrote:

    So many people have forgotten all about the Dot Com bubble.already?

  • Report this Comment On August 01, 2012, at 8:10 AM, FundamentalFrank wrote:

    I am following Facebook for some time now. It's much to early to judge on some numbers only. Most advertisers have been thrilled with the success of the ad-campaigns on Facebook, even if only some examples fitting into the current "everbody bashing Facebook trend" are highlighted in the press. The engagement of Facebook users is great and growing all the time.

    -It's already foto-sharing platform Nr.1

    -will become messaging platform Nr.1 soon

    -is able to deliver demand creating adds (Google can't do this properly)

    -will become most important for media consumption (music, video ...)

    - has a great starting position considering social shopping

    - has a very good position regarding location based services (payment, shopping, coupons etc.)

    - will become the "new TV" considering the time people spent on the platform, which is of great importance, regarding the new way the media business works, depending on "attention and recommendation" Facebook is king considering both attention and recommendation.

    Therefore I would estimate Facebook value to be in the same region as Googles.

    I agree that technically with all those banks sitting on shares they bought due to (NASDAQ's) mistake and employees starting to sell soon, in combination with negative press, I expect some more minor losses. But I think some high level Silicon Valley investors, who know how much Facebook is worth will stop this downtrend sooner than many expect.

  • Report this Comment On August 01, 2012, at 8:49 AM, TMFBreakerRob wrote:

    Shucks! I guess I'm way out among the outliers.

    I've been figuring that I *might* start being interested in buying shares once the price dropped to $14, but you guys are all aiming below that!

    Frankly, there are so many excellent companies... with excellent track records..... that Facebook would have to show amazing progress to interest me. After all, it isn't a choice between Facebook and nothing... it's a choice between Facebook and those many excellent companies with excellent track records.

    Does FB have what it takes? With current management? <shrug> There's certainly no need to take a risk on it since there are other choices that look more attractive....let them prove themselves, then maybe I'll add them to my watch list.

  • Report this Comment On August 01, 2012, at 10:05 AM, PeakOilBill wrote:

    If I had to guess, I would say FB will be selling for about $18 at the end of 2013. FB is fun and interesting, but it remains to be seen how it will become a big revenue generator.

    And it has new competition which limits you to 150 friends, but isn't yet a public stock. The co-founder was on CNBC Squawk this morning.

  • Report this Comment On August 01, 2012, at 1:02 PM, PostScience wrote:

    Good analysis, but missing one thing. The growth doesn't have to come from more users, it can come from better monetization.

    Just like Google was never very profitable until AdWords, Facebook could finally discover the secret sauce to increase earnings. Will they? Who knows, but they will certainly try.

  • Report this Comment On August 01, 2012, at 1:18 PM, TMFAleph1 wrote:

    @PostScience

    Absolutely! The $1.20 profit per user per annum S&C use in the model is not an immutable constant; however, some of the current trends will actually put pressure on average profit per user -- at least in the forseaable future (transition to mobile platform, users outside the U.S. generate lower revenue/ profit.)

    Thanks for your comment!

  • Report this Comment On August 01, 2012, at 9:41 PM, scoobster007 wrote:

    With regard to buying when it's cheaper, how do you know when you are buying at a bargain price when the CFO won't give any guidance? The stock price may be cheaper than before, but how do you value a stock with no certaintly whatsoever as to future revenue and earnings? P/E has gone from about 100 to 60 but this was trailing P/E, which is still high when usage is rapidly moving from computers to mobile and they don't know how to monetize mobile yet, so their revenues will be decreasing. Plus you've got a hooded techie as a CEO with no experience running businesses and none running public companies. Oh and all of social media stocks are tanking. What a mess!

  • Report this Comment On August 03, 2012, at 1:58 PM, robertt253 wrote:

    I feel that many of these failed IPOs are just big scams, its amazing how a company such as Facebook could sell stock at $38.00 in an IPO. When Big Companies that are struggleing like F and BAC stock is in the pits. These are well established Companies Face book is a fad.

  • Report this Comment On August 04, 2012, at 4:22 AM, sonrisa1 wrote:

    I agree with robertt253 & others who see it vastly overpriced maybe will go to $3,80 by 2013 or 2014, I have never even realised it had ads & do not look at them & in fact find it such a waste of time.

    Why buy this when there are so many other stocks with a worth while return & produce something sellable & have some say in how the company is run, avoid companies were you have no voting rights.

  • Report this Comment On August 04, 2012, at 7:51 PM, bobbyk1 wrote:

    Numbers are numbers but I think FB is a different case.Can they monetize their product?If they do they got a monster.If I liked the potential I would average in 1/4 posistion at a time.When they pop they will pop big if not you limit losses.

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