Why I'll Buy the Facebook IPO

Facebook is priced reasonably enough that I'm considering buying shares when the company completes a rumored IPO next year.

Sound crazy? Maybe. Before you judge, consider that data published at The Wall Street Journal put The Social Network on track to produce $487 million in profit last year. That's $0.22 for each of the company's 2.2 billion shares outstanding -- just enough information to get us started developing an earnings multiple.

First, we need a market value. SharesPost supplied one last month when it revealed that buyers were paying an implied $82.9 billion valuation to acquire shares of Facebook on its exchange, or $37.68 each assuming there really are 2.2 billion shares outstanding. I think it's fair to trust the Journal's reporting. In doing so here, I'm assigning Facebook a P/E ratio of 171.

And your point is?
I know, I know -- that's a rich multiple. For comparison's sake, here are the eight tech stocks that Capital IQ says trade for even richer premiums:

Company

P/E Ratio

3-Year Revenue Growth

Applied Micro Circuits

296.2

0.3%

Constant Contact (Nasdaq: CTCT  )

291.2

51.1%

Synchronoss Technologies

281.7

10.3%

Anadigics

278.0

(2.0%)

Pegasystems

275.3

28.4%

salesforce.com (NYSE: CRM  )

252.5

30.3%

Quantum Corp.

243.2

(13.1%)

Riverbed Technology (Nasdaq: RVBD  )

190.0

32.7%

Source: Capital IQ, a division of Standard & Poor's.

Some of these stocks have provided brilliant returns for shareholders even as the market has spent the last three years losing ground. Both Riverbed and salesforce.com have more than doubled. Constant Contact is up more than 60%.

My point isn't that premium-priced stocks tend to outperform, though they often do. My point is that some businesses grow fast enough to defy not only conventional valuation metrics but also turbulent markets. Facebook looks like that kind of business today.

Look at the numbers. Revenue is up 128% annually over the past three years -- from $150 million in 2007 to $1.8 billion last year. So while salesforce.com trades for a significant premium to Facebook on an earnings basis, it's Facebook that's grown faster. Four times faster, in fact.

The importance of being social
To be fair, some of this may have to do with the long tail of social media. Twitter is growing at breakneck speed and now trades for a premium to Facebook. Social gaming specialist Zynga is seeking $500 million more in financing at an implied $10 billion valuation. And don't forget Groupon, which for a time had a $6 billion grip on Google.

Social media is growing as fast as any business you'll find. Researcher BIA/Kelsey says social media advertising will account for $23 billion in spending this year alone. Facebook should claim a big share of that, with EMarketer pegging the total at roughly $4 billion.

Now here's why I'm interested in Facebook's IPO. Goldman Sachs recently put clients into Facebook at around $50 billion. I can't see the IPO market paying much of premium to that, if any.

There's no rule that says late private equity buyers must see a return on the first day of trading. Just ask Harris & Harris (Nasdaq: TINY  ) . The nanotech venture capitalist had valued its pre-public shares of NeoPhotonics (Nasdaq: NPTN  ) at around $16.83 apiece only to see the stock come public at $14 a share.

Here, have a cocktail with that valuation
We don't know exactly how many shares Facebook would issue, but dividing a $50 billion market value by $487 million in earnings yields a P/E of 102. Yes, that's high, but it's also nowhere near as pricey as the multiples assigned to many of Facebook's cloud computing peers. And most of those are smaller, slower-growing businesses.

In other words, buying Facebook at the IPO should amount to buying a quality company at a premium yet justifiable price. Exactly the sort of formula we've employed for six years at Motley Fool Rule Breakers, with market-beating results.

Now it's your turn to weigh in. Would you buy a piece of Facebook at the IPO? Please vote in the poll below and then leave a comment to explain your thinking. You can also follow the Fool on Twitter or become a fan on Facebook.

Interested in more info on the stocks mentioned in this story? Add Constant Contact, Harris & Harris, NeoPhotonics, Riverbed Technology or salesforce.com to your watchlist.

Google is a Motley Fool Inside Value pick. Google and salesforce.com are Motley Fool Rule Breakers recommendations. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is a member of the Rule Breakers stock-picking team. He owned shares of Google and Harris & Harris at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader. 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 owns shares of Google. The Fool is also on Twitter as @TheMotleyFool. Its disclosure policy is invaluable.


Read/Post Comments (13) | Recommend This Article (14)

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 01, 2011, at 1:49 PM, bottomfisherman wrote:

    Facebook claims to have over 500 million subscribers with profiles worldwide. This is a false claim since a person can set up multiple profiles and many people do, so what exactly is their true subscriber number? Also how many of these subscribers are no longer active or came on once and never came back? Will watch but will not touch this one.

  • Report this Comment On March 01, 2011, at 5:52 PM, CustardPies wrote:

    I believe Facebook's growth will slow significantly in the coming years. The popularity of social networking sites is high and will likely remain there for quite some time. However, the Facebook buzz seems to be slowing down.

    The reason Facebook has exploded in the past three years is because it became popular among older generations, not just the college crowd. So, unless my grandmother joins soon (along with her nursing home friends), we won't be seeing that type of growth continue because, simply, there are only so many people in the world.

    As for buying into an IPO, I think I would pass unless the valuation was fair. If the stock were priced at a premium factoring in continued explosive growth, I'd look elsewhere to place my investment.

    On a final note, I have been on Facebook for about 6 years. I find it less and less appealing as time goes on. And I notice that I'm not alone. My friends are the same way. But, that's pretty anecdotal. I would just be weary buying into the company if that were to become a nationwide trend.

    Just my two cents.

  • Report this Comment On March 01, 2011, at 6:22 PM, BrianBristow wrote:

    Do you remember when Friendster was going to take over the world? Or Myspace? Facebook is the biggest today, but a large user base does not equal a "moat"

    Hi5 is growing more popular in some places. I'm not saying hi5 is the next one(I don't think it is) but I don't think Fb is the final destination.

  • Report this Comment On March 01, 2011, at 6:37 PM, Borbality wrote:

    We need a better idea of how they make money. Crazy valuations abounded in the early 2000s and now look silly. I think facebook, groupon, twitter, etc. could be looked upon similarly if things don't go right.

    I think Google is much more likely to have the staying power and long term growth.

  • Report this Comment On March 01, 2011, at 9:34 PM, vidar712 wrote:

    I believe that people will buy facebook shares without any concern for valuation. People will buy facebook because it is a 'great company'. That should push the share price higher after the IPO.

    But, if you are looking for a long term investment, that short term factor shouldn't affect your investment decision.

    The way I understand it, facebook is an advertising company with a captive audience.

    If facebook was popular when you were in college (you must be younger than thirty), then half of your life is cataloged on facebook's servers. Pictures from college parties, pictures of ex-girlfriends, photos of friends that have moved away. Facebook turned into a photo album of your life. How many people throw away their photo albums? These people are not going to leave facebook.

    You can't sell much to college students. They need their money for ramen, beer, and (if they have enough money left) books. College students are not a desirable market (no-money).

    After they graduate, these people get an apartment, buy a futon, and go out drinking after they get off of work. They aren't making much money (especially once they start paying off loans), so this group is also not a very desirable market. (But it is better than the college student market.) (little-money).

    The next group has work experience. They get promotions or have found a better job. They now have disposable income. Now that they have some financial security, they will get married and buy a house. Or, have a kid and buy kids toys. Perhaps they will buy a new car. (Just like 'Nsync, they will Buy, buy, buy.) This is a very desirable market. (Disposable income and a variety of needs.) (Mo-Money Mo-Problems).

    The first adopters of facebook (those people who's photos are being held hostage) have become the last group. But the users who are in the graduate group (and the college students, and high schoolers) are going to age. Soon they will be the desirable users too.

    I believe that facebooks growth is not determined by the growth of the number of users that it has, but by the growth in the quality of users that it has nurtured.

    Advertisers can use facebook to advertise to specific groups of people. But, they should be willing to pay more for users who can better afford their services.

    Is facebook's hypothetical valuation (IF it has an IPO) justified by this growth?

    I'm not really a growth investor.

  • Report this Comment On March 02, 2011, at 3:36 AM, sungura2005 wrote:

    So long as the P/S is less than 14, it should be a good buy.

  • Report this Comment On March 02, 2011, at 9:31 AM, Brent2223 wrote:

    I see Facebook continuing to evolve. The one indicator that makes me bullish on their success is the integration into corporate advertising. Anyone else notice that all major companies seem to be pushing their Facebook site more aggressively than email, 800 number, etc. in TV commercials? Facebook is truly evolving into a virtual 'mall'. First there were just a bunch of scruffy college kids hanging around after hours, but now the 'mall' is open and is a hub for consumerism. With the investment made by companies around Facebook they all have a vested interest in keeping the site 'hot'. No other social media has penetrated the corporate culture like Facebook is doing.

  • Report this Comment On March 02, 2011, at 12:02 PM, mikecart1 wrote:

    Facebook is another Google. Giving mediocre returns from its IPO price with no dividends or splitting. Also the 500 member value is fake. It maybe be half that. They would have had a real member number if they kept facebook to university students only. Now everyone has an account from kids to the elderly. Some homeless guy probably got an account to.

  • Report this Comment On March 02, 2011, at 12:21 PM, racchole wrote:

    Mikecart1,

    So if Facebook's popularity and influx of consumerism is dependent on the effort of corporations and the amount of advertising they put on Facebook, when do we expect that trend to die down?

    The problem I am noticing with Facebook is that the word "trend" keeps coming up, and trend never equates to long-term domination. We all see what Facebook has done. Some expect it to stop growing, some see it growing forever. Nobody knows anything about it.

    I think people should stop speculating about the future of Facebook and treat it as it should be - a continuous short-term study.

  • Report this Comment On March 26, 2011, at 1:56 PM, Pandorabelle wrote:

    Facebook is the "flavor" du jour. With the speed of changing tech trends, everyone will be jumping on the next "new" (cool/hip) social media bandwagon as soon as it appears.

    Hasn't Zuckerberg made enough...?

    But go ahead, make him richer and buy a few shares! I won't.

  • Report this Comment On May 02, 2011, at 1:03 PM, TMFTypeoh wrote:

    Tim,

    Totally agree. I would be a buyer of Facebook for anywhere under 200x earnings.

    Its a risk, a big one even, but worth it. The upside is tremendous, and the company has won the social media game.

  • Report this Comment On August 09, 2011, at 12:08 PM, MortgagePesos wrote:

    Get on the action, pre-ipo sales at 37.50, I'm on it. I wonder how many others said, google wouldn't last opening at $40.00 a share and its what now, $613.00 dollars a share? Well, hear this and hear it now, by one year after opening, add $500.00 dollars to it per share!

    I know where you can purchase the pre-ipo's email me if you are interested.

  • Report this Comment On January 31, 2012, at 12:04 AM, MHedgeFundTrader wrote:

    The street is chattering today over the prospect of an enormous payday with the imminent IPO for the social media company, Facebook. Price talk is valuing the company as high as $100 billion, making it the largest such floatation in history. Could the mega deal spell the end of the current bull market?

    Look at it this way. That is $100 billion that gets sucked out of the market. It is $100 billion that gets diverted away from existing equity allocations. Many investors will need to sell existing positions in other companies to pay for their new Facebook shares, especially in the technology sector.

    Can the market afford to lose $100 billion in buying power in its current fragile condition? I think not. Take a look at the chart below which has the (SPY) making a near parabolic move since the beginning of the year. At the very least, we need to pull back to just above $126, which takes us down to 1,256 on the S&P 500, smack dab on the 200 day moving average. If you don’t believe me, then take a look at the chart for the financials sector ETF (XLF), which has led the market this year and is clearly rolling over.

    I’ll tell you who the big winner in a Facebook IPOP will be. The San Francisco Bay area. $100 billion is a ton of money to pour into a single urban area. The issue is expected to create several billionaires and as many as 3,000 new millionaires in my neighborhood.

    The last time that happened was when Google (GOOG) went public, creating a wealth effect that never went away, taking the waiting list for a new Ferrari or Tesla out two years. Better buy real estate near Facebook’s Menlo Park headquarters, such as in Atherton, Palo Alto, and Mountain View. The bidding wars are about to begin!

    The Mad Hedge Fund Trader

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