Facebook expects $5 billion from IPO

2nd February 2012

Its stock market debut, reports say, will be a bonanza for the company's employees and the investment banks selling the shares – and it dwarfs Google's $1.9bn IPO in 2004. But what about individual investors?

Headlines shout: "Facebook Sets Historic IPO", "Facebookers fight for slice of social network's float!" But are the bulls right? Or does the hype lack substance? As the scene builds for flotation between April and June, savvy investors will be asking themselves these questions as Facebook is reported to be filing for its long-awaited IPO as early as Wednesday, says TechCrunch blog.

What can investors learn from history?

Turn back to January 2000. This marks the top of the Internet and technology bubble, when stocks were selling at P/E ratios of 400, or infinity if they didn't have any earnings, says Forbes. That's when AOL bought the biggest media company in the world, Time Warner – a spectacular media marriage failure.

Bert Dohman of Forbes stresses: "Now we have another Web site "distributing" stock to the public. It's a Web site. The profits are not significant given the valuation. Nor apparently is there a plan to monetize its 800 million "members." These members pay nothing to join, and pay nothing to belong."

However, Facebook is profitable. It sells advertisements directed users, and eMarketer estimates that between 2009 and 2011, Facebook's revenues grew at a 127% annual rate to $3.8 billion in 2011, according to the Wall Street Journal, with operating profit of $1.5 billion, adds BusinessInsider.

But it's grossly over-valued

Fundamentally, Facebook has ‘revenues', not profits. So how much is it really worth? As CityAm explains: "To find the answer, you would normally try to value the company using traditional multiples – price to sales, price to earnings and so on – and you would quickly find out that the valuations being discussed look ridiculously rich."

Taking $3.8bn of revenues in 2011 and a valuation of, say, $90bn, that would put it on a price-to-sales ratio of 24 times – or more than any other tech firm out there.  

How about cash flow? At $100 billion valuation, the company's valuation of price/cash flow is eight times more expensive than Apple (AAPL) – and Apple has almost $100 billion of cash in the bank.

So what is the wise move for investors?

While the vast majority of the companies that floated during the initial dot com bubble have fallen by the wayside, those who survived – Amazon, for example, and Google – have thrived. And Facebook has the potential to do the same, but tread cautiously to avoid the ‘hype-cycle', warn experts.

Ian Warmerdam, manager of Henderson's Global Technology Fund, says: "While Facebook is generating a lot of excitement and hype it remains impossible for us to form an investment opinion.

"This is not because we don't believe in the strength of the trend towards social media (we very much do) or that we don't believe in Facebook's competitive position (clearly dominant with a strong competitive moat).

"The spectacular hype surrounding the extraordinary proliferation of Facebook makes exciting headlines but it's only when the more prosaic aspects of P&L and Balance Sheet analysis are able to be properly considered in relation to market value that any genuine investment decision be made. And we have only vague details of these at best."

Beware of the fantasy profits

Wamerdam continues: "As exciting a growth prospect as Facebook presents, we are likely to be wary. The level of hype surrounding social media in general and Facebook in particular is so high that an attractive entry point (from a valuation point of view) may not be achievable.

"As we have seen so often through the history of technology a ‘hype-cycle' tends to envelop new and exciting technology developments. We only need to cast our minds back a short time in history to remember the stock market excitement that surrounded the rise of the Internet,  Nano Technology and Solar Technology to name but a few. These are all genuine long-term growth markets, but were each subject to periods of hype which destroyed returns for unwary investors.

"Analysis of this ‘hype cycle' is an embedded part of our process in the technology team, and we prefer to become involved at a later stage – when the hype has passed, strong growth prospects remain and valuations have become attractive. As strong believers in the social media trend we would love to have an investment in Facebook – but only at the right price."

The Facebook IPO is often compared to that of Google, whose price has risen substantially since its 2004 IPO – from $84 to $580. That amounts to 30% compound annual growth, but bear in mind that Google trades 19% below its 2007 peak of $715.

Ken Eisold, an internationally respected authority on the psychodynamics of organisations, and Mindful Money blogger, warns: "The over-valuation of an IPO is a collusion with the public – as they hope for a windfall and are excited about this prospect, and discount caution in the process. Investors believe they will catch the share price at the right moment and jump out at the right time too, but they are generally wrong – and fantasy fuels this belief."

 

More on Mindful Money

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Are global corporations a safer bet than governments?

What can investors learn from innovative failures?

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