Point/Counterpoint: Is Facebook’s Valuation or Its Business Model More Likely to Shape Its Future Stock Price?
It may be early days to pass judgment on the prospects for Facebook (FB.O) as a publicly traded company, as its share price continues to bounce around in the wake of what is now widely acknowledged to have been a bungled IPO. Perhaps that isn’t surprising: As we reported on Alpha Now last week, investors were already uneasy about the declining growth rate at Facebook, and a new e-book from Reuter Breakingviews suggested that an appropriate valuation for the company’s IPO was closer to $65 billion than the $105 billion that the deal eventually commanded. Earlier this week, as Facebook’s stock dropped, its valuation did come eerily close to that level.
But even as a handful of investors line up to file suit against the company and its underwriters, alleging that they didn’t disclose the fact that analysts at both Morgan Stanley (MS.N) and Goldman Sachs (GS.N) cut their forecasts for Facebook’s revenues in the week leading up to last week’s offering (and others begin to calculate their losses attributable to Nasdaq’s problems in handling the trading in Facebook shares), StarMine valuation models suggest that there may be other grounds for concern about the company’s stock. Other models are neutral or more encouraging – and then there is the fact that Facebook is by far the dominant social networking company. Already a gamechanger in the business sense, it could yet find a way to replace investor skepticism with enthusiasm.
As we will do with each of the companies, industries or issues presented in this recurring series of Point/Counterpoint features, AlphaNow will introduce two sides of an argument that is generating debate among investors. In this case, the question up for discussion is whether Facebook’s shares are likely to continue to languish or whether the post-IPO selloff is just a temporary setback. As in any traditional Oxford-style debate, we’ll introduce the question and invite you, our readers, to contribute your own opinions and to vote on which argument you find most compelling.
The issues that Facebook must deal with have received a lot of scrutiny in recent weeks. With 900 million active users around the world, one of every six inhabitants of the planet now has a Facebook profile. (Even founder Mark Zuckerberg’s dog has his own page, with half a million “likes”, at least report.) But the company has yet to devise a foolproof way to monetize all those eyeballs. So far, users have proven to be dismayingly reluctant to click on the growing array of banner ads that appear on the site. That’s why General Motors (GM.N) yanked its $10 million advertising account from Facebook only days before the IPO.
But are these concerns and headwinds serious enough to make buying Facebook stock a bad idea? It’s very early in the day to draw firm conclusions, but while the StarMine models are very volatile, they also are delivering some intriguing early results.
POINT: As Facebook’s shares struggle to stabilize a week after the company’s IPO, it often has seemed as if the bears have the upper hand. Certainly, at the time of writing, the stock price is trading 24% below its IPO price after losing 19% of its value in the first two days of this week. Let’s start by looking at the valuation argument, which is at the heart of many investors’ concerns about Facebook’s shares. Key StarMine valuation models show that the company still appears to command a premium valuation in both absolute and relative terms. The Relative Valuation Model gives Facebook a ranking of only 4, putting the company in the lowest decile among companies in the region. That is because it trades at a hefty 60.2 times trailing 12-month earnings and 48.9 times prospective 12-month earnings, at 43.0 times cash flow and 11.7 times book value. (Comparable figures for the S&P 500 are 13.2, 12.1, 7.7, and 1.8, respectively.) The other two ratios that are used to compute this score – enterprise value to sales and enterprise value to EBITDA – also suggest that Facebook is richly valued.
The Intrinsic Valuation Model is still more bearish; Facebook earns nearly the lowest possible score of 2 on a scale of 1 to 100. While the stock at the time of writing hovers around $28.84 a share, based on StarMine’s dividend discount model, it is worth only about $10.22, StarMine calculates. Currently, analysts believe the company’s earnings will grow from the 43 cents a share it reported for 2011 to $1.18 per share by 2015. But StarMine research has found analysts tend to be over optimistic when it comes to forecasting earnings, and the further forward in time those forecasts are, the greater that optimism bias. It’s very rare for most companies to sustain extraordinary growth rates over the long haul, so, assuming that Facebook turns out to be closer to typical than miraculous, what’s it worth? Today, the market is implying a 10-year compound annual growth rate of more than 23%, meaning that Facebook today trades at about 48.9 times earnings for the coming 12-month period. The model suggests that a more appropriate valuation would be closer to 18.2 times earnings – or a price of $10.22 a share. That is based in part on removing the optimism bias from the $1.18 per share 2015 forecast, and replacing it with a more realistic forecast of 75 cents a share for that year.
COUNTERPOINT: Perhaps the biggest argument in Facebook’s favor is that this isn’t just any company. Its 900 million or so users have invested time in cultivating their personal pages, rely on Facebook to connect rapidly with friends and family, and build support for their causes or commercial activities. That gives it a defensible competitive advantage that can’t yet be quantified, and betting against Facebook at this stage means reaching a conclusion that it can’t monetize that engaged user base. If it manages to figure out a way to woo users away from organizing Occupy Wall Street protests and playing Farmville and persuade them to start clicking on ads more frequently, and develops a way to deliver those ads to mobile users of Facebook, the company could be the first to deliver on the full business potential of social networking.
While they are waiting, investors at least don’t need to worry about the company’s balance sheet, according to StarMine’s SmartRatios Credit Risk model, which uses ratios for profitability, leverage, debt coverage, liquidity, and growth to predict the probability that a company will experience some kind of financial distress. Facebook – which has very little debt on its balance sheet – has a high score of 86, suggests that there’s a low probability that that it will need to find a way to address balance sheet problems as it grapples with bigger strategic issues.
A more neutral indicator, but one that remains intriguing, is that being sent by StarMine’s SmartHoldings model, a buy-side forecasting tool. Like many of the non-valuation models, Facebook’s score has been volatile in its first week as a public company, but currently it scores 59, meaning that Facebook, for all the controversy surrounding its IPO, may still pop up on some of the new-idea generation screens that those fund managers use when they are looking for stocks to add to their portfolios. In turn, that signals that some of these influential investors may be interested in buying the stock over the coming 90 days. As Thomson Reuters Ownership Intelligence reported Tuesday, a number of major institutions already are among the company’s biggest institutional shareholders; a list topped by T. Rowe Price, Fidelity Management and Capital World Investments and dominated by growth-style investors.
Since only nine analysts have published earnings forecasts, StarMine’s Analyst Revision Model is a particularly volatile metric, moving from bullish to bearish and back into bullish territory by late Thursday. This metric, which gauges future changes in analyst sentiment and tends to be highly predictive of future revisions and stock price movements, currently gives Facebook a score of 82 on a scale of 1 to 100. This likely will remain volatile as more analysts initiate coverage of the stock after the post-IPO “quiet period” ends. Still, to the extent that analysts begin to publish higher earnings and revenue estimates, or to revise those estimates upward based on better-than-expected second- and third-quarter results or because analysts gain confidence in the company’s business model, this will increase the company’s ARM score. It also will increase the company’s calculated intrinsic value (still languishing in very bearish territory, as noted above).
THE VERDICT: Once again, that is up to you, our readers. Are Facebook fans like T. Rowe Price overpaying for growth and too willing to bet heavily on a business model that is in the early stages of proving its value to the market? Or are the bears underestimating what that growth will be and overlooking the value that investors will find in its stable balance sheet and steady growth in a time of market turmoil? Please weigh in with your views. If you’re more concerned about Facebook’s premium valuation, please click the button below marked “bear”. If you think that Facebook, like Google (GOOG.O) or even Apple (AAPL.O), will turn out to be one of those rare “gamechangers” — an iconic technology company whose value will grow and justify a share price at these levels or perhaps even higher — please click the button labeled “bull”. Once you’ve done that, you’ll be able to see how others have voted – and then we encourage you to contribute your comments and engage in a debate with your fellow Alpha Now readers over Facebook and the market’s constantly shifting perceptions of its prospects.
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