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What techniques would you use to valuate Facebook to determine whether its current stock price is inflated, or whether it represents a good investment?

13

In the long term, a P/E of 15-25 is the more 'normal' range. With a 90 P/E, Facebook has to quadruple its earnings to get to normal. It this possible? Yes. Likely? I don't know.

I am not a stock analyst, but I love numbers and try to get to logical conclusions. I've seen data that worldwide advertising is about $400B, and US about $100B. If Facebook's profit runs 25% or so and I want a P/E of 20, it needs profit of $5B on sales of $20B (to reconcile its current $100B market cap). No matter what FB growth in sales is, the advertising spent worldwide will not rise or fall by much more than the economy. So with a focus on ads, they would need about 5% of the world market to grow into a comfortable P/E.

Flipping this around, if all advertising were 25% profit (a crazy assumption), there are $100B in profit to be had world wide each year, and the value of the companies might total $2T in aggregate.

The above is a rambling sharing of the reasonable bounds one might expect in analyzing a stock. It can be used for any otherwise finite market, such as soft drinks. There are only so many people on the planet, and in aggregate, the total soft drink consumption can't exceed, say 6 billion gallons per day. The pie may grow a bit, but it's considered fixed as an order of magnitude.

Edit - for what it's worth, as of 8/3/12, the price has dropped significantly, currently $20, and the P/E is showing as 70X. I'm not making any predictions, but the stock needs a combined higher earnings or lower valuation to still approach 'normal.'

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    The analysts may also note they are considering doing more things than selling ads. Not that this magically justifies their valuation or anything, just that there's something on the table. :P – fennec May 18 '12 at 20:54
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    fennec - and pre-iPod, the valuation of Apple couldn't possibly predict the insanely successful acceptance of iPod and iPad. So your comment is duly noted, and perhaps prescient. – JoeTaxpayer May 18 '12 at 22:18
  • What does "B" in "$400B$ mean? – Tim Jun 27 '12 at 10:36
  • @Tim: It's "billions". ("T" would be "trillions") – bhamby Aug 10 '12 at 13:55
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    @bhamby - If I'm not mistaken, these words don't mean the same thing across the globe. In the US, billion has 9 zeros after the 1, and trillion, 12 zeros. (Elsewhere, I think Billion may have 6 zeros?) – JoeTaxpayer Aug 10 '12 at 15:57
11

You could try this experiment:

  1. pay for an Ad/banner on Facebook for 1 month. The Ad/banner should link to your ecommerce site.

  2. Then see if the Ad/banner does or does not convert into ecommerce orders ("converting" means that people coming to your eccomerce site from Facebook after having clicked on your Ad/banner really buy something on your site).

If it does convert, you will go on paying for Ads/banners and other people will do the same for their sites, so FB might make cash in next years. But if it does NOT convert you and everybody else will soon discover and stop paying for Ads/banners, thus it will be hard for Facebook to make money with Advertising, thus Facebook might be just a big bubble (unless they find other ways of making money).

I did the experiment I suggested above and the conversion rate was an absoulte ZERO!!! (Instead Google Adwords converted well for the same site). So IMHO I would stay away from FB.

But remember that stock market is emotional (at least on short periods of time), so it might be that even if FB wil never become a cash cow, for the 1st few months people (expecially small investors tempeted by the brand) might go crazy for the stocks and buy buy buy, making the price go up up up.


EDIT in reply to some comments below arguing that my answer was boiled down to one single experiment:

General Motors said Tuesday that it will stop paid advertising on Facebook...the social media paid ads simply weren't delivering the hoped-for buyers... (CNN May/15/2012)

A donkey can not fly either when it's me (with a single experiment) trying to make it fly or the entire GM workforce.

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    -1 It could be that your add targeted the wrong people or was not attractive. Whether you can convert from facebook is not a determining factor for the long term success of facebook. Many companies have and do convert well because they have learned to leverage correctly. – user4127 May 21 '12 at 17:16
  • @Chad: it was not a real scientific experiment (infact I said "IMHO I would stay away..."), I did not have the time or the money to do a wide experiment with a more scientific approach testing thousands of differents ADs and investing thousands of bucks. What I know for sure is that the same AD (with the same money invested in) DID CONVERT WELL using Google Adwords. That was enough for me! – Marco Demaio May 21 '12 at 17:31
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    Your answer boiled down to my single experiment failed so it is no good. I just do not find any way to reconcile your answer to any real way of evaluating the company. I am not saying your overall conclusion is wrong just that your answer is. – user4127 May 21 '12 at 17:45
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    I think this kind of "sniff test" is very valuable for an individual investor, albeit just anecdotal. For the person doing the test, it gives them a good sense of whether to be comfortable with the risk or not. – Ganesh Sittampalam May 24 '12 at 16:26
  • GM is not the only company in the world. The fact that it was not able to leverage Facebook advertising could just as easily be a failure of its marketing department as a failure of Facebook to deliver. Zynga figured out how to turn it in to gold for them. So for every failure i have a success story. But these can just as easily be outliers meaning that any individual anecdote is not reliable for predicting future growth. I think Ganesh hit the nail on the head for the value of these. If you are squeemish after a few anecdotes then the risk is probably to high for you. – user4127 May 30 '12 at 13:22
9

To know if a stock is undervalued is not something that can be easily assessed (else, everybody would know which stock is undervalued and everybody will buy it until it reaches its "true" value). But there are methods to assess the value of a company, I think that the 3 most known methods are:

  • Net Asset Value, which can simply be understood as:

If the assets of the company were to be sold right now and that all its debts were to be paid back right now, how much will be left? This remaining amount would be the fundamental value of your company.

That method could work well on real estate company whose value is more or less the buildings that they own minus of much they borrowed to acquire them. It's not really usefull in the case of Facebook, as most of its business is immaterial.

  • Comparable analysis, which can be understood as:

I know the value of several companies of the same sector, so if I want to assess the value of another company of this sector I just have to compare it to the others.

For example, you find out that simiral internet companies are being traded at a price that is 15 times their projected dividends (its called a Price Earning Ratio). Then, if you see that Facebook, all else being equal, is trading at 10 times its projected dividends, you could say that buying it would be at a discount.

  • Discounted Cash flow, which is saying that:

A company is worth as much as the cash flow that it will give me in the future

If you think that facebook will give some dividends for a certain period of time, then you compute their present value (this means finding how much you should put in a bank account today to have the same amount in the future, this can be done by dividing the amount by some interest rates). So, if you think that holding a share of a Facebook for a long period of time would give you (at present value) 100 and that the share of the Facebook is being traded at 70, then buy it.

There is another well known method, a more quantitative one, this is the Capital Asset Pricing Model. I won't go into the details of this one, but its about looking at how a company should be priced relatively to a benchmark of other companies.

Also there are a lot's of factor that could affect the price of a company and make it strays away from its fundamental value: crisis, interest rates, regulation, price of oil, bad management, .....

And even by applying the previous methods, the fundemantal value itself will remain speculative and you can never be sure of it. And saying that you are buying at a discount will remain an opinion.

After that, to price companies, you are likely to understand financial analysis, corporate finance and a bit of macroeconomy.

  • The one big problem with the discounted cash flow is that you'd have to decide on what the appropriate discount rate is. Tweaking that can predict a big range of "reasonable" prices. – Lagerbaer Apr 30 '13 at 14:59
6

The amount of hype and uneducated investors/speculators driving its prices up. Just by that I would say its prices are inflated.

Bear in mind that Facebook don't sell anything tangible. They can go down as fast as they went up. Most of their income is ad based and single-product oriented, and as such highly dependent on usage and trends (remember MySpace?).

Having said that, all the other "classic" valuation techniques are still valid and you should utilize them.

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    It's true that they don't sell anything tangible, but they run advertising and that's a real service with real demand. So they don't sell air, they sell a service. – sharptooth May 23 '12 at 7:47
  • However, as internet ads get more and more annoying, more and more people finally get around and install AdBlock or similar tools. I haven't seen a Facebook ad in years. – Lagerbaer Apr 30 '13 at 15:00

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