Investors: Don't Friend Facebook

 | Feb 02, 2012 | 11:30 AM EST  | Comments
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Facebook's IPO filing yesterday revealed a lot of interesting information about the company. One fun tidbit was that the graffiti artist, David Choe, who painted the company's walls several years ago and opted to take stock in the unknown company instead of "several thousands of dollars in cash." Choe is expected to find himself $200 million richer as a result of the initial public offering (IPO).

Perhaps the most interesting revelation, however, was how enormously profitable Facebook has become. The filings reveal that Facebook earned $1 billion from $3.7 billion in sales in 2011. A couple of years prior, revenues hadn't even reached $1 billion mark and profits were nonexistent. Still, unless you have been blessed like Choe, or the hundreds of other individuals or institutions who got in on Facebook pre-IPO, Facebook may not be as good to you. 

If the market environment is still favorable, Facebook's IPO will likely be a success and momentum investors may carry the shares higher. But even at the low end of the valuation of $75 billion, investors are putting enormous expectations on Facebook to deliver in a highly uncertain industry. Now that we have some real numbers from Facebook, I decided to run a discounted cash flow analysis in attempt to arrive at a valuation estimate. I did this same exercise for Microsoft (MSFT) and Cisco (CSCO) back in 2001 after the Nasdaq collapsed and found it very helpful. Consider that Microsoft shares ended the year 2000 trading at about $44.75, having plunged more than 60% over the course of that year and losing more than $400 billion in market capitalization. At the time, my estimate of intrinsic value for Softy was $25 a share, using very generous growth assumptions. Trading at $45 at the time, the shares were still significantly overvalued, based on my figures. More than a decade later, the shares are currently trading for $30

Starting with a net income figure of $688 million in 2011, I will be overly generous and project that Facebook will grow this figure by 50% per year over the next five years. For the purposes of this exercise, I will set net income to be a close approximation to free cash flow. I will assume a discount rate of 15% -- given the uncertainty of new publicity. I will also assume that Facebook would be worth 25x the present value of its cash flows after the fifth year. The numbers look like this ($ in millions):

(In this table, I assume that Facebook is valued at 30x this present value figure of $3.392 million, or $101 billion). So, if Facebook grows its free cash flow by 50% a year, the present value (PV) of the cash flows from 2012-16 is $8.2 billion. At the end of 2016, Facebook's terminal value would be $101 billion, based on a valuation of 30x the PV of cash-flows in 2017. The sum, or estimated intrinsic value of Facebook is $109 billion. 

So if Facebook goes public at a valuation of $75 billion to $100 billion, investors will be paying a full price and betting that free cash flow will grow at a 50% clip for at least five years. Given that Facebook is working with a relatively small numbers for a company of its size, it is not overreaching to project that the company can sustain a growth rate higher than 50% in early years. On the other hand, the company will likely continue to hand out buckets of stock options in order to recruit top talent, so it is very likely that its share count will grow and reduce the intrinsic value per share.

In addition, Zuckerberg will effectively control the company with a special class of stock that gives him majority voting interest. Over time, that situation could prove bothersome to many of large sophisticated investors if they are not happy with the company's direction and numbers. With those investors sitting on massive paper pre-IPO gains, they could dispose of their shares, which would add another element of risk for the individual or smaller investor.

I anticipate increasing hype as the IPO date gets closer. In the beginning, that buzz will likely prove to be a strong tailwind for the stock, but as the hype wears off, Facebook may not make friends with many investors who get in post-IPO.

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