Monday, January 10, 2011

Facebook: Love the product, don’t really love the stock

By the time this article gets published, it would probably be the 10,735th article written on how Facebook is now valued at $50 billion. While I love using Facebook, I personally would stay away from the stock, as I believe that it’s overvalued, and it could have more than its fair share of growth already priced in.

According to this article here, Facebook made around $2 billion in revenue, and around $400 million in profits in 2010. That could put Facebook at a P/E ratio of more than a 100, and a price to revenue ratio of about 25, very expensive indeed. I am aware that Facebook has more than 500 million users, and could very well have a lot of room to grow revenue and profits, but paying too much for growth is no recipe for investment success, and can in fact cause significant paper losses that could cause you to miss out on years of compounding returns.

People who say that Facebook is a growth company and that its current high price shouldn’t worry you don’t know what they are talking about. Forsaking value investing principles just because a company is growing very fast is never a good idea, and can in fact be a very costly idea. As Warren Buffett said, value investing and growth investing are joined to the hip, and that growth is a component in the calculation of value.

Facebook might do some really amazing things in the future, but I don’t know what those amazing things are yet. I also don’t know if Facebook can consistently execute to the point that its $50 billion price tag is justified. Just look back to the dot-com bubble, everyone thought that tech companies would do amazing things, and investors paid irrationally high prices for tech companies only to see a lot of those companies turn out to be very lousy businesses.

True, some tech companies like Google and Microsoft turned out to be great companies, but I’m not smart enough to tell if Facebook could turn out to be a great enough company that you can buy its stock today when it’s valued at $50 billion and still earn good returns.  To the people that think they can accurately tell that Facebook will become an obscenely profitable cash cow that can rival the lights of the great companies in terms of creating value for shareholders, I wish you the best of luck!

Since Facebook is a rapidly growing company, it will probably issue more shares (I keep hearing and/or reading about how Facebook might have an IPO in 2012), and that could result in existing shareholders facing significant dilution to their holdings, effectively requiring the company to perform even better to justify its current price tag.

I’m not saying Facebook won’t go up in value, it very well could (either because it really creates shareholder value or because of more speculative fever), I just personally feel that it’s a gamble and not an investment to buy shares in Facebook at its current price. I admit that I hardly have any information on the company, and I could be missing out on something that justifies its $50 billion valuation. But the something that I might have missed really has to be huge though and be on par with something like being able to turn lead into gold or water into Johnnie Walker Blue Label.

I really hope that the people who bought or want to buy Facebook’s stock on the shadow market are given enough information to properly calculate the company’s intrinsic value. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

While this article mainly talks about Facebook and its stock, my hope is that it can be used to help at least some of you form sort of a mental template to think rationally about any "hot stock."