We kicked off our finance column (creatively titled "Broker") with a guest post from two guys who know a lot about finances. "Warren Brofett" and Joe Holleran wrote this article about the Facebook IPO (when Facebook sold shares to the public for the first time so that you can buy part of the company). We are re-running it now because what they said turned out to be true...Facebook is at less than 50% of it's initial value as of today.
"Warren" has an MBA from the University of Pittsburgh and Joe is completing his MBA as well. Enjoy...it's a great read, and you don't have to possess an MBA yourself to understand it.
The buzz around Facebook in recent months has been the fact that the company is going to “go public” sometime in the next several quarters. In the world of IPO’s, the Facebook offering is at the top of the news feed.
When a company goes public, individual investors (i.e. you and me) can buy shares of a company in the stock market, and literally become a part owner of the business. When you become an owner of a company ( shareholder), you have a share of the growth and success of the company in the form of cash paid out by the company (dividends), or from the stock price going above the price you paid initially (capital appreciation).
A company first goes public through an Initial Public Offering, or IPO, for short. In this transaction, large banks (think Goldman Sachs, Morgan Stanley, JP Morgan, etc.) work with the company to get buyers for shares of its stock. Once those shares go public, they are fair game to anyone with a brokerage account and enough money to purchase them.
So this should be exciting, right? Facebook is something you use every single day, a website that has literally changed the way we use the internet and stay in touch with people. You can become part owner alongside Mark Zuckerberg. Who wouldn’t want to do this?
Well, for starters, us. Don’t get us wrong, we love Facebook. We use it all the time, and have wasted more time on that site than we’d probably like to know (checked it twice while writing this article). You probably love Facebook too, and may have even come to this post from a Bro Council blurb on your newsfeed. But there’s a difference between loving a service and loving an investment. That’s what we’re here to bring to your attention....
In investing, the whole point of investing in something is because you think it is going to go up in value. How we gauge value in the stock market is the current price of the stock. If we know what the price of the stock is, we can compute the value of the firm, simply by multiplying the price by the total number of shares outstanding (info on Google finance). When we compare this value to what we think a company is worth it can provide insight on whether to buy or sell.
As an example, if a company has 10 million shares outstanding, and the price per share is $10, then the market is currently saying the value of ownership, or equity value, for the company is $100 million.
But remember what we said above, this is the value of the ownership stake. A company also has other sources of capital to finance its business – things like debt and other forms of stock. If we want to know what the firm as a whole is worth, we talk about the enterprise value. Enterprise value is the value of the company as a whole, from all sources of capital.
Continuing the example above, say the firm has $50 million in debt, and $20 million in cash. In total, it has net debt of $30 million. When we add this to the equity value, we get $130 million as the value of a company as a whole.
Anyone can calculate these metrics, but the key thing as stock investors is the equity value. We figure this out by a subjective assessment of the company’s business prospects, financial strength, ability to generate cash, etc. This is called valuation, and is all about getting to a numerical assessment of what a company is worth.
So how does all this apply to Facebook? Well, according to leaked figures from Facebook’s financial statements, the company has no debt outstanding. This is good – it means that the company’s capital structure (i.e. how it is financed) is less risky for stockholders, because every dollar earned by Facebook can be given to shareholders, if the company chooses (note: the company would not do this in any scenario). When a company has debt, it’s contractually required to pay out certain portions of its cash to the providers of the debt.
Additionally, the company allegedly has approximately $3.5 billion in cash. This is good as well – having a lot of cash on the balance sheet gives the company a lot of flexibility to use cash to invest in its own business, buy other companies, and expand without having to take on debt. Nice work Facebook. 
According to company plans, however, Facebook expects to do an IPO this year to raise $10 billion. Due to the structure of the transaction some believe it could make the company worth $100 billion. $100 billion. Yes, you read that right. Here’s where things get dicey, in our view.
In the stock market, when we look at companies we examine how their equity is valued relative to their earnings to assess the reasonableness of the valuation. Through the first 9 months of 2011, the company is reported to have made net income of $714 million. If we spread this pace over a full year (run rate), this represents $952 million in earnings after all expenses have been paid. If we do this, we see that Facebook is deemed to be worth $100 billion, which is more than 100 TIMES its earnings. In essence, people would literally be saying they are willing to pay $100 for every $1 of net income Facebook makes. To put it in context, Google, one of the world’s best companies and most popular brands, trades between 30 and 31 times earnings.
Now, trading at a P/E (price/earnings – what we just calculated) above 1 is common. A P/E above 1 is reasonable if we believe earnings will grow. Accordingly people are willing to pay more if they think the current growth is sustainable. Trading at the 100x level requires an assumption for a huge amount of growth for the foreseeable future. Keep that in mind, because it’s important to note.
Another way to look at this is how much revenue the company makes – this is pretty common for internet companies. Some sources cite the potential for the company to make $4.2 billion in revenue for the full year of 2011. If we compare that to the equity value of the company, it’s about 23 – 24 times revenue. Google, on the other hand, trades at 5 times. When we look at this, it seems ridiculous. Facebook makes nearly 90% of its revenues from online advertising; just like Google does (Google has other revenue sources too). The bad thing about advertising is that it can leave a company as quickly as it comes. Yes, Facebook is likely here to stay, and it should be able to keep growing its revenue base. But the growth needed to justify a $100 billion valuation is extremely high, particularly when we think about the sheer number of people already using Facebook. Yes, that number could grow significantly, but we would take a conservative stance.
So what’s the conclusion? We believe that Facebook is a good company. But we also believe that the current buzz about the company is overstating the value in preparation for the IPO. Typically, after a company goes public, there’s a huge increase in the stock price as investors rush in to get a piece of the new, hot company. In our view, this would only make the company even more overvalued.
In our opinion, if you like Facebook and are desperate to own a piece of the company once you can, go ahead. But we’d be cautious to do it at the valuation level that people are throwing around. We believe the market’s assessment of the company’s worth will come back down to earth, at which point investors who are patient and truly value-seeking may actually be able to find a bargain.
