So let me be a killjoy this Monday morning and say that Facebook is a bubble. And like all bubbles it will burst.
The price of the Facebook share closed at $38.23 at the close of trading on Friday. At this price the company was worth around $104.6billion.The basic question that crops up here is that whether Facebook deserves such a high price? “It’s exceedingly dangerous to pay a $100 billion valuation for a company that hasn’t figured out a way to make money,” Aswath Damodaran, a professor at Stern Business School at New York University told Barrons Online. Damodaran is one of the world’s premier experts on valuation.
Facebook versus Google
Facebook earned 43 cents per share in 2011. At its Friday closing price of $38.23, the company has a price to earnings ratio of around 88.4 ($38.23/43cents). Now compare this to Google, which is the closest comparison we can make with a stock like Facebook. Google had an earnings per share of $33 in 2011. The market price of the company closed at $600.4 on Friday, implying a price to earnings ratio of 18.2 ($600.14/$33). This makes Facebook around five times as expensively priced as Google (88.4/18.2). Price to earnings ratio is equal to the latest market price of the share of the company divided by its earnings per share.
Even if we were to look at the expected earnings for the current year, Facebook is expensively priced. Analysts expected Facebook to earn around 50 cents per share in 2012. This means that the forward price to earnings ratio of the company is at 76.5($38.23/50cents). Google’s forward price to earnings ratio for 2012 works out to 14, making Facebook more than five times as expensive as Google.
Let us get into little more detail here. Both Google and Facebook have around 900million users. “There isn’t much scope for growth here, really – we’re beginning to run out of connected adults on the planet,” points out venture capitalist Mahesh Murthy on his Facebook page.
Google had sales of $39.98billion with a profit of $10.83billion. From almost a similar number of users Facebook had sales of $3.71billion and profits of $1billion. Hence Google makes average revenue of around $44per user. At the same time Facebook makes average revenue of around $4 per user. It is rather ironic that even though Google has average revenue per user 11 times that of Facebook and also earned a profit which was nearly 11times, the price to earnings ratio of Facebook is 5 times that of Google.
So what are investors paying for?
Investors are essentially paying for the future growth of Facebook. As Kevin Landis chief investment officer at Firsthand Capital, a Facebook holder told Barrons Online “The investment thesis is pretty simple. Facebook knows more things about more people than does Google, and those people have stronger emotional connections and loyalty because that’s where their friends are…So given a few years to figure it out, Facebook could end up being worth more than Google, which has a market value of $200 billion.”
One advantage with more user data is that Facebook can help advertisers reach their targeted audience better. When companies advertise in mass market mediums like newspapers or television channels they have no clue of whether they are reaching their target audience. But with Facebook they can be sure.
At least the story being bandied around by analysts who are bullish on the stock. But companies aren’t buying this yet. In fact General Motors, a company with one of the largest advertising budgets in the United States, recently pulled its ads from Facebook, cancelling its $10million Facebook advertising budget.
As Matthew Yeomans wrote in a recent column on www.guardian.co.uk “GM clearly believes Facebook users aren’t engaging in banner and targeted advertising and, in that analysis, the company is probably right. Frankly I’ve never met a single person (apart from those who work in the digital advertising industry) who believe online banner ads are effective”.
This is something I totally agree with. What makes it even worse on Facebook is its cluttered look. In fact I only realised that my homepage on Facebook page has ads when I went looking for them. In comparison the Google.com page has a very clean look and with a white background the targeted ads are easily available.
Given this Facebook might find it a little difficult to grow its revenues. As Murthy puts it “This (the valuation of Facebook) might make sense if there was room for Facebook to grow. Where is that? More ads per user? Would we really like that? More charges per ad? Advertisers are already smarting at FB’s rates. Will you pay for apps on their store? Will you pay for premium listings? Not many will, I believe. The point is that FB will find it hard to grow its revenues per user – which is around $4 per year now.”
In fact the revenue growth of Facebook is slowing. Its revenues for the first quarter of 2012 stood at $1.06billion in comparison to $1.13billion in the fourth quarter of 2011. The primary reason for the same is the fact that more and more users are accessing Facebook from their smartphones. And smartsphone screens do not lend themselves well to advertising. Facebook admitted to this in a recent filing with the Securities and Exchange Commission, the stock market regulator in the United States, where it said “we do not currently directly generate any meaningful revenue from the use of Facebook mobile products, and our ability to do so successfully is unproven.”
The bubble signs
Other than the basic doubt on the business model (i.e. how does the company plan to make money) of Facebook, there are other signs also of why the company is in bubbly territory. Too many analysts are bullish on it.
Towards the end of the dotcom bubble in 1999, even though the stock market had gone up too soon too fast, most the stock recommendations from the analysts remained a buy i.e. the analysts of Wall Street were commending investors to buy stocks even at very high levels.
According to data from Zack Investment Research only about 1% of the recommendations on some 6000 companies were sell recommendations. The remaining 99% was divided between 69.5% buy recommendations and 29.9%hold recommendations(i.e. don’t buy more shares but don’t sell what you already have).
Analysts typically do not like issuing sell recommendations (or in the case of Facebook asking investors not to buy the stock) because that did not put them in the good books of the company involved. This would mean that the company would stop sharing information and deny the analyst access to its top people. And what good is an analyst who has no access to information on the company he is covering.
Henry Blodget one of the premier analysts during the days of the dotcom boom is quoted as saying in Andy Kessler’s Wall Street Meat “You’ve got to understand. If I stop recommending stock and the shares keep going up, there is hell to pay. Brokers call you up and yell to you for missing more of the upside. Bankers yell at you for messing up their relationships. There is just too much risk in not recommending these stocks.”
Facebook is in a similar situation. Analysts are predicting that Facebook will grow its profits by 38% and its revenues by 35% on an average over the course of the next three years. This is groupthink at its worst.
Another thing that happened during dotcom bubble was the fact that the valuations of the dotcom companies with no business models were worth much more than companies which had genuine businesses in place which had been generating revenue for years. Priceline.com sold its shares at $16 and ended its first day of trading at $69. The website basically resold airline tickets and did not own any airplanes, but was worth more than the entire tangible airline industry put together.
Valuations had reached crazy levels. eToys a tiny seller of toys on the web with revenues of $25million was listed on the stock exchanges at a market capitalization of three times the value of Toys “R” Us, a company with tangible business and stores throughout the United States generating a revenue of $11billion.
While the situation is nowhere as crazy now as it was back then but it is a tad similar. At its current market capitalization of around $104.6billion, Facebook is worth as much as PepsiCo, a company which has been in the business for years. PepsiCo has a sales of $67billion with profits of around $6billion. While people may call PepsiCo an old economy stock but it can be pointed out that the company still has huge scope to expand across large parts of Asia and Africa where the annual per capita consumption of cold drinks continues to remain low.
In comparison there is not much scope for Facebook to grow from its current levels as far as number of users is concerned.
Warren Buffett one of the greatest investors of our times did not invest in any of the dotcom stocks in the late 1990s. His returns fell for a few years and he was also the laughing stock of the market. But when the bubble burst and billions of dollars of investor money were lost, Buffett was the last man standing. What he wrote in his annual letter to the shareholders of Berkshire Hathaway for the year 2000 after the dotcom bubble burst is worth repeating here:
By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen.
But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street – a community in which quality control is not prized – will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.
And for all we know Facebook might just be a passing fad. I would like to conclude with something a gentleman by the name of Marc Effron, the President of The Talent Strategy Group, and author of One Page Talent Management, told me a few months back, when I asked him if Facebook was just a passing fad. “The first thing that comes to my mind when you say Facebook is MySpace,” he replied.
(The article originally appeared at www.firstpost.com on May 19,2012. http://www.firstpost.com/investing/facebook-is-a-bubble-and-it-will-burst-316100.html)
(Vivek Kaul is a writer and can be reached at [email protected])