Facebook Inc. may have 900-million users and the second most popular website on the Internet (behind Google Inc.), but the consumer-Internet company’s initial public offering (IPO) is coming to market with a valuation “off the charts,” and everything basically has to go right in its growth trajectory to support the lofty growth expectations. “Facebook does indeed have to become the next Google,” says IPO expert and University of Florida finance professor, Jay Ritter.
At a valuation of approximately US$100-billion, Facebook shares will begin trading (ticker: FB) at a price-to-earnings ratio close to 100, compared to an average P/E ratio of 14 for companies in the S&P 500 Index. Facebook will also be trading at over 30-times annual advertising revenues, far above Google, which is trading at just over five-times revenues. If Facebook is going to be as big as Google and entitled to a similar valuation, it needs to grow advertising sales sixfold, to $19 billion (U.S.).
The shares will likely “pop” on the first day of trading, when most retail investors get their first chance to buy. Extrapolating from secondary markets operating prior to the IPO, the price could hit $45 (but the fever seems to have intensified in the past week, so it wouldn’t be surprising to see a bigger move up). As such, retail investors will be paying even higher valuations than the stockbrokers’ favoured clients who get allotments at the IPO price.
This makes it even more likely that small investors will end up disappointed. Indeed, according to Professor Ritter, the historical record shows that stocks newly listed on U.S. exchanges from 1970 to 2008 trailed stocks of similar market capitalization by an average 4.7% one year after the first day of trading, and by 4% three years after. The larger IPOs performed somewhat better, matching the average market return over the same periods—but why bother even with them if the same kind of result can be achieved with much less risk by simply owning index funds?
As I noted in “Facebook IPO tempting but be wary,” most investment books urge retail investors to avoid IPOs. Respected investment writers such as Burton Malkiel, Benjamin Graham, Stephen Jarislowsky, and Jeremy Siegel have all said that IPOs tend to be timed to coincide with a peak in the issuer’s performance—and that most of them can usually be purchased at lower prices a year or so later.
Within the consumer-Internet space, the script seems to be playing out. Close to a dozen such companies went public in the U.S. over the past year; only three are still priced higher than their first-day closing price. Some, such as Groupon and Pandora Media, have fallen by more than half.
The true believer in Facebook may prefer to jump in right away, believing its IPO will be one of the few that never look back. Yet a policy of waiting to buy IPOs some months or quarters after the listing is likely to deliver a better risk-reward outcome. In fact, given all the complexities in assessing prospects for individual companies, investors who don’t study stocks full time are better off avoiding IPOs entirely—and stock picking in general—in favour of portfolios of index funds or exchange-traded funds.
Facebook needs to grow like Google—but that may not be possible
The question of whether or not Facebook can grow at a blistering pace like Google did is indeed a complex, almost unfathomable, one. Management’s challenge is to boost revenues by six times to keep up with expectations. From a similar stage of development, Google did manage such a growth rate over eight years, but is Facebook in the same league?
I have my doubts. Admittedly, Facebook can add many new applications to its platform and enjoy the growth dynamic that comes from the “network effect.” But as Robert Armstrong and Stuart Kirk write in the Financial Times of London: “It is hard to quit using Microsoft’s software or Google’s search engine, not just because of network effects but also because almost everyone needs to do things those tools make possible. Competitors are more expensive or not as good. Facebook simply is not essential to life or work in the same way.”
Facebook’s past growth was largely based on adding new users, except now that the base is at 900 million, there is limited scope from this avenue (especially when Facebook is banned in China). That means management has to work on extracting revenues from existing users as well as Google does. This is a bit of wild card and the execution risk is high for both the PC-based and mobile platforms (where Facebook is still largely absent).
Google’s advertising revenues per page view are an estimated 100 to 200 times greater than Facebook’s, notes Chris Dixon, co-founder of an early-stage venture fund. That’s because Facebook relies on the old Internet business model of display ads, such as banners, images and other graphics. “Display ads generally hurt the user experience, and are also not very efficient at producing revenues,” observes Dixon. Google, on the other hand, uses keyword advertising and can target ads to users’ needs.
Facebook can, and will, move to targeted advertising by mining its huge databases. The bad news here is that, “if there is one consistent theme in both online and offline advertising, it’s that ads work dramatically better when consumers have purchasing intent,” declares Dixon. “Google makes the vast majority of their revenues when people search for something to buy. They don’t have to stoke demand—they simply harvest it. When people use Facebook, they are generally socializing with friends.”
Within this context, the large amount of insider selling at the IPO may constitute a red flag. Over 55% of the proceeds will go toward paying off early-stage investors, not to the company itself. This is an unusually high proportion compared to other IPOs. Facebook still has considerable growth potential, but there may well be better opportunities down the road to buy at more reasonable valuations.