1 Big Number That Will Burn Facebook Investors

On Wednesday, Facebook shares changed hands on a private market at an implied valuation in excess of $100 billion. That's wonderful news for Facebook's employees and venture backers -- the only constituencies Mark Zuckerberg is concerned with in the impending initial public offering (the prospectus is explicit on this point). But if you're considering buying shares when the company goes public, it's awful news: The higher the pre-IPO valuation gets, the lower your expected share returns.

I stand by my prediction
At the end of last June, I predicted that Facebook would close its first day of trading with a market capitalization in excess of $150 billion. The private market value at the time was $70 billion. At the company's current valuation, my prediction is beginning to look conservative. And yet there are plenty of excellent reasons to remain skeptical regarding this IPO.

At the beginning of February, I argued that high-profile companies that go public with a low float (the percentage of shares being offered) have a poor track record in terms of shareholder returns. Facebook certainly falls under "high profile" -- I can't think of any IPO that has generated as much hype (Blackstone and Google came close).

Tom Gardner weighs in
Motley Fool CEO Tom Gardner countered that, in light of the expected dollar size of Facebook's issue ($5 billion-$10 billion), the float percentage is irrelevant -- that is, given the absolute dollar amount of supply, a squeeze that would produce an overpricing is unlikely.

That argument has merit, in theory, but my guess is that the pent-up demand for these shares is such that the issue will be heavily oversubscribed. I'm expecting that the market will gobble it up before going to Mark Zuckerberg, basin and spoon in hand, to ask: "Please, sir, I want some more." There is already anecdotal evidence of ravenous demand for the shares, with qualified investors going to great lengths to obtain shares in private markets.

Paying a premium on top of the premium
Let's imagine that the current $100 billion private market valuation holds until the IPO. The offer price will be set at a premium to that valuation. Once the shares hit the secondary market, the stallion is out of the gate -- who knows how far or how fast it will run? If LinkedIn (NYS: LNKD) shares can double on their first day of trading, who'll be foolish enough to argue that Facebook shares can't gain 30%, 40% or 50%?

Still, the number $150 billion holds no specific significance. There is no law that says a company can't go on to produce decent returns from that level and, if any company can, I can't think of many better candidates than Facebook (but that doesn't mean I think it's likely). It's a big starting number, but it must be possible -- Apple's market value has increased by over $100 billion since the beginning of the year! Of course, Apple generated over $10 billion in cash flow last quarter.

Facebook vs. Google
I'll admit I thought Google (NAS: GOOG) looked very pricey when it came public in 2004 and the company subsequently proved me wrong, delivering superb operating results and share performance. However, while the situations share some similarities, there are a couple of important differences between the two flotations:

  • Google went public earlier in its growth cycle.
  • The valuation multiples we are currently juggling for Facebook are significantly higher than Google's were.

You can't ignore size as a limiting factor. With 800 million users there is natural ceiling on the growth Facebook can still achieve and that ceiling may not be all that far off, as the total number of Internet users globally at the end of 2011 is estimated at 2.3 billion (of course, that number is growing also). Proponents will argue that the company has merely scratched the surface in terms of monetizing its existing user base, let alone its future user base, and that argument isn't without merit.

I couldn't imagine how Google was going to monetize my web searches, either, but sure enough, I did end up using the search engine to find certain products. I use Facebook every day, but I find the ads deeply irritating (and poorly targeted, for the most part). I've never even considered buying anything. As for spending time and money growing virtual vegetable patches or rubbing out Mafia rivals, either we are on the brink of a new Dark Age or Zynga's (NAS: ZNGA) games are the Cabbage Patch Kid of the digital age (maybe I'm just too old to understand).

Explain this to me like I'm a 6-year-old
If you're impatient to buy into Facebook's IPO, I invite you to tell me why I'm wrong in the comments section below. I don't wish for investors to suffer the same fate as those who invested in the Cowen Group -- another IPO I panned several years ago -- but I fear the odds of disappointment are climbing with every uptick in Facebook's private-market share price.

At the time this article was published Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of LinkedIn and Google. Motley Fool newsletter services have recommended buying shares of Google and LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Kirk Larson

Alex,
Excellent article, yet I disagree with your notion that Facebook IPO will sour before its time. 800 Million users are also potential investors in this day in age and the nature of day trading against demand may well force the market valuations to drive prices higher. More over the global market mean that Commercial Entities whose online marketing investment may well offset expenses with stock options in an easy market access twisting Facebook into a commercial twitter type advertisement site expanding exposure. Expand that to 2.5 Billion as your article says and the Facebook may well face a split before the years out. The low float you mentioned may well be deliberate in driving initial spike high to record levels to further drive the later stock hype as an investment baseline which will drive delayed buyers for long term holding bringing down the post spike volume left in the open market available. The after math after the initial spike will tell the story. If the low float dumps a large volume on the market, the value will sour as you say. But speculators may well look to that as the ultimate option consuming the stock and reducing the available volume for day traders and drive a more wildly active stock.

As for me, I played, lost and learned only to realize that the old school possessed more wisdom and folly. Studying the stock immediately after the initial public offering will only show ruff rocky and unpredictable peaks and valleys. Yet I would bet that all patterns trend toward rising flags with a 60 to 90 cycle for plateaus at 3% increase which is close to market average after the first year of chaos for a well run business platform.

Facebook's follow up challenge after the IPO is pivoting the platform toward advertisement asset enabling businesses and consumers better access and greater returns. Thus, with confined space, advertisement costs for access can rise and superior returns on investments can be achieved with expanding customers. However, the pitfall is that if Facebook becomes an eyesore to the consumer and drives members out, the honeymoon ends with a disastrous market failure. Facebook must balance the fun, ease and commerciality of the asset to degree that maximizes the consumers drive to use the asset as means to stay in front of local economic issues and concerns. The advent and affect of twitter, has revised the internet role and the smart phone combined with Facebook may well prove Facebook to be Googles, Amazons, and Apples best friend ever, to say nothing on banking.

The Potential is there, the question is whether or not Facebook leaders are cognitively capable to maximize the opportunity.

One Amateur Observer,
Kirk John Larson

March 10 2012 at 9:26 PM Report abuse rate up rate down Reply