17 August 2012

Facebook Valuation Update - Still Expensive

I think Facebook shares (Nasdaq: FB) are properly valued at ~$12.50 per share. They IPOd in May at $38. They closed last night at $19.87. (Yes, that's how ridiculously overvalued the IPO was, as I wrote at that time.)

At last night's closing price, I believe Facebook shares trade at 7.0x consensus sell-side analyst estimated 2013 sales. For casual comparison, Apple shares (Nasdaq: AAPL) trade at 2.5x that.*

I get that Facebook sales are estimated to grow ~25% over the next year; Apple ~21% (a company with sales 34-times greater, market cap 11-times larger than Facebook's; and with over three decades more than Facebook's three months of proven public company performance; and not controlled by insiders, like Facebook is).

In my view, at the end of the day, a public company's market multiple relies on its perceived future ability to generate cash for all shareholders. Period. It doesn't matter if they make iPhones, provide Internet-based social medium, or sell umbrellas.

How much cash do they have (net of debt) and generate now? How much do we expect that to grow (or not)? Everything else that we could talk about to characterize the business or its industry is effectively moot. That's because all that is ultimately boiled down and quantified in the answers to the above two questions.

Like I said, Apple sales are expected to grow ~21% in the next year; Facebook' at ~25% (if consensus sell-side analyst estimates are correct). If they continue to both grow at these rates over several years (which they won't, but let's just use it), Facebook will have turned $1 of cash into an amount ~1.25-times what Apple will have generated. Keeping it simple, it should not be unreasonable to expect Facebook to have a multiple not materially deviant from 1.25-times Apple's.

The price we pay to purchase shares of a publicly traded company is the perceived capitalized value of those future cash flows. With the Apple benchmark in mind, that is what ~$12.50 today is for Facebook to me.

But there is one more thing. Facebook is controlled. The insiders own most of the vote. In other words, it is barely a public company in actuality. Privately-held companies transact at multiples far lower than publicly-traded ones.**

Publicly-traded companies that are effectively controlled by the insiders typically trade at discounts to valuations they should trade at, had they been fully democratically owned by all shareholders. In a controlled situation, public shareholders get nervous that the interests of all shareholders, and not just the insiders' interests, will be represented.

For Facebook, Our Dear Leader Zuckerberg presently controls 55.8% of the vote - all insiders 95.9% (per the offering documents). He has a majority vote (whether he stays on as CEO or not). Every other public Facebook shareholder, then, effectively has no voice on voting matters in most situations regarding the company.

Public share ownership is supposed to be about being a part owner in a company. If the public shareholders have no voice, then owning the shares is truly just like owning a commodity, and nothing about being a public partner. They can't - with full force - elect their representation; their board members. They can't fire the board members or CEO if their shares... oh, I don't know... get cut in half in three months' time, for example.

Only Our Dear Leader Zuckerberg can do that at Facebook. And everyone else has to just hope that his interests will always be aligned with ours. Because of that, $12.50 might still be overstating its value. But if it got near there, I'd start loading up on it. (Of course, if the world still has not ended for a second time, like everyone seems to be anticipating - precisely why it won't.)

At the end of the day, this is just my view. And there are many different views that make the market place, pushing these stocks all over. But I at least want to demonstrate that, despite Facebook's share price devastation, there is a decent argument for it to continue demonstrably lower. Happy Hunting.

* All multiples, unless otherwise expressed, refer to Total Enterprise Value ("TEV"), as a multiple of these measures. I calculate TEV as the equity market value, diluted and adjusted for in-the-money granted stock options assumed exercised, plus debt, less cash on the balance sheet.

** Primarily because publicly-traded shares open up a vast pool of investors not available to privately-held companies. And such public shares can thus be used as a far richer source of raising funds. It is far more lucrative to me, if I can sell the public a piece of my company at, say, 15 times earnings, versus bringing in a partner privately at maybe only one-quarter that. A new private partner pays the lower multiple because he does not have nearly as liquid an exit strategy for (or sale of) his investment. as he might if he owned a stake in a publicly-traded company. He also, by nature of being a private investor, owns a riskier company, as it has less options for accessing capital than a public one.

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