Facebook: Blockbuster IPO, Speculative Investment

It’s not every day that investors get the opportunity to invest in the hottest property on the Web. With the amount of Facebook (Nasdaq: FB) users slated to reach one billion in 2012, the site has become the crowned jewel of social media. But more importantly, how does Facebook stack up as an investment?

Last night, the company priced a modest 420 million or so shares at $38 per share, which would raise about $18 billion for the company and value it at around $100 billion. Today when it starts trading -- probably well north of $38 -- it's likely to be the largest IPO in history.

Even with a valuation in excess of $100 billion, investor demand for shares of the social networking darling has already been reaching the stratosphere. The IPO size was increased 25% just yesterday, and many traders and analysts expect an additional IPO-day pop of anywhere from 10% to 50%. Apple co-founder Steve Wozniak recently said that he would buy shares in the company regardless of the price.

Retail investors, institutional investors, technology luminaries, and even amateur investors are piling in en masse. It appears that some folks are taking Peter Lynch’s “invest in what you know” advice pretty seriously.

When Facebook goes public today, the sprawling social network is poised to shatter several records:

• Largest venture-backed IPO in history. Facebook’s dizzying $100 billion valuation is four times larger than Google’s 2004 IPO.
• Largest venture-backed company in the United States. Facebook takes in a total of $2.2 billion in venture funding. For reference, Twitter has raised only $1.1 billion to date.
• Largest pre-IPO acquirer. Facebook has acquired 13 other startups, including its most recent $1 billion deal for photo-sharing site Instagram.

In total, the company is expected to raise a whopping $18 billion from this historic IPO. However, a lot of that money will go to existing shareholders selling their shares in the IPO. The company will be left with a modest $10 billion or so. While these numbers are impressive and the hype surrounding Facebook’s IPO is palpable, is all this buzz really justified?

I could write several articles discussing Facebook’s amazing accomplishments and their potential, but that has little to no bearing on how the stock will perform in the coming months. In the end, investing all comes down to price; specifically, what fair value is for ownership in a certain company.

From a valuation perspective, Facebook has one of the loftiest valuations I’ve come across in my 10 years of following companies in the technology sector. When you consider that the valuation will invariably increase when shares of Facebook open up on their first trading day, the steep valuation is even more perplexing -- it looks as if it will have a valuation exceeding 100 times its expected 2012 earnings.

Price is price -- and Facebook’s lavish valuation is largely based on pretense of future growth and future profits. Obviously, digital advertising is an integral component of Facebook’s business model, and potential investors are banking on continued growth in that segment. But is its advertising business as thriving as investors make it out to be? The financials paint a very different picture.

When Facebook’s Q1 2012 financials were released, it was revealed that advertising revenue grew only 37% year-over-year, which isn’t all that impressive for a high-growth company. For a company whose future viability depends on executing in the online advertising space, this datapoint is certainly not encouraging to investors.

Ad Revenue Questions

The fact that Facebook's advertising revenue recently dipped may not reassure investors.

Prominent Wall Street analysts talk about how Facebook could blow past Google (Nasdaq: GOOG) and eventually re-invent the ad display market, but the numbers just don’t tell that story at all. Yet.

The biggest thing that jumps out at me is the extreme level of optimism towards future profits. Facebook’s future will not be determined by its next earnings report but by its ability to innovate and find new revenue streams in the future.

It is pretty clear that investors are paying for potential when it comes to Facebook. It’s not too different than an NFL team that drafts a top-rated quarterback straight from the college ranks and hands him a $20 million+ contract before he steps into the training camp. A calculated risk? Sure, but a big risk nonetheless.

Premium Valuation

Depending on where Facebook trades today, it's valuation could climb as high as $150 billion.

When you look at the valuation from a price-to-earnings perspective, using Facebook’s reported $1 billion in net income for 2011, it equates to a 104x multiple. Of course, that's likely to be much higher today, depending on where the stock trades. Investor demand could drive it up to $130 billion to $150 billion, which translates to a multiple of 130x to 150x.

Mark Zuckerberg is undoubtedly a genius when it comes to building social platforms on the Web, but that doesn’t always translate into profits for shareholders. Many people question his drive for profits.

"These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits," Zuckerberg is quoted as saying.

Zuckerberg has stated numerous times that he will not sacrifice product quality for the sake of maximizing profits, which is somewhat disconcerting. For example, Facebook has over 425,000,000 mobile users, but the company has still yet to earn any advertising revenues from mobile.

Even though the company has built a great platform that should continue to grow, the valuation is "priced for perfection," which means that one bad earnings report or misstep could be very costly.

When companies carry such a premium valuation, the margin of error is slim. In the last year, high P/E "darling" stocks like Netflix Inc. (Nasdaq: NFLX) and Green Mountain Coffee Roasters (Nasdaq: GMCR) learned this lesson the hard way.

For investors who are looking to gain exposure into social media, I think there are better alternatives out there such as LinkedIn Corp. or Jive Software Inc. . Both of these companies have much more reasonable valuations.

I traded LinkedIn on its opening day and generated a nice rate-of-return in doing so, but I will be sitting out this Facebook IPO. Will I be looking to get in if the stock dips to a valuation of $80 billion or so? Absolutely.

Facebook will continue to be one of the most admired technology companies for years to come -- but price is price.