Valuing Facebook

I was in Times Square Friday, watching the news camera crews setting up for shots with the NASDAQ 7-story high marquee behind them, toting the new FB listing. I had actually written this Thursday night, and held off posting it because as much as I thought the Facebook IPO was over-valued, I prefer not to be embarassed when the euphoria of a market overrides mathematics — and I was half right, but in the wrong direction (I’m long on Zynga, and Facebook’s failure to pop sunk ZNGA about 13%). While there has been a lot of pent-up demand, excitement and interest, none of it is backed up by a financial model for an advertising company. I don’t think Facebook is going out of business, or that its revenue model is broken (see previous post on the GM advertising issue), or that they can’t sustain growth – they are smart engineers who will figure out how to monetize those advertising channels, perhaps on an increasingly fine-grain basis.

I’m talking about the stock, not the company. I remain a huge Facebook fan and user, engaging in everything from teasing family to promoting various side projects to finding serendipitous connections between old and new friends. The stock exists in a virtual world of the NASDAQ stock market which doesn’t always behave rationally (or fairly), and when it snaps a lot of individuals tend to get impacted. My purpose in scribbling this out last night was to explain why I don’t plan on being one smitten but not bitten.

I digress.

As an advertising company, Facebook’s valuation is way too high. As a technology company, it’s valuation is also high: With a trailing twelve months earnings number around $1B, Facebook today is selling for 103x earnings. Advertising accounts for more than 85% of Facebook’s revenue, so that segment is a fair proxy for valuation, and it’s the comparisons to technology-driven advertising companies (read: Google) that give me the larger, Control-Z full stop pause.

Google is selling for a bit over 5x its last four quarters of revenue ($37.9B in sales, and a $600 share price with 326M shares outstanding). Perhaps sales multiples are less accurate than modeling earnings, but I think growth businesses get a fair number of hall passes for variations in earnings due to the cost of acquiring new customers, cost of growth initiatives, and accretive acquisitions. More simply, if revenue is growing, the company’s core business of selling ads is growing — top line monotonic growth is overly simple but pretty directly correlated to acquiring, retaining and monetizing advertisers.

Do the math on Facebook — at $4.5B in sales (being optimisitc for 2012, based on solid growth off of 2011), even a 5.5x sales multiple yields about a $25B market cap. Not $100+B. That’s a factor-of-four issue.

There are about 2.7B shares of Facebook outstanding (I took 2.7B shares outstanding from Google Finance); and a few lines buried in the S1 indicate that there are more shares backing RSU grants that have a vesting cliff in 180 days — I’m guessing but given the $5B line of credit taken to cover various costs of stock vesting, I’d estimate there are at most a few hundred million shares still to be released). Let’s say their float stays around 2.7B shares (fewer shares = higher price per share), and they can fetch 6x sales, and hit $5B revenue run rate by Q4-12: That’s $30B market cap, which translates to $11 and change a share. Dilution due to stock grants, revenue growth shortfalls, or compression of the multiple on revenues would increase my confidence ratio around that lower price. At $11, though, I’d buy the growth, and “like” away.

The old adage is that you’re buying a stock and not a company (or worse yet, a financial model done by an aging nerd on the back of an envelope containing a leased car bill). Your mileage will vary. There’s a reason I use a professional manager for all things finance related: I suck at it. But as a failed semi-mathematician, I’m eager to see how the market pricing calculus works for Facebook.