November 24, 2014

I Think the Facebook IPO Is Overvalued. I Think It Is Obscenely, Offensively, Immorally Overvalued to the Point I Think the Offering Banks Should Be Sued.

That’s my opinion, anyway.  I believe the valuation put on the Facebook IPO is asinine.  I am of the opinion this is the type of valuation that only a complete, total, idiotic moron who wanted to get screwed could accept.  Again, this is entirely my opinion looking at the financials.  I’m about to wrap up my work for the night but here is a brief overview of how I see the situation.

Remember what Benjamin Graham said … at what price and on what terms?  Let’s look at both.

Facebook IPO Overvalued

My opinion is that the Facebook IPO is overvalued. It is more than overvalued. It is offensively, stupid, insanely, moronically overvalued to the point that only an idiot would buy the stock. With the shares set to trade on the public markets this month, you can bet that someone, somewhere is stupid enough to buy an asset that has already saturated its market and has an earnings yield of roughly 1%.

 

Why I Think the Facebook IPO Is Overvalued (By the Numbers)

Facebook is a business.  It’s actually a fantastic business that generates beautiful returns on equity, has a dominent market position, and enjoys strong user loyalty for the time being.  The existing owners want to sell out some of their ownership stake and raise a little money.  They plan on selling 337.4 million shares, raising $11.8 billion in cash.  That would put the valuation of the entire business at $96 billion.  

What are investors getting for $96 billion?

  • An online social platform that generates roughly 83% of its money from advertising.  The rest mostly comes from Facebook payment credits for games, etc..
  • Sales of $3.71 billion
  • Net income of $1 billion
  • Current customers total 900 million users, of which 526 million are active, daily users.

Remember the lesson I’ve taught you countless times?  When you invest your money, your job is to buy the most profit you can.  It doesn’t matter if $1 in profit comes from advertising, as in the case of Facebook, or from selling roasted coffee beans in a little cart at the county fair.  It doesn’t matter if the dollar comes from an “exciting” business, like a Hollywood movie studio, or a “boring” business like a water treatment plant.  A dollar spends the same regardless of how it was generated.  

That means our base valuation for the Facebook IPO is 96x earnings.  That works out to an earnings yield of 1.04%.  If the company were to pay all of its profit out as dividends, you would get hit with a 15% dividend tax, so adjusting for that, your net earnings yield is 0.88%.  That is 88 basis points.  That is 88/100 of 1%.  That is a rounding error.  

What is our opportunity cost?  Right now, the 30 year United States Treasury bond yield is 3.07%.  That is 307 basis points.  

Think of it this way: If Facebook never grew, and remained the same size forever, you would make 300% more profit per year by buying and holding long-term Treasury bonds until maturity, which are guaranteed by the taxing power of the United States.  You’d take less risk, and get paid 3x more.  This is basic earnings yield vs. Treasury bond yield stuff you should know as a freshman finance student and it fails even that test.

The Entire Justification for the Overvalued Facebook IPO Is Future Growth

Thus, we know that the underwriters – the people trying to unload the stock on the public – are implicitly arguing that Facebook’s growth will be huge following the IPO.  Okay, let’s look at that.  I normally get nervous when people insist on having you pay for chickens that have not yet hatched, but we’ll examine Facebook’s track record.

Last year, revenue was up 88% over the previous year.  This year, it is expected to be up 64%.  Notice a trend?  The growth figure is dropping.  Plus, remember, they already have 1 out of 7.77 people on the planet as users.  To continue growing quickly, they have to introduce new, untested products, get existing users to spend more time on the site, and / or convince the rest of the globe to become obsessed with Facebook.  

Then there are the low switching costs.  I shut my Facebook account down back in February and haven’t thought about it much since.  All of the pageviews, followers, comments, likes, and game credits I generated evaporated overnight.  You don’t want to be in a business like that unless you have some diversification.  Many of the younger people I know don’t spend time on Facebook, they hang out on Tumblr.

But say we give Facebook the benefit of the doubt.  Say that they are wildly, madly successful.  They grow profits by 1,000% by getting every man, woman, and child on the planet to obsessively check their Facebook account.  Profits would stand at $10 billion.  After this perfect scenario, when everything has gone right, rainbows and kittens have bloomed out of flowers in fields of strawberries and Mary Poppins herself is taking the Facebook employees on wellness outings at corporate headquarters, this feat, which presumably would take years to accomplish, would result in an earnings yield of 9.6% on cost.  If all the net profit were distributed as dividends, you’d pay the 15% dividend tax, leaving owners a take-home earnings yield of 8.16%.

But even major components in the Dow Jones Industrial Average provide higher returns than that right now.  At this very moment.  ExxonMobil, for example, has an earnings yield of 10%, and a net earnings yield of 8.5%.  It would never even have to grow.  It could remain precisely the same size to generate that return year in and year out, assuming stable energy prices.

Looking at the Facebook IPO valuation from another angle, if Facebook performed a miracle on the scale of walking on water, and grew from $1 billion in profit to $26 billion in profit, making it the same size as Apple, due to valuation compression, the best an investor could reasonably hope for would be turning every $1 into $5.56 before taxes due to a market capitalization rise from $96 billion to $533.47 billion, putting it on par with the Cupertino giant.  That presumes there are no share issuances for employee compensation, which is unlikely.  Could it happen?  Sure, anything could happen.  That isn’t investing.  That is a lottery.  There is no rational way you can get to those numbers short of a miracle, and you don’t invest in miracles.  Not if you want to get rich in the long-run, anyway.

The Facebook IPO Terms Are Atrocious

Even if you could somehow have intellectual denial sufficient to get past the obscene valuation, there is a bit of a problem in that Mark Zuckerberg has uncontested control of the business with 56.9% of the voting power, despite holding only 28.2% of the stock.  That means, for all intents are purposes, you aren’t an equal owner, you are merely along for the ride.  It’s like some of the much maligned dual class voting structures you see at other businesses.

Final Thoughts on the Facebook IPO Valuation

What makes the Facebook IPO so interesting is that Facebook is a very good business.  Mark Zuckerberg has built a tremendously successful enterprise.  In effect, he owns 28.2% economic ownership in a company that churned out $1 billion in after-tax profit last year, giving him $282 million in net income indirectly through his dorm room start-up.  That is immensely impressive.  It’s huge.  It puts him in a club that includes a handful of successful elites like Michael Dell and Bill Gates.  He should be enormously proud, studied in business schools, and emulated in careers.

With growth, and current income, I think Mark Zuckerberg is worth no more than $5 billion, rationally valued.  For a 27-year-old guy, that is mind boggling.  It’s awesome.  He will always be in the history books, and rightfully so.  The idea that his 28.2% equity stake is worth $25 billion?  It’s madness.  Utter stupidity.  Delusion.  

Anyone that buys at these prices is, in my opinion, a fool.  Could the stock skyrocket?  Of course.  The Dutch lost their minds, too, over tulips a few centuries ago and were selling farmland that would produce centuries worth of food for a few, prize bulbs.  But bubbles always end.  When they do, the last one holding the bag is often ruined for life, or at least severely harmed.  I think the banks that are underwriting this deal should be sued into oblivion, and the bankers involved held personally liable.  That is how immoral I think the whole thing is.  It is preying on the uninformed, the financially gullible, and the easily swayed masses who can’t tell you the difference between LIFO and FIFO.

  • FratMan

    Amen, amen, I say to you! I couldn’t agree more. When the Wall Street crowd says to potential investors, “Show me the money!”, we should respond, “Show me the earnings!”

    • Joshua Kennon

      I like that.

  • Jacek Janiszewski

     > All of the pageviews, followers, comments, likes, and game credits I generated evaporated overnight.

    You’re dead wrong. You are the product facebook is selling. You are giving away your personal information for all time. Chances are your facebook account is linked to other social services (implicitly or explicitly) as well as mail, plaintext name and so on. Even if your facebook account is closed the data is still retained and used for marketing purposes and continually mined via other services you may use.

    • Joshua Kennon

      I’m not saying the past data was deleted. I realize they still have it. I am talking about the economic impact going forward of someone deactivating a Facebook account.

      We talk a lot on the blog about not confusing the means and the ends. People often think that Facebook is in the business of gathering personal data. It’s not. That is merely a means to an end. Facebook is in the business of selling advertising. That is all it does. The personal data is a way, a means, a mechanism, to deliver specific ads to specific people to maximize the likelihood those ads are relevant to them, increasing clicks.

      Many businesses fall into this category. Target retail stores are so sophisticated at analyzing consumer data that they can tell when a woman is pregnant and even predict the due date, making sure to send coupons for diapers around the same time. It has to do with tying specific debit and credit cards to purchases, cross-referencing that information with address data. There was a story in the news about a father finding out his 16-year-old daughter was pregnant because Target analyzed her purchase of non-scented lotion and sent her congratulations marketing material in the mail. Walmart knows consumers in the Eastern United States buy more Strawberry Pop Tarts when a hurricane warning has been expected, and their systems automatically increase orders for the pastries prior to landfall, down to specific store levels for people living in particular communities.

      The point is, the information is useful only to Target, or Walmart, insomuch as it can use it to sell something – products like shampoo or milk, cereal or televisions.

      Likewise, the personal data is only relevant to Facebook so it can sell targeted advertisements on its primary platform, the Facebook website.

      The data itself has a very small residual value unless it is coupled with a platform that generates cash (again, in this case, the Facebook website or in the case of Target, the neighborhood Target retail store). That is because the United States has various consumer protection laws in place that allow families to register their phones, addresses, etc. and forbid companies from contacting them with solicitations.

      If a user quits Facebook, the company loses nearly all of the revenue and profits that were being generated by that user’s activity. The historical data becomes, for all intents and purposes, worth fractions of pennies on the dollar, at best.

      In other words, if I woke up tomorrow as the sole owner of 100% of Facebook’s stock so that the business were mine entirely, my greatest fear would be people deactivating their account. The residual data I retained would have an economic value of pennies on the dollar. The real money would have evaporated overnight because I lost the ability to sell target advertisements. A user who quits the site no longer generates page views, advertising impressions, or game credits. Sure, I’d still have their historical personal data, which would be good for 5 to 10 years, at best. But that would be cold comfort when I watched 99% of the profit evaporate.

      If you doubt this to be the case, look at MySpace.

  • Scott Mc.

    If nothing else, investors can at least be assured that they are buying a management team that is willing to act rationally.  If your company could get a public valuation of ~100x earnings, it would be irrational NOT to take it public.  facebook is clearly acting in the best interests of (existing…) shareholders here.

    When the stock starts to fall, it’ll be interesting to see at what valuation they start considering share buy backs (what insiders think the company is actually worth).

    • Joshua Kennon

      There are two schools of thought on the matter.  The first is the Benjamin Graham camp, who believes that management’s duty is to treat all shareholders equally and fairly, including new shareholders coming into the business and old shareholders leaving the business.  It is unethical to benefit one group at the expense of the other, often because the one getting hurt as the non-sophisticated; the widows, the students, the inexperienced who don’t have the life experience to know they are being treated as marks to be robbed. This camp would have looked at the underwriters and fired them for even considering a 100x earnings valuation. They want to deal to be fair for everyone.

      The other school of thought is the John Singleton of Teledyne group, who believes that shares should be issued when overpriced, and reacquired when underpriced, to the point of maximizing value for those who are long-term owners because we live in a free country and it is the duty of every person to manage his or her own affairs wisely.  As long as the policies are specifically, clearly articulated, and everyone has access to the same information, it is not my problem if you want to make foolish mistakes, just as you have the freedom to smoke, gamble, or get yourself into credit card debt.

      For me, it is a struggle.  My heart falls into the first camp, my head in the second.

      • Gilvus

        At first, the latter option seems ruthless and selfish. But on second thought, that’s exactly how a meritocracy operates.

        • Scott Mc.

           It all comes down to how you frame the issue:
          If I asked you “is it good for a parent to burn her child?” the answer, of course, is a resounding “NO!”
          But if the mother warns her child “be careful, that stove is hot!” the child may obey for a short while, but eventually it will be overcome with curiosity.  Pain tends to be the best teacher, and short-term pain often provides outsized long-term benefits.

        • Scott Mc.

          As the saying goes: ” Good judgement comes from experience, which comes from bad judgement.”

      • Scott Mc.

        Just from personal experience, I’m not sure that hurting new shareholders in the short run is necessarily bad for them in the long run – especially for students.  Case in point: my first experience with investing was in January of 2000, when I bought the parent company of the old Lycos search engine.  As far as timing, that was pretty close to the Nasdaq’s peak, and I was warned in advance by my father that it was probably over-priced, and subject to fickle consumer patterns (of course at the time he suggested Block-Buster…lol).

        I learned so much more from losing money than I would have learned from profit, that’s to this day it’s probably the best investment I’ve ever made.  If teens and college students treat this stock like a fashion accessory (which I think may well happen), then they stand to benefit twice: 1) from being attracted to the stock market, which is invaluable for someone in that age group; 2) either they’ll have some profit, which they can enjoy and which may make them more likely to continue investing – or they’ll have losses and hopefully learn (as I did) that stocks need to be analyzed not on the basis of whether or not you like the company’s products, but on their financials.

        • Gilvus

          That sounds good in theory, but people who’ve been burned could just as easily swear off the market forever and point fingers rather than figure out what they did wrong. I’ve heard plenty of people claiming that “the system is rigged” or “the fat cats are padding their pockets at our expense.”

        • Ian Francis

          True, but you can’t argue with idiots. All you can do is provide them with fair opportunity and let them do what they will. If they end up failing, blaming the successful, and starting a “We are the (insert populist sounding name here)” campaign, then there is nothing you can do.

          As for the two schools of thought, while the former is the more moral-sounding one, it is inevitably going to fail at some point. The second, while being the greedier one, is much more stable. This has to do with positive and negative feedback (not as in advice, but science). An engineer who is trying to design a stable system strives for one with negative feedback. This means if the system parameters get out of whack, the natural forces that be tend to push the system back into equilibrium. Positive feedback is the opposite. Move a little bit in one direction and the natural forces want to keep going in that same direction. This is a much harder system to keep stable, because you are constantly fighting nature. The same applies for finances. While not issuing an IPO at such ridiculous prices may be taking the high road, you end up more likely to hurt the business because all another company has to do is take the low road and grow their business faster. The inevitable conclusion is that businesses will take the low road in order to all be on the same level.

          The only solution to this would be government regulation, which can force the high road and make that the stable point. So while ethical business practices above and beyond the law may be desirable, they are not sustainable unless they are already the better financial decision, or the government sets them as the minimum requirements. If you want someone to complain to, make it the government, because business will just do what is in its own self-interest.

  • James

    Ok so this is getting ridiculous; they have upped the price by 10%-20% and the float by 25%.  I really want to know who is buying all those shares because it isn’t retail that’s for sure. I’m going to be pretty po’d if any of my vanguard ETFs invest in this crap.

  • James

    Ok so this is getting ridiculous; they have upped the price by 10%-20% and the float by 25%.  I really want to know who is buying all those shares because it isn’t retail that’s for sure. I’m going to be pretty po’d if any of my vanguard ETFs invest in this crap.

    • Joshua Kennon

      I’ve been incredibly curious to find out which funds were buying.  I figured it would make for an interesting end-of-quarter analysis.

  • Ian Francis

    I now hear that one of their income strategies is to start allowing companies and individuals to pay to advertise a post.  Still not seeing the value in the IPO.

  • Shelpa2

    Genius

  • http://www.facebook.com/jacobxcaliber Kristoffer Adams

    I totally agree what is Facebook’s next move buying Instagram and Lightbox is not enough. They need to focus on mobile since its what in our hands constantly and make it where their proprietary app is better than third party ones. There is room for growth on the mobile front i believe they should start there. 

  • spacerogue

    May be the original and new investors counted on greater fools theory. We all know who is making the money (Microsoft made back it’s initial investment by selling less than a third of it’s stock), but for how long can the new investors wait?

  • Josh Hill

    Well you just the true meaning of a IPO really was

    It’s Probably Overpriced

    Nothing to see in Facebook, to ever changing. Plus, remember the 90’s a majority of tech IPOs were trading at obscenely high values.

  • innerscorecard

    Any thoughts given Facebook’s current price and business?

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