When Facebook’s IPO didn’t result in a spike in its stock valuation on its first day of trading, people speculated. Was it because Facebook isn’t as hip as it once was? Was it because we don’t have technology bubbles anymore? Was it because $38 sounds like a lot for a stock that just went IPO?
Here’s the truth: These questions are irrelevant to understanding whether Facebook is valued fairly or not. And if you have sincerely asked yourself these questions, you may want to reconsider purchasing stock.
Disclaimers: I am not a professional financial expert, nor do I have insider knowledge about Facebook or Google. I have never invested a penny in the stock market. This piece is my personal opinion.
I’m writing because of two recent bubbles (the dot-com bubble and the more recent housing bubble) that seemed to be a surefire way to create wealth, but many investors ended up losing a lot of money. Some of this loss could have been prevented if people fully understood their investments and asked critical questions upfront.
How do you make sense of Facebook’s valuation, or any stock valuation for that matter? Here’s a crash course on the stock market. First, the actual price of the stock is irrelevant to any discussion about stock value. A $38 Facebook stock sounds a like a bargain compared to a $600 Apple stock, but it’s not. The number is irrelevant because Facebook and Apple have different numbers of shares outstanding.
At its current enterprise valuation of roughly $100 billion, Facebook is one of the most highly valued companies in the world. You need to compare that number to the company’s revenue, earnings, and growth. Facebook’s current earnings are $1 billion. That means that the company’s price-to-earnings ratio is 100. If I wanted to buy all of Facebook at today’s price, I would have to invest 100 times what it would earn me back this year. Here’s another way to look at it; if Facebook’s earnings stay constant for the next century, it would take me more than 100 years to get my $100 billion back. Google’s price-to-earnings ratio is a fairly standard 15-20, but even this number is high by historical standards. To hold its current stock price, Facebook’s earnings need to grow, rather quickly, from $1 billion to more than $5 billion.
Where will future growth come from? What may happen in the marketplace that could disrupt that growth? Can Facebook monetize its user base to five times its current earnings over the next few years and then add some on top of that? Because, of course, you want your shares to grow. Right now, Facebook has 1 billion users, so the math is pretty easy – Facebook is currently making $1 on each of its users each year. To keep its current value, Facebook needs to make $5 per user. For the stock price to double in a non-bubble economy, Facebook would quickly need to extract $10 per user per year (or significantly grow its user base, of course). Armed with these numbers, you can judge for yourself and think about whether you want to buy Facebook stock. I bet most people don’t think this critically when they invest.
None of this analysis matters, of course, in a bubble, where a stock price may rise, not because the fundamentals change, but because there is high demand. I hope that people are smarter this time around and are not the ones holding the bag when the buying stops. No one wants to be the sucker at the end of the line.