Facebook’s Stock Should Trade for $13.80

May 25, 2012 at 08:35

truthing

Not a topic we might normally cover however seeing as everyone is talking about it, we thought we would to.

Rather than endlessly rehashing the events that have taken place over the last week, it is this question that investors should be asking. What is the true the value of Facebook? Surprisingly, however, few are doing so.

And yet, courtesy of a just-released study, calculating a fair price for Facebook’s stock isn’t as difficult as it might otherwise seem.

The study is entitled “Post-IPO Employment and Revenue Growth for U.S. IPOs, June 1996–2010.” Its authors are Jay Ritter, a finance professor at the University of Florida, and two researchers at the University of California, Davis: Martin Kenney, a professor in the Department of Human and Community Development, and Donald Patton, a research associate in that same department.

The researchers found that the revenue of the average company going public between 1996 and 2010 grew by 212% over the five years after its IPO. Assuming Facebook’s revenue grows just as fast, and given that the company’s latest-year revenue was $3.71 billion, its annual revenue in five years’ time will be $11.58 billion.

Since Facebook is most often compared to Google, let’s assume that its price-to-sales ratio in five years will be just as high as Google’s is currently: 5.51-to-1. You could argue that this is an overly generous assumption, of course. But it nevertheless means Facebook’s market cap in five years will be just $63.8 billion — 30% less than where it stands today.

Assuming that the total number of its shares stays constant, that works out to a price per share of just $23.26 — in contrast to its recent closing price of $33.03.

Actually, however, the news is even worse: No one is going to invest in Facebook shares today if its price will be 30% lower in five years. So, in order to entice someone to invest in it today, Facebook needs to offer a handsome return. Assuming that its five-year return is equal to the stock market’s long-term average return of 11% annualized, Facebook shares currently would need to be trading at just $13.80.

Don’t like that answer? Try focusing on earnings rather than sales, and you get only a marginally different result. Assuming its profit margin stays constant (instead of falling as it could very well do as it grows), assuming its P/E ratio in five years will be just as high as Google’s is today, and assuming that its stock will produce a five-year return of 11% annualized, Facebook’s stock today should be just $16.66.

How can Facebook investors wriggle out from underneath the awful picture these calculations paint? By assuming that its revenue and profitability will grow faster than the average IPO between 1996 and 2010 — and not just by a little bit, either, but a whole lot faster.

Of course, it’s always possible that Facebook will be able to pull that off.

But, as Professor Ritter pointed out to me earlier this week, “the bigger a company gets, the harder it is to maintain percentage growth.” And Facebook is already huge — larger, in fact, than all but 47 other publicly traded companies in the U.S.

So my back-of-the-envelope calculations for this column could very well be too optimistic rather than too pessimistic.

Given all this, Ritter said that a market cap “of $63 billion … five years from now seems like a very reasonable scenario.”