Sizing Up Facebook
The initial public offering, expected on May 18, could value the company at anywhere from $77 billion to $96 billion based on its $28- to $35-a-share price range—making Facebook the biggest company to go public in U.S. history, according to Dealogic. Some analysts already have issued one-year price targets as high as $46 a share.
Over the longer term, conventional metrics suggest Facebook's sky-high valuation will be difficult to sustain. Skeptics point to worries that the company's rocketing sales and earnings growth is slowing, and say the biggest investment gains for the eight-year-old company already might have been reaped by the founders, venture capitalists and other well-heeled investors who took earlier stakes.
The best bet for small investors, experts say: Wait awhile. While the Facebook IPO is like no other before it, many of the classic rules for investing in IPOs apply: Avoid the initial rush into the stock, monitor the company's early financial reports for signs of softness, keep any bets small and beware the six-month mark, when insiders can start dumping their shares.No matter how you slice it, Facebook is a special company," says Tim Keating, CEO of Denver-based Keating Capital, which provides funding to pre-IPO companies. "But investors have to recognize that a great company isn't automatically a great investment."
Social Media Frenzy
Investors can be forgiven for getting caught up in the hype. After an earlier wave of smaller social-media IPOs such as Groupon GRPN +0.30% and Zynga, ZNGA -4.35% they finally have a chance to invest in the big daddy of them all.
But consider some comparisons with another highflying social-media stock, LinkedIn, LNKD -3.40% which went public in May 2011. The stock more than doubled on its first day of trading, then lost a third of its value over the following month, then zoomed again, trading recently at about 19% above its first-day closing price.
When Facebook goes public, the company is expected to trade at anywhere from 77 to 96 times its 2011 earnings, a seeming bargain compared with LinkedIn's multiple of well over 200 times its earnings in 2010, the year before it went public.
But Facebook is orders of magnitude larger. It has about 900 million users globally, compared with about 102 million for LinkedIn at the time of its IPO. Facebook's sales totaled $3.7 billion in 2011, the last calendar year before its IPO—15 times greater than LinkedIn's sales in 2010.
Compared to Google
The closest comparison to Facebook's IPO is Google's GOOG -1.37% 2004 offering, but Facebook already is much larger than Google was then. Its revenue is about 50% greater than Google's was, and Facebook's expected market capitalization will be as much as four times that of Google at its IPO, according to Dealogic.
Yet Facebook is nearly as richly valued as Google, whose P/E at its offering price was about 120 times its earnings in the previous four quarters.
The bottom line: Facebook's valuation "leaves zero margin of safety," says Vitaliy Katsenelson, chief investment officer of Denver-based Investment Management Associates, which manages about $60 million. Mr. Katsenelson doesn't plan to buy
Facebook in April reported a first-quarter net income of $205 million, down from $233 million in the first quarter of 2011, mainly because of higher costs. Looking ahead, Brian Wieser, an analyst at Pivotal Research Group, says revenue could increase 34% in 2012, down from 88% in 2011, while earnings per share could rise 54% in 2012, down from 64% last year.
Taking all of this into account, Aswath Damodaran, a finance professor at New York University and an expert on valuation, says Facebook probably is fairly valued at around $75 billion to $80 billion, assuming its revenue and earnings keep rising briskly and it can keep profit margins near 30%.
Nasdaq Pop?
Facebook does have one factor in its favor: Major stock indexes want to include it quickly, and that could give the share price a booster shot.
Nasdaq OMX Group NDAQ -1.56% changed its rules last month so that it can include stocks after just three full months of trading, rather than at least one year. That means Facebook would be eligible for inclusion in the Nasdaq-100 stock index as soon as September and could be part of the index by the end of the year.
Standard & Poor's can add companies to its indexes after as little as six months of trading. Although it usually waits longer, some experts say in Facebook's case it could act sooner.
"S&P tries to recognize all industries," says Jay Ritter, a finance professor at the University of Florida and an IPO expert. "I wouldn't be surprised if it added Facebook after the [six-month insider-selling] lockup expired."
An S&P spokesman says that just because a company meets every inclusion criteria doesn't mean it automatically is included in the S&P 500.
Being added to an index can have an immediate impact on a company's share price, as funds that track the index scramble to buy shares. Prof. Ritter estimates a company the size of Facebook can gain as much as 1% for every $100 million of stock connected to any index. So inclusion in the Nasdaq-100 alone could translate to as much as a 7% bump in Facebook's share price, according to his analysis.
The problem for small investors? Most of the buying happens the day an index firm announces it is including a stock, not when it actually adds the stock. Investors who blink could miss out on the short-term gain.
For example, after the close of trading on March 23, 2006, S&P said Google would be added to the S&P 500. The stock jumped 7% the next day. It gained just 0.4% on March 31, the day it was officially added to the index.
What to Expect on Day One
During Facebook's early days of trading, questions of valuation will take a back seat as big investors look to make a quick buck off the IPO. "It's a momentum game," Prof. Damodaran says. "Many people want to buy it and flip it."
Given its size, Facebook might not be primed for the sort of frenzied first-day rally that some smaller companies enjoy. In general, the bigger the company, the smaller the initial jump. From 1980 through 2010, the stocks of companies with revenue of $500 million or more gained an average of 9.1% on their first day of trading, about half that of the average IPO generally, according to data from Prof. Ritter.
The reason: Smaller companies are typically seen as having more growth potential. Whereas LinkedIn doubled on its first day of trading, Google rose at a much more modest 18% in its 2004 debut.
Facebook's offering price can make a big difference, Prof. Ritter says. If it prices within its range of $28 to $35, its first-day return is likely to be between 10% and 18%, he says. If the stock prices above $35, the return could be substantially higher. If the stock prices below $28, the first-day return could be near zero.
Bear in mind that only about 20% of the shares sold at the typical IPO's offering price go to individuals, Prof. Ritter says. The rest go to professionals.
E*Trade Financial ETFC -0.52% was added to the list of Facebook underwriters on May 3, suggesting Facebook is looking to give more small investors a shot. E*Trade, via its IPO center, already is taking orders for Facebook shares, though there isn't a guarantee clients will get them.
So What to Do?
If the IPO doesn't soar and the stock trades at the low end of its expected valuation, investors might want to start nibbling, Prof. Damodaran says.
But waiting a bit longer can be beneficial. Facebook might not provide much financial guidance beyond its reported results during its first few quarters of trading, says Steve Bishop, portfolio manager of the RS Technology fund, who added that he expects to buy Facebook at its offering. That, he says, could result in a rocky ride for investors but also better buying opportunities.
That has been the pattern with recent social-media IPOs. LinkedIn, for instance, lost about a third of its value during its first month of trading following its first-day close of $94.25, but has since come back to about $110. Investors who bought on that dip could have made as much as 77%.
The longer the wait, the more time investors have to watch how management handles its first few earnings reports. Sometimes early troubles can hammer a new stock. Shares of Groupon, for example, soared 31% on their first day of trading on Nov. 4; since then they have lost more than two-thirds of their value after the company restated its revenue amid widening losses.
By waiting, small investors also could capitalize on any dip resulting from insider selling.
In Facebook's case, most insiders are barred from selling their shares for six months after the IPO, though some will be permitted to sell after three months. There is no way of knowing for sure when Facebook insiders will sell, but in general the six-month mark tends to bring brisk insider selling—and a drop in share prices.
Investors who decide to buy should keep their bets small, Prof. Damodaran says. Most financial advisers recommend that a single stock make up no more than 5% of a portfolio. And given that Facebook might soon be included in the major indexes, many investors will end up owning some percentage of the stock without even trying.
Says Prof. Damodaran: "Facebook has something to offer, but there's so much we don't know."
