Should You Buy Facebook Shares? Read This First

"I would invest in Facebook; I don't care what the opening price is."
-- Steve Wozniak, co-founder, Apple (NAS: AAPL)

"If you're a growth investor, you more or less have to own [Facebook] and hold your nose at the initial price." -- Lawrence Haverty Jr., Associate Portfolio Manager, The Gabelli Multimedia Trust

If you're the billionaire co-founder of the most successful tech company in history and you simply have to own some shares in the hot new technology company, go ahead and buy shares without any consideration for price. If you're a growth-fund manager and your primary concern is minimizing your career risk, it's "Damn the torpedoes -- full speed ahead!"; after all, unlike Admiral Farragut, you're not actually in the boat with your investors. If you're neither and you invest for profit rather than entertainment, I urge you to hear my appeal: Observe, don't participate, in Facebook's IPO.

Climb aboard my bubble machine!
Price matters. How did the bankers come up with their valuation for Facebook shares? They used three methods, but the one to which they assigned the highest weighting -- 50% -- simply amounts to looking at the most recent prices at which the shares changed hands in private markets open to qualified investors. This has produced a massive "greater fool" dynamic, as each round of "investors" anchors on the price paid at the preceding stage:

Stage one: Qualified investors are eager to buy shares in the private market. Why wouldn't they be? It's a nearly sure thing the stock will appreciate once it becomes publicly traded.

Stage two: Bankers award a favored group of investors shares in the initial public offering. The bankers' indicative valuation is largely based on the prices paid in private share markets. IPO investors expect that the shares will pop once they hit the secondary market.

Stage three: It's a stampede as investors (including numerous individual investors) who couldn't get in during stages one and two finally get the chance to get their hands on some shares, sending prices higher yet. At this stage, investors will need to find a greater fool (small "f," mind you) to realize a quick profit, but they risk running out of fools and becoming the greatest fool.

By virtue of this process, I expect to witness a deep incursion by investors into bubble territory. Last June, I predicted that Facebook would end its first day of trading with a market capitalization in excess of $150 billion. While that's by no means certain, I think there's an excellent chance it will come to pass.

How does that figure relate to the shares' intrinsic value? Peter Cauwels and Didier Sornette, "econo-physicists" at the Swiss Federal Institute of Technology, developed their own valuation model for social-networking companies, which they published in October 2011. Here's how Cauwels summed their results in an interview with New Scientist: "Investors should be aware that everything they pay above $30 billion [for Facebook] is just an option on future potential and everything above $60 billion is bubble money."

Facebook by the numbers
Cauwels and Sornette modeled the value by focusing on expected per-user revenue, using the following assumptions:

  • Revenue per user per year: $3.50 (average over the prior five years)

  • Profit margin: 29% (average over the prior three years)

  • Equity risk premium: 5%

The model also assumed that revenue per user per year grows in line with inflation and that the risk-free rate is equal to inflation. In fact, Cauwels and Sornette found that revenue per user per year has halved every 3.5 years during Facebook's short life.

On that basis, and under their "extreme growth" scenario in which the number of users tops out at roughly 1.8 billion, the company stopped growing exponentially in 2010, and Facebook is worth $32 billion. Compare that with the top of the newly raised IPO pricing range ($34 to $38), which values the company at $104 billion -- more than three times that amount -- and remember that $38 is the price a "lucky few" who receive shares in the IPO would pay.

The numbers keep going up -- and so does the risk
A year ago, on the day following LinkedIn's (NYS: LNKD) IPO, I warned that "investors who get in at these levels will almost certainly experience very disappointing returns -- with a significant possibility of a permanent loss of capital." Since then, the shares have appreciated by nearly 20% against just a 3.5% gain for the Nasdaq index! However, investors had to ride out a greater than one-third decline in the share price to achieve that level.

Was I wrong about LinkedIn? Am I wrong about Facebook? In the former case, it's still too early to tell. On Facebook, I could end up being wrong. In fact, the Fool's senior technology analyst thinks just that. He highlights what he thinks is the best play in social media in our brand new research report. We made it free for our readers, so grab your copy today.

At the time thisarticle was published Fool contributorAlex Dumortierholds no position in any company mentioned. Check out hisholdings and a short bio. You can follow himon Twitter. The Motley Fool owns shares of LinkedIn and Apple.Motley Fool newsletter serviceshave recommended buying shares of LinkedIn and Apple and creating a bull call spread position in Apple. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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