Facebook Through Peter Lynch's Eyes

One of these days I'd love to sit down with super-investor Peter Lynch and find out just how annoyed he is that an stellar career as an investor and educator of individual investors has been boiled down to the cliché "buy what you know."

With the Facebook (NAS: FB) bonanza we've had yet another run-in with the public's misunderstanding of Lynch's wisdom. "Buy what you know" is now popularly interpreted as "if you're familiar with it and like it, it must be a good investment." That garbled message helped retail investors -- with plenty of help from the media -- get worked up into a frothy frenzy over the possibility of buying shares of the pop-culture icon that is Facebook.

But it hasn't worked out at all so far. For somebody that sunk $40,000 into the stock at the IPO price, the loss so far tallies to more than $10,000.

A Lynchian look at Facebook
Peter Lynch did indeed counsel investors to buy what they know. However, the lesson wasn't "anything that you know is worth buying" but, rather, more of an admonition against buying what you don't know.

Further, if Lynch's One Up on Wall Street was nothing more than advising investors to "buy what you know" it'd be a darn short book. But if you dig into the rest of what Lynch has to say, Facebook, though familiar to many investors, doesn't end up looking like a very Lynch-worthy investment.

In the final chapter of the section titled "Picking Winners," Lynch presents his "Final Checklist." Let's see how Facebook stacks up.

First, there are checklist items for "stocks in general:"

Lynch: "The p/e ratio. Is it high or low for this particular company and for similar companies in the industry."

Me: At more than 70, Facebook's p/e ratio is high, high, high. On an absolute basis it's high and compared to similar companies it's high. Google (NAS: GOOG) trades at a p/e of 17.8 while Apple (NAS: AAPL) has a p/e of 14.1.

Lynch: "The percentage of institutional ownership. The lower the better."

Me: Facebook gets a checkmark here -- insiders still own a lot of the shares.

Lynch: "Whether insiders are buying and whether the company itself is buying back its own shares. Both are positive signs."

Me: Nope! Through the IPO both insiders and the company were selling shares.

Lynch: "The record of earnings growth to date and whether the earnings are sporadic or consistent."

Me: Facebook's growth has been blazing fast, but with a very short history, it's hard to know how fast the company can consistently grow.

Lynch: "Whether the company has a strong balance sheet."

Me: Facebook has a very strong balance sheet. Though it's notable -- as my fellow Fool Morgan Housel pointed out -- that the financial strength has mostly come via outside investments in the company rather than the company's performance.

Lynch also offers criteria specific for growth companies like Facebook. Let's take a look at a few of those as well.

Lynch: "What the growth rate in earnings has been in recent years. (My favorites are the ones in the 20 to 25 percent range. I'm wary of companies that seem to be growing faster than 25 percent. Those 50 percenters usually are found in hot industries, and you know what that means.)"

Me: Uh oh! Facebook's earnings growth from 2009 -- its first year of profits -- to 2011 averaged more than 100% per year. It's certainly a fast grower, but as a social networking company it also would fall into that "hot industries" category that would make Lynch skeptical.

Lynch: "That the company still has room to grow."

Me: The simple answer is "yes." However, that growth will only come if Facebook figures out how to consistently monetize its users.

Lynch: "Whether expansion is speeding up ... or slowing down."

Me: From 2010 to 2011, revenue grew 88% and profits were up 65%. For the quarter ended in March, year-over-year revenue growth was 45% and net income fell 12%. And let's not forget all of the grumblings over Facebook's admission that its business on mobile phones is lackluster.

The final jab
Lynch doesn't have a whole lot to say about IPOs in One Up on Wall Street, but when he does bring them up, he doesn't exactly sound enthusiastic:

IPOs of brand-new enterprises are very risky because there's so little to go on. Though I've bought some that have done very well over time ... I'd say that three out of four have been long-term disappointments.

Fed up with Facebook and ready for some better ideas? Think big and check out these three companies that my fellow Fools think are set to "dominate the world."

At the time this article was published The Motley Fool owns shares of Apple. The Fool owns shares of Google. Motley Fool newsletter services have recommended buying shares of Google and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

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