Facebook: "An Intriguing Mid-Cap Growth Story, However an Overvalued Mega-Cap"

Jason Lily, Director of Portfolio Management
February 2, 2012

Wall Street and the financial media have been buzzing the past 48 hours over the Facebook IPO news. With almost 500 million daily users, Facebook has an impressive base and a unique delivery method that appeal to marketers. With copious amounts of data, Facebook has the ability to deliver marketing messages to a very distinct target audience. Advertisers are enamored. Revenue has grown approximately 115% per year over the last two years, while the cost for advertising on Facebook has increased by double digits over the last year.
The competitive landscape is not without its challenges. Tech titans Microsoft, Apple, and Amazon occupy unique positions that can offer alternatives to marketers, either as complements to Facebook or substitutes. Relative new comers such as Groupon and Zynga also offer distinct advantages, and let's not forget Google.

The Facebook IPO is being touted as the biggest thing in internet tech land since Google's IPO in August of 2004. The comparisons are apt. Both companies derive a majority of their revenue from advertising. Growth rates in years six-eight were similar, at over 100% per year. Profit margins were also similar over the same time period (49% for Facebook, 48% for Google). Both are considered pioneers in their fields and both command lofty valuations, which is where we pause.

When Google went public the company raised $1.9 billion, reflecting an enterprise value of approximately $23 billion. Revenue at the time was over $10 billion (more than twice Facebook's 2011 revenue). In Google's eighth year (Facebook turns eight this year) revenue was four times higher than Facebook's 2011 revenue of approximately $3.7 billion. Yet should Facebook be valued four times higher?

If current estimates are accurate, the $5 billion- $10 billion raised in the IPO would place a value on the company of $80 billion-$100 billion - roughly four times higher than Google at a similar stage in their history, but with 25% of the revenue Google had at that time! Yes, a head scratcher indeed.

In the first two years as a publicly traded company, Google's market value went from $23 billion to more than $100 billion. At the current market value of $190 billion, Google hasn't doubled in the five years since. Facebook would need to growth at over 100% per year over the next two years - just to justify an IPO value of $100 billion. Ad revenue for the company is not growing at this pace, based on the most recent quarter.

Facebook's distinct advantage, unique market position, and substantial opportunity for growth make it an intriguing company, but with an IPO target valuation of $80 billion- $100 billion, we believe most of the upside will go to existing shareholders that cash out.