Wednesday, 30 January 2013

Is Facebook growing fast enough?

Commentary: Questions to ask when company releases its earnings

By Mark Hulbert, MarketWatch
CHAPEL HILL, N.C. (MarketWatch) — Facebook’s revenues are growing at a fast pace. But they aren’t growing fast enough to support their current stock price.
Facebook FB +1.77% , of course, is scheduled to release its latest quarterly earnings report after the close on Wednesday. The consensus forecast from Wall Street analysts, according to FactSet, is for the social-media company to report quarterly earnings totalling $1.5 billion. That would mean that, for all of last year, Facebook’s revenue would be $5.0 billion.
That’s a big number, for sure, and certainly seems impressive.
To understand why I nevertheless believe that it’s not good enough, it’s helpful to review a back-of-the-envelope calculation of Facebook’s valuation that I introduced in a column immediately after the company went public last May at $38 per share.
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That calculation required just three inputs:
  • Facebook’s revenue growth rate over its first five years as a publicly traded company. I assumed that it would be the same as the average of all U.S. IPOs between 1996 and 2005 — 212% cumulatively, or 25.6% on an annualized basis (after excluding spinoffs and buyouts).
  • Facebook’s price-to-sales ratio in five years’ time. I assumed it would be the same as Google’s is today GOOG +0.33%  — which is a quite generous assumption, since Google’s price-to-sales ratio is nearly four times larger than the overall market’s.
  • The rate of return Facebook investors would require to hold the stock for the five years after its IPO. Generously, I assumed the market’s long-term average return of 11%. If I had assumed a higher return number, then the outcome of my analysis would have been an even lower fair value today.
Armed with these three otherwise generous inputs, calculating a fair price for Facebook was a matter of simple math: As I reported last May, that price was $13.80. ( Read my May 25, 2012, column: “Facebook’s stock should trade for $13.80” ).
How can Facebook overcome this awful fate? Since investors won’t be happy earning less than 11% per year, and since it’s unreasonable to expect the company’s price-to-sales ratio in 2017 to be markedly higher than Google’s is today, the only realistic way for Facebook to overcome my dismal price target is for its revenue growth rate to be far higher than 25.6% per year through 2016.
Yet the company has not shown that it can maintain this much higher revenue growth rate.
To be sure, it might on the surface seem otherwise. Provided the consensus estimate is correct, for example, the company’s 2012 revenues will have been 35.5% higher than in 2011.
But, according to Jay Ritter, a finance professor at the University of Florida who is one of academia’s leading experts on IPOs, the typical pattern is for a post-IPO company’s revenue growth rate to decline over its first several years after going public.
To average 25.6% over its first five years after coming to market, therefore, a company’s revenue growth in its first couple of years needs to be above that rate.
Consider, for instance, the average revenue growth rate over the first three years after a company comes to market. According to Ritter, this three-year growth rate was 36.7% per year for the same sample of IPOs that produced a five-year annualized growth rate of 25.6%.
So Facebook’s revenue growth over this past year is almost precisely in line with the rate that was the basis of my back-of-the-envelope calculation.
How, then, is Wall Street able to persuade itself that Facebook should be trading at its currently high price? As far as I can tell, by assuming Facebook deserves to have a sky-high price-to-sales ratio — not just now, but also well into the future.
Consider, according to FactSet, the consensus estimate of Facebook’s revenues in calendar 2015 — the furthest year out for which a consensus estimate is provided. That consensus is $10.5 billion.
Assuming that consensus is on target, and assuming Facebook’s price-to-sales ratio in 2015 will be the same as Google’s is today, then Facebook’s market cap at the end of 2015 would be around $52 billion. That’s 25% lower than where the company’s market cap stands today.
Don’t like the conclusions of my calculations? Be my guest and go through the exercise yourself, employing any of the standard valuation metrics. And use your calculations to subject Facebook’s latest quarterly earnings report to a smell test.
My hunch is that if you do so, you will not be running out to buy Facebook stock afterward.
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980. Follow him on Twitter @MktwHulbert.
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