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Published: Friday, 5/18/2012

FACEBOOK FACE-OFF: It could take years for stock price to fall to something reasonable

ASSOCIATED PRESS

EDITOR'S NOTE — Facebook begins selling stock to the public Friday in the most talked-about market debut in years. Two Associated Press business writers are debating whether the stock is a smart buy.

NEW YORK —First, forget the numbers and go with your gut: Given the breathless press coverage, the ubiquity of its product, the Oscar-winning film about its unlikely success and the rock-star status of its 28-year-old founder, do you really believe the smart folks on Wall Street coming up with a stock price for Facebook resisted the temptation to wring every cent out of buyers?

In investing, hype is the enemy. I was skeptical from the start.

The company listed a range of possible prices for its initial public offering of stock, then raised it, then told us that insiders and early investors would be selling even more in the offering. Now I'm convinced: Don't touch this stock.

The banks helping take Facebook public want us to value this 8-year-old upstart at as much as $104 billion, more than Disney or Kraft Foods, though those companies earn three and four times more. That top valuation is also more than 100 times Facebook's annual per-share earnings, versus 13 times for the average company.

At such a high price, it will take years for this so-called earnings multiple to fall to a more reasonable level, and that's assuming the company can maintain its torrid growth.

To make money in Facebook, you're betting that other buyers will be just as willing as you to hold their nose at the valuation, and keep doing so for years.

Facebook grew profits 65 percent last year, faster than at most companies, so you should pay more for it than you would the typical company. But how much more? Profits at Apple grew 85 percent last year. Its stock is trading at 13 times.

And while the big profit growth for Facebook is impressive, it's slowing, and has been for three years. Last quarter, the growth turned negative, meaning it fell — down 12 percent from the first three months a year ago.

I think Facebook is one of the best things to happen in America in years. It's an unlikely, brazen success that makes you believe that the nation's best days may still be ahead. A college kid starts an online bulletin board for his classmates in 2004, and now one-seventh of the world's population is using it.

And the company is not just profitable, but incredibly so. Whereas most companies have to content themselves with pulling 10 cents of profit out of every dollar of sales, Facebook gets to keep a seemingly impossible 50 cents.

And therein lies another problem: No company can sustain margins that high for long. If you believe America is a place that gives rise to destructive, capitalistic forces like Mark Zuckerberg, you know those margins are going to collapse, and fast. They are too high not to attract competitors.

What Facebook did to MySpace, a rival yet unknown can do to it. Or a rival suddenly known, like Pinterest.

Not familiar with that company? I wasn't until earlier this year. A sort of online scrapbook, Pinterest now has 10 million monthly visitors, even though its site was launched just in 2009. That growth is faster than even Facebook's, according to comScore, a tracker of Internet traffic.

The fact is, the social media industry is too open to competition for comfort. It lacks what Warren Buffett calls a "deep moat" protecting it from rivals. Scoff if you want, but how many college kids can build a rival to Burlington Northern Santa Fe railroad, a Buffett holding? Where would they get the steel for the lines, much less the men to lay them?

Another problem with Facebook is that the very qualities that made it so successful as a private firm could sink it as a public one.

Facebook says in its IPO papers that it's not about to rein in the sort of rebel culture at the company that has encouraged "innovation" just to deliver "short-term" profits that please Wall Street investors.

If only "short-term" profits were the only demand. When you go public, you are promising investors that your profits will not only rise, but do so consistently, quarter after quarter, in predictable increments. It's a fiction. The nature of many businesses is such that profits come in messy lumps. But companies exploit loose accounting rules, as Wall Street expects them to do, to make their profits seem smoother than they really are.

Is Facebook not going play this game, either? That would be admirable. And disastrous for investors.

I suspect what's got everyone in a lather about Facebook is that they think it could become the next Google or Amazon. Those stocks went public at high earnings multiples, and still managed to reward investors handsomely.

But the bulls forget the big role played by happenstance and luck in business success, and how difficult it is to separate winners from clunkers ahead of time. And there have been a lot of clunkers: ICG, Priceline.com, Pets.com, Netscape and, more recently, Pandora Media, Demand Media and Groupon. The stocks of those latter three are down more than a third from their IPOs last year.

Maybe this is just a matter of taste. I prefer the dowdy and obscure over the hot and well-known.

But I think there's another distinction here. Facebook is a gamble, a fun fling, like buying a lottery ticket. The valuation is just too high, the unknowns too many, to call it an investment. If you're going to sink money into the company, recognize that much at least.



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