Facebook IPO

02.01.12

Beware the Facebook Hype: Investors Encourage Company’s Insane IPO

No rational person thinks Facebook is worth $100 billion. But that’s OK—there are more than enough irrational people to make the company’s massive IPO deal happen.

Facebook is expected to announce its IPO registration Wednesday, and is rumored to be seeking a valuation of $100 billion. That’s more than half of Google’s market value, which stands at $188 billion. But Facebook brings in only one 10th the revenues that Google does. So how can it possibly be worth half as much as Google?

That is a question that any other company might have to answer as it tries to sell stock to the public. But not Facebook. This company is different. No matter what the price, investors will clamor to own a piece of a company that has defined social networking and has, in effect, built its own private Internet, with more than 800 million members.

Facebook reportedly aims to raise $5 billion (earlier reports guessed $10 billion) in the deal, which would take place in May and rank as one of the biggest IPOs of all time. (See chart.)

There are lots of reasons to be wary, including these:

• Facebook’s operating profit for 2011 is said to have been about $1.5 billion. That’s a respectable profit margin, but by no means outstanding.

• As Business Insider pointed out, Facebook is seven years old and its revenues lag behind what Google’s were in its seventh year. Moreover, Google was building its business at a time when there was less overall ad spending on the Internet.

• Google’s answer to Facebook, the Google+ social network, now has 90 million members and is growing quickly. It’s no threat to Facebook today but could be in the future.

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But the biggest concern is the $100 billion valuation that Facebook is seeking. To get an idea how outrageous this is, consider that Apple—the biggest, most powerful, most lucrative tech company in the world—sells for just over three times last year’s revenues. If you valued Facebook that way it would be worth only $12.5 billion.

Do the same calculation with Google, and Facebook is worth $20 billion. Assign the same multiple as Facebook game maker Zynga, which is one of Facebook’s biggest sources of revenue (Facebook skims 30 percent of Zynga’s virtual-goods transactions) and Facebook is worth $25 billion.

But maybe you figure that Facebook deserves a better multiple, because it will grow faster than any of these companies. So, fine. Assign Facebook double the multiple of Zynga, and even then it’s only worth $50 billion.

You get the idea. The idea that Facebook is worth $100 billion, or even $75 billion, is, well, a bit optimistic. Or would be, if there were anything rational about this deal. But there isn’t.

Investors will view the Facebook IPO the way Apple fans view every new iPad or iPhone, not so much as a product but as a kind of cultural event.

Heck, $50 billion is the valuation that Goldman Sachs and other investors paid for a chunk of Facebook in January of 2011.

Recently, shares in Facebook have been trading on secondary markets at valuations around $80 billion, according to TechCrunch.

If Facebook traded at a rational price, those investors would be underwater. But chances are, they’ll be fine. Because Facebook has a great story and an amazing brand. Who hasn’t heard of Facebook? Who doesn’t use it?

For every curmudgeon like me who grumbles about relative valuations, there will be 10 optimists in Silicon Valley who will say Facebook’s valuation makes perfect sense. They’ll remind everyone that Google and Amazon once seemed to be outrageously expensive too, but look at them today. (Just keep in mind that those optimists are probably holding Facebook shares and hoping to flog them off to the public, so of course they'll tell you what a great deal they are.)

The guys in Silicon Valley will say who cares about last year’s revenues, because Facebook is just getting started. And how can you compare Facebook with Google, or any company, for that matter? Facebook is uniquely positioned to cash in on the Internet in ways no other company can match.

Investors will view the Facebook IPO as a once-in-a-lifetime event. They will view this deal the way Apple fans view every new iPad or iPhone, not so much as a product but as a kind of cultural event, something you can’t afford to miss.

Finally, selling only $5 billion worth of stock, Facebook will constrain supply, which should boost its price. If demand is insane, Facebook can expand the amount of stock to sell.

The risk is that while Facebook may pull off a $100 billion valuation, it might have trouble going higher. Especially if at some point the irrational exuberance wears off and reality starts to set in.

The fault lies with private investors who have driven this company up so much in private markets that it’s been picked clean, leaving little upside for public investors. Something similar happened to Zynga, which had been so overpriced in private funding rounds that its IPO price was actually lower than what it fetched from T. Rowe Price, Fidelity, and others.

That sort of thing isn’t supposed to happen. But this is the brave new world of tech investing. With Facebook, and some of the other new tech companies, the smart money has already got in and got out long before the IPO ever happens.