Fuzzy Math, Greater Fools and the Facebook IPO

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I have several friends who think the Facebook IPO is the next Microsoft.

I think it's more likely the next Research in Motion.

Or perhaps the next Sony, Kodak, or Eastern Airlines–all of which were once world-class brands that got sideswiped by hungry new competitors.

Facebook…you may as well buy a lottery ticket.

Don't get me wrong. In just a few short years, Facebook has accumulated an unprecedented 845 million users representing 12.07% of the world's population.

But does that merit an offering worth as much as $100 billion?

Maybe to a lot of people, but not to me.

Think about the numbers.

There are 7 billion people on the planet today, 5.15 billion of whom live on $10 or less a day. Of that group, roughly 3 billion people live on less than $2.50 a day.

That means if you remove those who live on less than $10 a day because theoretically they can't afford a computer or don't have enough disposable income to be monetized, that leaves roughly 1.85 billion potential Facebook users.

In a perfect world where a company could capture 100% of its target market, that would cap Facebook's potential user growth at 118.93%.

But we don't live in perfect world. As far as I know, no company has ever captured 100% of its target market. Not once.

There are always those who drop off, leave or simply don't buy no matter what the product is or how good the "offer."

That's not to say it couldn't happen, but unless Team Zuckerberg figures out new ways to monetize users or invents an entirely new class of customers, there is relatively little upside remaining in terms of the company's target market.

The Fuzzy Math Behind Facebook

And another thing, in my best Andy Rooney voice, according to Yahoo Finance, Microsoft's adjusted close on March 13, 1986 was $0.08. As of January 30, 2012, the stock was trading at $29.61, which means Microsoft stock has delivered a mouthwatering 36,913% return over the last 26 years.

For Facebook to deliver similar returns at its proposed $100 billion valuation, Facebook's market cap would have to increase to $36.21 trillion. That's roughly 57.47% of the entire world's GDP.

Possible? Sure. But there's a big difference between that and what's probable.

If Facebook is really worth $100 billion, that means the company would come out of the gate at roughly 27 times 2011 sales and nearly 100 times 2011 earnings. By comparison, Google trades at 5.22 times sales and carries a P/E ratio of 20.42 times earnings.

In other words, you'll have to wait 100 years to justify your Facebook investment versus a mere 20.42 years for Google. Dividends would obviously bring that figure down in a hurry, but to my knowledge the company has no such plans.

Google went public in 2004, raising $1.9 billion against a valuation of $23 billion – a record for the largest U.S. Internet IPO that has stood until now. At the time that worked out to 10 times sales, or less than half of Facebook's proposed initial valuation.

Even Apple, by a far more dynamic company backed by real products, trades at only 3.38 times sales. That's less than 20% of the estimates for Facebook's projected price to sales ratio. And Apple has a market cap of $460 billion.

Facebook's Greater Fools

At the end of the day, I realize that nothing I say can change your mind if you've decided to take the plunge, so I'll wrap up with one final thought.

Investors who fancy tech stocks often argue that the future matters more than current valuations, no matter how absurd they might be. That's why stocks like Facebook are "worth" the risk.

I have no comeback to that. I can't argue with how a technology might be used 10 years from now.

But I can point out that companies like Apple (Nasdaq: AAPL), Google (Nasdaq: GOOG), and Microsoft (Nasdaq: MSFT) are fairly valued based on current earnings, cash flow and their respective cash stockpiles.

In other words, their stock prices reflect stuff that could realistically have a material effect on how each of these companies grows within the next 12 months – or not.

So where does that leave us?

If you're a day trader and you have money to burn, Facebook may make a superb opportunity. I think it could easily double on nothing more than the greater fool theory.

You know the one…that's where you plunk your money down on nothing more than a wing and a prayer (because you don't have earnings, sales or real products to back up your chosen investment).

And you hope a greater fool comes along at some point in the future willing to pay you more money than you spent to buy the stock in the first place. Just remember — you're the greater fool who bought it in the first place.

But if you're an investor, I'd wait a year.

Let Facebook go public and bleed out the hype. Give it some time to build a public track record. Then, using that data, make a market-based determination as to whether or not you want to invest.

Of course, I suppose you could always break out the Magic 8-ball, too.

Just make sure you shake it hard enough to avoid another case of "MySpace."

Join the conversation. Click here to jump to comments…

About the Author

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs The Geiger Index, a reliable, emotion-free guide to making big money and avoiding losses, and Strike Force, which aims to get in, target gains, and get out clean. In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.

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  1. Sterling Lamoreux | February 10, 2012

    Right on, my thoughts exactly.

  2. Saso | February 10, 2012

    Keith thank you for your point of view on facebook. I think I'll pass:)

  3. Joe Barboza | February 10, 2012

    I could not agree more, Facebook has yet to fiqure how to monitize themselves to profitability nevermind dividends

  4. brian | February 10, 2012

    Keith,
    Just so you know, Eastern Air lines was out to sleep by organized labor as it believed that scrificing that airline would effectively halt the trend of de-unionizing led by Frank Lorenzo that was going on in the industry at the time. Hungry new competetors had absolutely nothing to do with Easterns demise.

  5. ELWEX | February 10, 2012

    THOUGHT THIS WOULD BE OF INTEREST TO YOU

    MAGOO

  6. Joseph | February 10, 2012

    Thanks I agree wholeheartedly with all of your thoughts and impressions! I say hype and marketing
    is not substitute for cash-flow and real products, services and paying customers. Having a free
    account on Facebook is not the same as being a paying customer like say Verizon, Comcast, Apple,
    etc etc etc have and I see this as another tech bubble so buyer, or investor beware! It has been
    proven by AOL already that people will not pay for services that they can get for free!!!

  7. José | February 10, 2012

    Not being a financial or economic expert i though that the criterium of value was profit. Not sales or customer numbers. Am I wrong?..

  8. Paul | February 10, 2012

    Between the lack of barriers to entry, the fickleness of the user base, and the already demonstrated fact that Facebook can only increase its revenues by data mining that will be declared illegal over privacy concerns, there is no sustainable business model that I can see. Google was the rarity, and even it has moved away from search and ads to selling the Droid OS, which is certainly the Microsoft revenue model. Facebook seems to me to like Yahoo when it first broke in the mid 90's during the dot bomb era. And oh, yes, throw LinkedIn and Groupon into the same hole.

  9. jrj90620 | February 10, 2012

    According to one analyst,on the PBS Nightly Business Report,young people,she's spoken to, are getting tired of Facebook and leaving it.If that's true,they may have a hard time even keeping their current numbers from declining.Add all the new competitors,like Google and this looks like a potential disaster.

  10. Tom | February 10, 2012

    Thanks for the insight. There are better places to speculate.

  11. Steve | February 10, 2012

    I have no use for Facebook. Too busy.

  12. Justin Case | February 10, 2012

    "As far as I know, no company has ever captured 100% of its target market. Not once."

    That would be incorrect.
    There is a company called Apple Computer that has successfully done that. It's target market is the iDiots with money. It has captured every single one of them. Even some outside it's target market. Ka-ching……….

  13. Carlos | February 11, 2012

    It seems like a short story to me after the hype…remember ebay?

  14. Mike | February 12, 2012

    This isn't just a simple case of a sucker and his money soon parting, but how they ever got together in the first place. This is not an investment but a day trade looking to dump stock on the bigger sucker because at the end of the day, all you have left is a piece of wothless paper. He is just a carny with face paint. " This way to see the egress" for all you older folks.

  15. MARK KEMPER | February 12, 2012

    You can not use the number of users because so many of the users have dormant accounts. They post for a week or two then hardly look at it again. I like Google+ better but Google messed up and kept it invite only for too long. All Facebook has to do is have one really bad misstep an a lot of Facebook users already have inactive accounts on Google+ they can move too.

  16. Mina Teal | February 12, 2012

    Dear Folks

    I have just come a board. I have lots of goodies to get into. I think you are wise to stay to stay away from Facebook. I think to many bankers and ect. will try to make to much money out of it when first comes on board. Let it cool away down then look at it.
    Mina Teal

  17. Jack | May 25, 2012

    Thanks for your thoughts and speculations! I realy agree with you….. Please keep up the good work.

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