If you’re tapped into social media, you’ve likely heard the latest hype about Facebook’s share prices. Facebook has drawn a lot of attention and, as a result, a lot of demand for its underlying common stock.
How Facebook is Valued
There are a lot of different methods for valuing shares in publicly traded companies. Two of the more common approaches are to look at present earnings versus the current share price and decide whether a company is under or overvalued based on some multiple of those two figures. This is known as the price to earnings ratio. The second common approach, and probably the one more applicable to social media companies, is future projected price to earnings. This approach is nothing more then educated guess work, and in many cases can lead investors to pay large dollar amounts for a company based on their potential earnings rather than current earnings.
The argument is that because social media sites have so many users, they can leverage that user base into advertising dollars. It sounds great, in theory, and even in practice we are starting to see those advertising dollars roll in for Facebook. The company recently reported $2.02 billion of revenue for the third quarter of 2013. That’s certainly a lot of money, but if you take a look at what that means in the bigger picture that’s simply .39 cents for each share they have outstanding. If you were to purchase Facebook’s stock today, you would be paying almost 150 times their earnings. The closing price on January 13th, 2014, was $56.46 per share.
Even if you account for future potential earnings, Facebook would have to triple their revenue to bring their multiples down to any sort of reasonable historical P/E ratio (according to Morningstar.com, S&P 500 companies have a historical P/E ratio of roughly 15). Furthermore, a future tripling of revenue would only justify the current price. For any further appreciation of the share price, the growth would have to continue at an exponential rate, which seems highly unrealistic, even by Facebook standards.
Technology Craze Notables
Despite all this, don’t be surprised if Facebook’s share price continues to rise in the short term. It’s widely documented from the 1999-2000 technology craze that companies share prices appreciated substantially regardless of their underlying fundamentals or profitability. You may or may not remember some of these under-achievers from that time period:
- Boo.com -- spent $188 million in just six months n an attempt to create a global online fashion store that went bankrupt in May 2000.
- Broadcast.com -- acquired by Yahoo! for $5.9 billion in stock, making Mark Cuban a multi-billionaire. The site is now defunct and redirects to Yahoo!'s home page.
- Freeinternet.com – Filed for bankruptcy in October 2000, soon after canceling its initial public offeringISP in the United StatesBaby Bob, the company lost $19 million in 1999 on revenues of less than $1 million.
- GeoCities – Purchased by Yahoo! for $3.57 billion in January 1999. Yahoo! closed GeoCities on October 26, 2009.
- theGlobe.com -- social networking service that went live in April 1995 and made headlines by going public on November 1998 and posting the largest first day gain of any IPO in history up to that date.
- inktomi – Valuation of $25 billion in March 2000.
- InfoSpace – In March 2000 this stock reached a price $1,305 per share, but by April 2001 the price had crashed down to $22 a share.
- MicroStrategy -- shares lost more than half of their value on March 20, 2000, following their announcement of re-stated financials for the previous two years. A BusinessWeek editorial said at the time, "The company's misfortune is a wake-up call to all dot-com investors. The message: It's time, at last, to pay attention to the numbers."
- Xcelera.com – Swedish investor in start-up technology firms that was one of the "greatest one-year rise of any exchange-listed stock in the history of Wall Street."
If there’s one take-away from this list it is this: Short-term speculation is no different than gambling and can end badly. In the end, fundamentals usually win. As legendary investor Warren Buffet so aptly put it, "The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money.”
Matthew Trujillo is a Registered Support Associate at Center for Financial Planning, Inc. Matt currently assists Center planners and clients, and is a contributor to Money Centered.
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