Too much success is priced into Facebook’s IPO

February 2, 2012

By Richard Beales
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Investors will have to like Facebook a lot to justify a potential $100 billion valuation. Essentially, growth and margins would both need to track Google’s trajectory to justify a price tag so high.

A 12-digit valuation is conceivable. Equate Facebook’s 2011 revenue of $3.7 billion with Google’s $3.1 billion in 2004. Apply Google’s subsequent annual growth and its fairly consistent 30 percent operating margins. Allow for tax and a little investment and then discount the remaining cash flow at 12 percent, and the present value is almost exactly $100 billion, according to Anant Sundaram of Dartmouth’s Tuck School of Business.

That puts a lot of faith in Facebook founder Mark Zuckerberg. Assuming the company’s dependence on advertising for 85 percent of revenue declines to 75 percent in a decade, Sundaram reckons current trends suggest Google and Facebook together would need to attract a fifth of all global ad spending by 2021. That would mean displacing a lot of media.

Then there’s growth. Google’s revenue more than doubled in 2004 before drifting down to 92 percent the following year. Facebook’s 2011 revenue was already “only” 88 percent more than in 2010. And sales increased just 55 percent in the last quarter over the same period a year earlier.

Facebook could reignite growth, extract more dollars per user and beat Google at parts of the ad game. Then again, maybe Google triumphs or upstarts muscle in on both of them. Two-thirds of the value in Sundaram’s discounted cash flow model comes after 2021, and distant cash flows are highly susceptible to such risks.

Instead, conservatively cap Facebook’s annual revenue growth at 55 percent and raise the discount rate to a more risk-averse 15 percent, and the valuation falls below $50 billion – coincidentally, about what Google was worth at the end of 2004.

Of course, Facebook could sustain its impressive operating margins and discover new sources of revenue. The hype coupled with limited supply also could make the IPO a hit. But anyone with a longer investment horizon will have to decide if any valuation much above $50 billion leaves enough room for uncertainty and upside.

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