Market Valuation: Does Facebook deserve $100 bln?

This particular question has been asked so many times since February 1, 2012, when the famous social network announced its decision to go public. Articles by experts placing the valuation at $100 bln have caused a storm of comments in the media.
The long-promised IPO has been delayed. Apparently, Facebook founder and CEO Mark Zuckerberg has been too busy with acquisitions to get prepared for the initial public offering. The social network giant bought in early April Instagram, the famous photo-sharing service, and also it struck a rather big deal with Microsoft to purchase hundreds of its patents.
Latest news came last Thursday, May 3, when Facebook filed with the SEC the official range for the price of its first offering of stock: $28 to $35, which means that Facebook aims to reach at its IPO, which should be coming within a week, the market valuation of minimum $77 bln and maximum $96 bln. After that, FB shares will be traded in the stock market.
There are fundamental questions behind this story. How do we measure the value of a business? Which methods do professionals use for valuation assessment? What makes us think a company is undervalued, or overvalued?
Professionals usually start with the Asset-based valuation. Since Facebook is expected to grow fast and generate a lot more profits in the future, its market price is bound to be much-much higher than its book value (which is $5.3 bln now).
There is also the discounted cash flow valuation, which is used by investment bankers. The DCF method involves a lot of calculations and is generally rather complicated. An interesting online simulation of the DCF analysis for Facebook has been introduced on the Financial Times web page (you can find it through Google search as “FT Facebook valuation calculator”).
Recent discussions on Facebook refer to the Multiples method. The main valuation ratio used is P/E, Price to Earnings ratio, which is the current stock price of a company divided by the company earnings per share. For example, on May 3, 2012 Apple stock was trading at $581.82 a share and earnings over the last 12 months were $41.04 per share, so Apple’s P/E ratio was 14.18. Considering that the historical P/E for S&P 500 (US stock market) is around 16, and that the current P/E ratio in the technology sector is close to 16 as well, Apple – with its relatively low P/E – is an attractive stock for investors. In fact, Apple deserves a higher P/E due to its growth potential, which is demonstrated through its low PEG (P/E to earnings growth) ratio of 0.63.
Let’s see what the market thinks about Facebook value. If we look at the recent private-market deals at SharesPost, they put Facebook value at $103-$104 bln. Back in January, two weeks before the IPO was announced, the implied valuation of the social media giant was around $80 bln. Going further back – to the year 2007 when the three-year-old social network accepted a $240 mln investment from Microsoft – most analysts laughed at the idea that Facebook may be worth $15 bln. They were so wrong.
Now again, many experts say that Facebook is a bubble. Their main arguments are based on the Multiples valuation: with $1 bln in earnings last year, the Facebook $100 bln valuation will imply the P/E ratio of 100. Normally, a P/E ratio of 25+ means the shares are overpriced. Many experts quote Apple’s multiple of 14 and Google’s P/E of 18. But is it appropriate to compare young revolutionary Facebook with dynamic but relatively mature Apple and Google?
Facebook offers to its 900-mln-and-still-growing users a totally new experience in socializing: connecting and sharing has never been so easy, the physical boundaries of relationships have been lifted, and this is all just the beginning of its powerful empire. To give you a different kind of P/E comparison: LinkedIn (another hugely popular social network site) reached the P/E of 1460 after its IPO a year ago, on May 19, 2011, and at the moment it has the P/E of 953. That one is a candidate for a bubble, Facebook is not. At least not yet. It is a demonstration of investors’ strong faith in the company’s incredible creativity and amazing brand potential. And so far there are good reasons for such high trust.