Facebook (Nasdaq:FB) shares have all but halved in value since its IPO in May. What is next for Facebook's stock price? Well, if the arguments for a recovery don't differ significantly from the arguments made for the IPO, surely gravity will continue to exert its influence on this popular tech stock.
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Does Facebook's P/E Make Sense?
It is tough to see how. With the stock at around $20 and using declared earnings per share, the P/E ratio is in excess of 100. History has not been kind to the price of stocks in this P/E ballpark. Even using current predicted earnings, the P/E is somewhere around 40, which by any historical measure points to over-valuation. Therefore, to expect a rally, the investor has to believe these ratios will improve. This means that Facebook needs either more users and/or more earnings per user.
Active Facebook users are somewhere just shy of one billion in number. This has grown at around 30% over the last year. So investors might point to this growth rate and see exponential numbers at work. Surely if this growth continues, the earnings will skyrocket, right? Unfortunately, when a company reaches such huge absolute numbers of users, applying a percentage growth rate becomes fraught with danger. After all, if this growth rate continues, within five years Facebook users will exceed the number of Internet users in the world, (currently around 2.27 billion). At this rate, there will be more Facebook users than human beings by the end of the decade. In short, an increase in user numbers cannot bring these P/E ratios into sensible order by itself.
Earnings Per User
That leaves increasing revenue per user as the only way to improve the P/E situation. The problem here is that there is really too little to go on to predict a surge in the yield per user. Sure, Facebook may be looking to diversify its revenue stream (currently over 80% advertising-based). But then we are entering the realms of hope rather than expectation. There is little track record and often no precedent here for what Facebook needs to achieve to prevent the decline in its valuation.
Does Facebook Offer Reasons to Be Bullish?
Because, really, this is the only other way for the stock price to be in any way justifiable at its current level, let alone to indicate a rally. If Facebook has vast quantities of low-hanging fruit to harvest and the company just needs the right business strategy in place, then great. However, as soon as we try to run with that story, we find ourselves mired in risk. Facebook clearly does not represent a low-risk proposition by any sensible assessment. High risk is fine of course, so long as the investor is compensated with a generous P/E or an otherwise cheap stock valuation. Yet we know Facebook to be expensive by these metrics. This is concerning, because the risks are considerable.
For example, take the 67% growth in mobile users in the last 12 months; that's a large figure that few predicted. At the moment, it represents a risk more than an opportunity, because mobile users yield far less than non-mobile users. While so many of Facebook's eggs are in the advertising basket, its sensitivity to changes in user behavior patterns, such as migration to other devices or platforms to access the service, will remain acute.
Further risks lie in the vesting of stock and the end of various lock-ins. These mechanisms prevent some stockholders from selling their shares, many of which are set to expire presently, before a certain date. Although hard to quantify, all one can say is that this adds selling pressure, rather than anything positive.
Finally, the Sword of Dotcomacles, represented by unforeseeable up-start social networks, hangs over Facebook, no less than it did over MySpace. Sure, Facebook has its war chest (namely a $10 billion cash pile mainly from its IPO), and it can, in theory, buy out potential rivals that could spring up at any moment from another campus dormitory. But do you recall a social network startup that surpassed the established competition and whose CEO steadfastly refused to sell the company at any price until they achieved dominance?
The Bottom Line
The stock is expensive by any traditional measure. A rally could only really come from an irrational market move (not based on fundamentals) or a completely unforeseeable surge in revenues, which is hardly an appealing foundation for any investment strategy. The most credible case that can currently be made surely points to another round of selling off for FB. Expect put options to trade at a premium.
At the time of writing, Simon Gleadall did not own shares in any of the companies mentioned in this article.