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.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

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.

Facebook Users
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.

Mobile Risk
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.

DotCom Trends
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.

Related Articles
  1. Investing

    Is It Time To Bet On The iPad Again?

    Apple's focus on iPad has been fairly tepid these past few years. But, the iPad Pro was the centerpiece of the company's latest product announcements. Why?
  2. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  3. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  4. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  5. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  6. Stock Analysis

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  7. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  8. Stock Analysis

    The Biggest Risks of Investing in Netflix Stock

    Examine the current state of Netflix Inc., and learn about three of the major fundamental risks that the company is currently facing.
  9. Stock Analysis

    What Seagate Gains by Acquiring Dot Hill Systems

    Examine the Seagate acquisition of Dot Hill Systems, and learn what Seagate is looking to gain by acquiring Dot Hill's software technology.
  10. Stock Analysis

    What Will HP's Split Do to Its Stock?

    Read about Hewlett-Packard Enterprises, a new spinoff company from Hewlett-Packard. Understand how the two companies will focus on different markets.
  1. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
  2. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
  3. How do I use discounted cash flow (DCF) to value stock?

    Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
  4. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  5. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  6. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!