With Facebook looking to issue shares on the stock market this spring, a popular question at the moment is “should I buy Facebook shares”?

The answer to this question, of course, depends on the share price you will have to pay at the time of the float, which will not be published until nearer the time.

In other words, it all depends on the valuation of the business at the time of Facebook’s Initial Public Offering (IPO).

If you think the business is worth more than this valuation, then buy the shares.

If you think the business is not worth that much money, then avoid the shares and wait for them to fall in price before buying.

But how will you know whether the company’s valuation is high, low or about right?

What Is Fair Value For Facebook?

Valuing a company is not quite as straight-forward as you might think.

As I explained in my article on Valuation Methods, there are 3 main ways of valuing a company which we will apply to Facebook now.

The data we will use is taken from the Facebook Inc.’s Registration Document recently published with the Securities Exchange Commission (SEC).

Net Asset Valuation Method

At the end of 2011, Facebook’s Net Assets were valued at $4,899 million.

However, as Facebook is not an asset rich company (it is not like a real estate company, for example), it would be unfair to value Facebook at only 1 times its asset value.

So how many times should we value it at?

As a comparator, Google is currently valued at 2.65 times net assets and Yahoo at 1.58 times.

These ratios are known as Price to Book Value (PBV) ratios.

Applying these ratios to Facebook, yields a valuation of $7.74 billion to $12.982 billion.

Notice that these valuations are well short of the $80 billion to $100 billion valuations that we have heard about in the media!

Price To Earnings Comparison Method

Facebook made $1 billion net income in 2011, otherwise known as earnings.

To arrive at a valuation, we need to multiply this figure by a suitable number.

Again, for comparison, Google’s share price is trading on a multiple of 20.4 times earnings and Yahoo is trading on 19.2 times.

These multiples are known as PE Ratios.

Applying these to Facebook yields a valuation of $19.2 billion to $20.4 billion.

Notice that these too, fall well short of the $80 to $100 billion valuations mentioned elsewhere.

Discounted Cash Flow Method

To do this, we need to forecast the future revenues, profit margins, profits, cash flows, capital expenditure, borrowing levels, and so on.

For the reasons I mentioned in my valuation methods article, I’m not going to attempt this method here as it is far too complicated and we would have to make far too many assumptions due to the scant data published in the prospectus.

However, it is worth considering some of the information we do have and considering the possible scenarios.

How Does Facebook Make Money?

Facebook is a social media website on the Internet where people can “go” to message their friends and share content such as pictures, videos, etc.

It has 847 million users around the world and is still growing, although there is evidence of slowing growth.

That said, Facebook does not make any money from these social media interactions directly.

85% of its income comes indirectly from advertising, charging businesses to advertise products and services on the Facebook website.

However, the document mentions that it does not advertise on its mobile platforms at the moment, presumably because of the lack of space?

It also mentions the growth in use of mobile devices as a risk in its prospectus document.

To my mind, this is a massive risk!

What the document fails to mention is how mobile devices are fast becoming the platform of choice for surfing the Internet.

Many of the countries around the world where Facebook are yet to penetrate and grow their user base do not have broadband networks and computers (desktops and laptops) akin to the US and Europe but they have fast growing mobile networks and smartphone devices.

Even in the “developed economies”, there is growing evidence that new Smartphone and tablet users are abandoning their computers and surfing the Internet exclusively on their new mobile device.

Internet surfing via mobile devices is set to overtake that by computers as early as 2014 – in the next 2 years!

The other 15% of Facebook’s revenue comes from games played on the Facebook “platform” all of which are provided by a single company/partner called Zynga.

The games revenue is growing much faster than the advertising revenue and this trend is expected to continue.

However, reliance on one company for 15% of your revenue is not good.

But why should we worry?

Facebook is dominant right, and who is going to stop Facebook from growing fast for ever?

Who Are Facebook’s Competitors?

The most obvious competitors are probably other social media sites like Twitter and Linkedin, however they seem to be growing rapidly alongside Facebook as complementary sites rather than competitors.

This could change though!

Note that Facebook has introduced a new Twitter-like ticker feed into its recent new-look timeline development.

How do you think Twitter will respond?

Google has recently launched its +1 service which is growing much faster than Facebook did at the same stage.

This suggests that it may not be too long before it becomes a serious contender in exactly the same space as Facebook and has certain advantages over Facebook with its email system, search engines, ownership of YouTube and advertising methods.

That reminds me – we need to remember that Facebook is making its money from selling its advertising space and gaming platform.

Thus it is competing against other forms of advertising space both online and offline and economic recessions, such as we have at the moment, are not good for advertising businesses.

Facebook’s advantages here, though, are the huge user base of 847 million users around the world and the personal information that it holds in its databases from all the social content, biographical information and “likes” that we give it for free!

As for gaming platforms, Facebook is competing against other online gaming providers.

It has a single joint venture relationship with Zynga and will need to sign up others in future to protect this revenue stream and grow it further.

All this is a bit obvious though and we need to look more broadly.

What about the mobile devices I mentioned earlier?

Who is big in this technology and could become the mobile version of Facebook?

Mobile Version of Facebook?

Ever heard of Apple?

Apple is doing a great job of developing those mobile devices I mentioned and integrating them with iTunes, Apps Store, the iCloud and developing social services such as Genius and so on.

If you think that Facebook is safe and secure and too dominant, think again!

Mobile devices could be the destructive technology that finally ends the use of desktop and laptop computers as we know it today.

Like Compact Disks replacing cassette tapes and vinyl records and like music downloads replacing CDs!

Remember Myspace?

It was around before Facebook but nobody seems to use it now, do they?

What happened to Yahoo as a search engine?

How did Google overtake it to become number 1?

Anybody still using Hotmail?

Yep, Google seemed to capture that market too?

What’s the betting that Google+1 will capture Facebook’s market too?

Facebook greatly increased its investment in research in 2011 in response to the challenge it realizes it now faces but it does not have the financial firepower of Google or Apple.

Google’s net income in 2011 was $9.737 billion, nearly 10 times that of Facebook.

Apple’s net income in 2011 was $25.922 billion, nearly 26 times that of Facebook.

Should I Buy Facebook Shares?

Before I did my research for this article, my instinct told me that Facebook’s shares were over-hyped and overpriced.

Why?

Because I’ve been around a long time and learned a lot of lessons (from losing money following the hype) during the last dotcom boom in 2000-2003.

Now that I’ve done some research, the financials and business analysis tell me that Facebook is definitely overpriced by 4 to 5 times its true fair value.

Ah yes, I hear you say, but Facebook has great prospects which I have not factored in to my valuation.

Really?!?!?

Google has great prospects too which are factored into it’s share price and ratios which we have compared against and applied to Facebook.

In other words, my valuation of Facebook assumes that it’s future prospects are as good as those of Google.

Whilst I agree that Facebook will continue to grow, I don’t agree that it will grow 4 to 5 times faster than Google and that it’s prospects are 4 to 5 times better.

If anything, I’d suggest that Facebook will not grow as fast as Google in the next 5 to 10 years.

I would also suggest that there is a greater likelihood of Facebook fading away like Myspace within a 5-10 year timescale and that is why Mark Zuckerburg is floating Facebook shares now, at their peak, just in case.

During its early years, Facebook was left alone to grow and develop unchecked.

Now, as it starts stepping on the toes of the bigger boys in the playground, Facebook will start to get more attention from those bigger boys.

And we are seeing this already with Google+1.

As you’ve probably guessed by now, I will be avoiding Facebook unless it is floated at a realistic price below $20 billion valuation.

Which means that if Facebook wants to raise $5 billion in their IPO, they will need to issue 25% of their shares or more for me to become interested.

I think that is very unlikely.

But there is some good news!

A by-product of my research is that I like the look of Google and I really like the look of Apple shares at the moment.

To my mind, they have much more to offer the investor than Facebook.

I’d be very interested in your views on this topic so please leave me a comment below.

Alternatively, let me know if you have found this article useful by leaving a comment or clicking the share buttons.

Kind regards,

Adrian