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  • fairvalue23 fairvalue23 Mar 1, 2013 8:57 AM Flag

    Facebook’s stock should trade for $13.80 Here’s a fair-price calculation for Facebook

    Facebook’s stock should trade for $13.80
    Commentary: Here’s a fair-price calculation for Facebook - . So, in order to entice someone to invest in it today, Facebook needs to offer a handsome return. Assuming that its five-year return is equal to the stock market’s long-term average return of 11% annualized, Facebook shares currently would need to be trading at just $13.80.
    CHAPEL HILL, N.C. (MarketWatch) — Well, then, what should be the price of Facebook’s stock?
    Rather than endlessly rehashing the events that have taken place over the past week, it is this question that investors should be asking. Surprisingly, however, few are doing so.
    And yet, courtesy of a just-released study, calculating a fair price for Facebook’s stock isn’t as difficult as it might otherwise seem.
    The study is entitled “Post-IPO Employment and Revenue Growth for U.S. IPOs, June 1996–2010.” Its authors are Jay Ritter, a finance professor at the University of Florida, and two researchers at the University of California, Davis: Martin Kenney, a professor in the Department of Human and Community Development, and Donald Patton, a research associate in that same department. (Click here to read a copy of their study.)

    The researchers found that the revenue of the average company going public in the period analyzed in the study grew by 212% over the five years after its IPO (excluding spinoffs and buyouts). Assuming Facebook’s revenue grows just as fast, and given that the company’s latest-year revenue was $3.71 billion, its annual revenue in five years’ time will be $11.58 billion.
    Since Facebook (US:FB) is most often compared to Google (US:GOOG) , let’s assume that its price-to-sales ratio in five years will be just as high as Google’s is currently: 5.51-to-1. You could argue that this is an overly generous assumption, of course. But it nevertheless means Facebook’s market cap in five years will be just $63.8 billion — 30% less than where it stands today.
    Assuming that the total number of its shares stays constant, that works out to a price per share of just $23.26 — in contrast to its recent closing price of $33.03.
    Ouch.
    Actually, however, the news is even worse: No one is going to invest in Facebook shares today if its price will be 30% lower in five years. So, in order to entice someone to invest in it today, Facebook needs to offer a handsome return. Assuming that its five-year return is equal to the stock market’s long-term average return of 11% annualized, Facebook shares currently would need to be trading at just $13.80.
    Double ouch.
    Don’t like that answer? Try focusing on earnings rather than sales, and you get only a marginally different result. Assuming its profit margin stays constant (instead of falling as it could very well do as it grows), assuming its P/E ratio in five years will be just as high as Google’s is today, and assuming that its stock will produce a five-year return of 11% annualized, Facebook’s stock today should be just $16.66.
    How can Facebook investors wriggle out from underneath the awful picture these calculations paint? By assuming that its revenue and profitability will grow faster than the average IPO between 1996 and 2010 — and not just by a little bit, either, but a whole lot faster.
    Of course, it’s always possible that Facebook will be able to pull that off.
    But, as Professor Ritter pointed out to me earlier this week, “the bigger a company gets, the harder it is to maintain percentage growth.” And Facebook is already huge — larger, in fact, than all but 47 other publicly traded companies in the U.S., by market capitalization.
    So my back-of-the-envelope calculations for this column could very well be too optimistic rather than too pessimistic.
    Given all this, Ritter said that a market cap “of $63 billion ... five years from now seems like a very reasonable scenario.”

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