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Is Facebook a Buy? Only If It’s the Next Google

Michael Santoli

With its share price roughly doubling since the summer, Facebook Inc.’s (FB) market value has surged by a greater amount in a short period of time than virtually any large company in memory.

Facebook image: Credit Reuters

When the stock of the social-media giant finished June at $24.88, it had a market value of just over $60 billion. By the end of the third quarter, it stood at $50.23 a share and was worth $122 billion. The shares continued to climb from there, inching above $51 in the past week, though they did pull back on Tuesday to $47.14 as tech stocks endured a tough session.

According to Standard & Poor’s Indexes and S&P Capial IQ, which performed historical screens upon request, only twice in a generation -- and probably only twice in history -- has a company that started with a market value of at least $40 billion doubled within a single quarter, both times near the climax of the late-‘90s tech-stock bubble.

Yahoo Inc. (YHOO) (parent company of Yahoo Finance), doubled to more than $110 billion in the final months of 1999, as an expectation that the company would be added to the S&P 500 served as an afterburner to the already break-neck speculative momentum in Internet stocks. In that same period, Oracle Corp. (ORCL) more than doubled in value off a similarly large base.

None of today's large moon-shot stocks that might come to mind achieved such a rapid accretion. Neither Apple Inc. (AAPL) nor Amazon.com (AMZN) did so, despite periods of intense appreciation. And the likes of Netflix Inc. (NFLX) and LinkedIn (LNKD) are not nearly so big.

What happened?

Several factors had to be in place for Facebook to go from doghouse to penthouse in just a few months.

There was deep, abiding skepticism among investors about whether Facebook could continue to command so much of users’ time, especially on mobile devices. The taint of Facebook’s botched initial public offering in May 2012 was slow to wear off, not least because founder and CEO Mark Zuckerberg hadn’t fully persuaded Wall Street that he was willing or able to produce investor-friendly financial results in the near term. Last quarter’s earnings report, including evidence of good traction in mobile ads, allayed those fears.

Mechanical elements were also at work. For such a big company, Facebook has a relatively small percentage of its shares freely floating, with founders and early investors controlling some 40%. Large money managers’ urgency to gain exposure to a relatively limited amount of social-media-stock supply has helped propel the whole sector skyward. (The impending IPO of Twitter Inc., which is at a more nascent stage in monetizing its user base, will likely increase excitement about social-media businesses while in the near term making Facebook appear financially impressive.)

Facebook stock chart

Talk that Facebook could join the S&P 500 before long -- entering many fund managers’ benchmark and triggering automatic demand from index funds -- has also been a feature of the rally.

This is not to say that Facebook is caught up in the same sort of unsustainable buying frenzy of the tech-stock mania that ended in 2000. While it's a very expensive stock at 50 times projected 2014 profits, Facebook is a dominant and quite profitable company with unmatched breadth of users and room for rapid growth overseas. And $120 billion in today’s dollars isn’t as huge as what it was 13 years ago.

Facebook is on pace to earn close to $2 billion on more than $7 billion in revenue this year, with the top line growing more than 40% from last year and projected to rise in excess of 30% annually in the future. Yet after its historic run, the value being placed on Facebook’s demonstrated earnings power and prospects means the market is suddenly giving the company enormous credit, up front, for many years of continued dominance and successful exploitation of advertising and e-commerce opportunities that remain uncertainties.

The Google experience

What to make of the fact that sentiment flipped so dramatically? Can such a change of heart by the market be taken as a reliable verdict? Being aggressively bullish on Facebook at its current price is implicitly a bet that it will replicate the growth and near-flawless strategic execution of Google Inc. (GOOG), the most successful, dominant, industry-defining company of the past decade.

As it happens, Facebook’s size and IPO experience match up rather nicely. When Google came public in 2004, it faced widespread skepticism of its financial opportunity and valuation. The consensus on Google ran something like this: A quirky management team running a company with a silly name that could easily be displaced by the next search engine, and one that used an odd electronic open-auction process to go public.

Yet the stock almost immediately began its impressive ascent (eliciting barbs that it was an echo of the ’99 ‘Net bubble). In year three as a public company, 2006, it had grown to a size very close to what Facebook is forecast to become in its year three in 2014.

Google reached $10.6 billion in revenue in 2006, while Facebook is expected to approach $10 billion next year. Google's earnings more than doubled to just over $3 billion in net income in ’06 -- a bit more than the $2.5 billion Facebook profit estimate for 2014.

And, what do you know, in 2005 Google's shares had soared 135% to attain a valuation of $120 billion, just about what Facebook has today.

Canaccord Genuity analyst Michael Graham, who began coverage of Facebook on Sept. 24 with a Buy rating and price target of $60, did so while invoking the Google comparison -- in an upbeat way.

“We recognize the stock was more attractive a few months ago when it only sported a $60 billion market cap,” Graham writes. “That said, we believe that as long as the business keeps moving in the right direction, growth can catch up with the multiple and help the stock to keep working.”

He notes that even after more than doubling in 2005, Google shares have handily outperformed the market since and today trade near $867.

This is true. But replicating the performance means clearing a high bar. And for investors who bought Google after its fabulous 2005 run, it wasn’t always smooth. Even as the company performed exceedingly well in 2006, Google stock knocked around a range, falling as much as 18% in the first quarter that year before recovering. The stock ultimately underperformed the S&P 500 for the calendar year, before lifting off anew.