Guest post written by Aswath Damodaran

Aswath Damodaran is Professor of Finance at the Stern School of Business at New York University.

Aswath Damodaran

Now that the Facebook IPO is behind us, though the hype and the debate about the offering will continue for the weeks to come, it is time to step back and make an assessment of its value as a company, how it was priced and what may have gone awry.

Let’s start with this: yes, Facebook can be valued.

Facebook is a company with tremendous potential, with two key drivers of value: an immense user base and unparalleled information about these users. The question is whether they can convert this potential into profits, and if so, how quickly. In its IPO filing in February, Facebook reported 2011 pre-tax operating profits of $1.8 billion on revenues of $3.7 billion, making it, by far, the largest and most profitable of the social media companies. Here are four key value drivers for Facebook:

• Revenue growth : Facebook has been on a steep growth path, with revenues growing 150% in 2009 and 88% in 2010, but the drop off in revenue growth from 2010 to 2011 suggests that growth will moderate. If the company can maintain a compounded revenue growth of 40% for the next 5 years, with growth rates scaling down after that towards the growth rate of the economy, the firm will have revenues of $44 billion in ten years, which would put it on the same growth path as Google in its first years as a public company.


• Operating margins : Facebook’s current operating margin of 45.68% is mind-boggling and likely to decline as revenues get larger. If Facebook is able to maintain a pre-tax margin of 35% (close to Apple’s, and higher than Google’s) as a mature company, it would be pulling off a very difficult feat.


• Cost of growth : As Facebook’s revenue grows, it will find itself under pressure to pay more for this growth. In fact, its acquisitions of Tagtile , Glancee and especially Instagram (for $1 billion) in the three months since the initial S-1 filing suggest that the company will be aggressive in its pursuit of growth, which is both good news (for those seeking growth) and bad news (for those worried about the cost of that growth).


• High risk : There is significant risk in the company. In valuing the company,  we use a cost of capital of 11.42%, which would put Facebook in the top quartile of publicly traded U.S. firms in terms of risk.

These inputs yield a value of equity for Facebook of about $70 billion, and a value per share of $29. Assuming a company will grow like Google and have margins like Apple is, by definition, optimistic and this value would be at the upper end of my range. Assuming a more rocky road to scaling up and lower profitability will deliver a value in the $20-$25 range.

Some may disagree with me on my basic assumptions, either viewing them as over optimistic or over pessimistic, but I think a discussion centered on growth, profitability and the cost of growth is not only a healthy one but one that we should be having about all young, growth companies.

I would use this framework to challenge two oft-stated views about these companies: (a) that they cannot be valued today because the future is too uncertain or (b) that they must be worth very little because they don’t have significant earnings today. The first is a cop-out, since not making estimates is not going to make uncertainty go away, and the second will leave you on the sidelines with any young, growth company.

Facebook has been a quasi-public company for a couple of years now, thanks to the rise of the private share market. The company traded in this market fro months before the investment banking syndicate priced it at $38 a share last Thursday. Much as I would like to believe that the pricing of Facebook in the IPO was based upon an assessment of the fundamentals, I am a realist. Much of what passes for valuation on Wall Street and corporate boardrooms is not valuation, but pricing.

Put bluntly, the investment bankers spent the bulk of the last week surveying investors, trying to get a sense of what they would pay, rather than assessing what Facebook was worth.

In hindsight, Facebook was priced right on Friday morning, but valued wrong. That may sound odd, given what the stock has done since, but I think it indicates one of the dangers of pricing stocks. You are trying to play the momentum game, and it is one that can shift on you quickly. I am surprised that it happened so soon after the offering, but the bankers and the company not only overplayed their hands with the extended hype and the hiking up of the offering price, but were undercut by insiders cashing out in the days leading up to it. While I would love to point to the decline in the stock price since the offering as evidence that the market is cognizant of value, I think it is more the consequence of momentum investors, disappointed in their inability to make money from the promised IPO pop, heading for the exits.

While we can debate what Facebook’s value is and whether investment bankers mispriced the stock, there can be no debate on the fact that the corporate governance at the company is abysmal. From the decision to incorporate as a “controlled” corporation to issuing shares to the public with diluted voting rights, the message has been sent that this is Zuckerberg’s company and that stockholders are just capital providers. Here is why we should care: Facebook has a great product but it is not a great company, not yet. To become one, it will have to navigate challenges in scaling up growth, while maintaining profitability and controlling costs. Like all businesses, the top managers will stumble along the way, and unless challenged, will not see the need to adapt.

With its user base, Facebook has the ingredients to generate sizable profits down the road, albeit with substantial risks along the way. At the right price, I would buy the company, notwithstanding the uncertainty about the future.

At the IPO offering price or even at the price at which it is trading at right now, I would not.

http://www.forbes.com/sites/ericsavitz/2012/0...ll-no-buy/