- Tools for Investors
- Stock News
- Investing Ideas
- Econ & Policy
- Personal Finance
One of the most important yet least understood aspects of investing is how to account for contracting multiples of maturing companies. Basically, when purchasing high growth companies with nosebleed valuations, you are in a race for the company to grow earnings faster than the P/E ratio contracts due to the normal life cycle of the business. In the case of Facebook (NASDAQ:FB), investors should expect the P/E ratio to contract faster than normal now that user acquisition growth will inevitably slow.
Actually, in just a few short weeks, we’ve already caught a glimpse of this phenomenon working against Facebook. When the company came public at $38 per share, the price-to-earnings (EPS = $0.39) was 97.4. On the first day of trading when the company hit a high of $45, the multiple rocketed to 115.3. Today, Facebook’s multiple has cratered to 66.20.
What does this mean?
The multiple reflects how aggressive the company can grow. In Facebook’s case, investors vehemently disagree over Facebook’s future growth. However, what the general investing public fails to realize is Facebook premeditated an IPO later in the company’s life cycle than a juggernaut such as Google (NASDAQ:GOOG). And company life cycle has nothing to do with years in business; instead, it’s a matter of market share and growth of the overall market.
For example, at last count, Facebook announced over 900 million users. That’s a significant portion of the global population. Assuming the absolute best case scenario, Facebook could sign up every living human being. That would get them ~7 billion users. Unfortunately, according to Mary Meeker’s newest report “KPCB Internet Trends 2012″, only 2.3 billion people worldwide have access to the Internet. That means Facebook already has 40% of the entire Internet population. Now, strip out people who will never use Facebook, don’t care to use Facebook, etc, and they have a much higher percentage.
Assuming the best case that Facebook (NASDAQ:FB) could sign up every internet user on Earth (which is impossible), we can clearly see the bulk of Facebook’s growth on a percentage basis is behind the company as exists today with the current product offering. So, why would anyone pay 66-115x EPS? Possibly for monetization growth, but that’s the biggest unknown for Facebook. I can’t justify paying a sky high multiple without more concrete proof the company is scaling a predictable, repeatable monetization effort.
As I noted last week, “the money Facebook has raised is going into what I would consider the research and development of possible monetization opportunities. Compare this with the much less risky and proven phenomenon of raising money to simply expand an already proven and repeatable way to extract money from customers.” Thus, like a biotech company that may or may not ultimately take a late stage trial drug to market for monetization, betting on Facebook is betting on an incredibly HUGE ‘maybe’.
At some point Facebook’s multiple will come in line with Apple (NASDAQ:AAPL) and Google, which are seeing P/E ratios in the teens at the moment. That’s market gravity. The question you need to answer is whether EPS can win the race and support a higher stock price than today as the multiple melts like ice.
Shares of Facebook (NASDAQ:FB) hit a new low of $19.01 today, roughly 50% lower than the company’s IPO price.
Now, don’t miss Facebook Investors: HYPE Fades as Reality Becomes More Clear >>
Don't miss one of the biggest bull markets in history! Covers Gold, Silver, Gold & Silver stocks, and miners.
There's always a bull market in some sector! Find the best opportunities in commodities.