Can Facebook’s IPO pay off for investors?
The social network is preparing for its coming-out party. Investors could reap big rewards, but that’s still a tall order.
When an eight-year-old social media company plans to go public with a valuation that could run as high as $100 billion, investors have every reason to be cautious. But for all the coverage of Facebook’s IPO, expected in May, real analysis of its soon-to-be-available stock has been in short supply.
We decided to seek answers from a team of rigorous by-the-numbers specialists: evaDimensions, a consultancy that uses a measure called economic value added to assess companies. EVA, in simplified terms, is a company’s profit after accounting for its cost of capital; it’s widely used by Fortune 500 companies and investors. Craig Sterling of evaDimensions crunched Facebook’s numbers, using data from its IPO registration statement.
Sterling’s view: Facebook boasts the best attributes of a young company (lightning growth) and a mature one (hefty profits). Its sales are increasing at an 88% compound annual rate. And the company is a prodigious cash generator, earning $1 billion last year on $3.7 billion in sales. That makes its profit margin, adjusted for the cost of capital, equal to that of Microsoft (MSFT), a legendary cash juggernaut. Like Microsoft, in Sterling’s view, Facebook enjoys “monopoly-like margins,” in Facebook’s case because it exerts a lucrative hold over the rapidly expanding worldwide social network category. (Not that it couldn’t lose that in a jiffy.)
Of course, there’s the matter of Facebook’s $100 billion valuation, which means a price/earnings ratio of 100 for its shares. That seems astronomical until you compare it to another much-hyped tech IPO. When Google (GOOG) prepared to launch its stock in 2004, skeptics chafed at its P/E of 120. But like a sprouting teenager who buys jeans a few sizes too big, Google grew into its valuation and trades these days around 22, as the stock shot up from $85 to $650 a share.
Now all Facebook has to do is match the search giant’s epic earnings run. Google’s rate of profit and revenue growth, in EVA terms, exceeded all but one Fortune 500 company (Gilead Sciences (GILD), the biopharma concern) from 2005 to 2010. As Sterling calculates it, a whopping 90% of Facebook’s market value is predicated on expectations of future EVA growth. To justify its stock price today, Facebook would need to record $68 billion in sales by the end of 2022 — a scorching 34% compound annual growth rate (CAGR) for a full decade, assuming it maintains its current margins. That’s not impossible given Facebook’s growth potential in mobile advertising and international markets.
Still, it’s a mighty tall order. If Facebook were to deliver a CAGR of 25%, which would normally qualify as off-the-charts performance, Sterling estimates that Facebook’s stock would be worth 50% less than its IPO price. Despite that risk, Sterling sees the shares as a buy — as long as Facebook continues to grow profitably: “The second you think growth is decelerating, watch out.”
This story is from the April 30, 2012 issue of Fortune.