By MoneyMorning.com.au
Whatever you think of Facebook (our old pal, Dan Denning says Facebook “diminishes the quality of your thought…”) there’s no arguing it’s a great example of free market entrepreneurialism.
For an eight year old company, it has come a long way.
According to the Form S-1 filed with the U.S. Securities & Exchange Commission, Facebook made a USD$1 billion profit in 2011. That’s the third year of profits in a row. It made USD$229 million in 2009 and USD$606 million in 2010.
Make a note. That’s profit. Facebook has more cash coming through the door than it has cash going out the door.
That sets Facebook apart from one of last year’s most-watched public offerings, Groupon Inc., [NASDAQ: GRPN]. In its last annual report Groupon lost USD$389 million in 2010.
And for the first nine months of last year it lost USD$214 million.
One Internet company makes a billion… another loses hundreds of millions.
But here’s the thing: just because Groupon loses money, it doesn’t make it any less entrepreneurial than Facebook.
Both guys behind the firms had an idea. They both figured they could make a bucket load of money from it. So they took a risk and got investors to back them.
The thing for investors, looking at both companies, is which is the better investment?
Should you buy Groupon while it’s still making a loss… but with potentially years of growth ahead of it? Or should you buy Facebook, which is set to trade at a premium? (Meaning that investors have built future profit growth into today’s price.)
Or maybe you should buy both.
Well, let’s look at Groupon first. We’ll straight out say we wouldn’t buy it.
Simply because we don’t see it as a viable business. The company approaches businesses to convince them to offer discounts. Groupon then splits the revenue with the business customer.
For instance, if a restaurant offers a 50% discount off a $100 meal, it splits the remaining $50 with Groupon. That’s great for Groupon. But not so great for the business – effectively, discounting its product by 75% with no guarantee of repeat business.
To us, that seems a costly way to get customers. And it seems as though while Groupon and the end consumer win, the business loses.
That’s no way to build a viable business. For a company to succeed, each side (the company and consumer) needs to believe they’re getting a good deal. That’s the beauty of free market capitalism. Each side of a deal walks away thinking they’ve come out ahead.
We’re not convinced that happens with Groupon.
Compare that to Facebook, where everyone gets something of perceived value: Facebook makes money. Advertisers pay comparatively cheap ad rates to get in front of hundreds of millions of people. And consumers get to network, show off and play silly games.
Everyone’s a winner.
So, does that mean we’d buy Facebook? Let’s see…
Even though everyone’s a winner, it doesn’t make Facebook a slam-dunk trade. As we say, investors have built profit growth into the current price.
Estimates are Facebook will list with a market capitalisation of USD$75-100 billion. That’s huge. It’s more than 100-year old technology company, Hewlett Packard [NYSE: HPQ], which has a USD$56.6 billion market cap.
And more than dot-com darling, Amazon Inc. [NASDAQ: AMZN], which has a market cap of USD$82.7 billion.
Not only that. If Facebook has a market cap of USD$75 billion, that would value it at 20-times sales, and 75-times earnings. That’s compared to Google Inc’s. [NASDAQ: GOOG] 20-times earnings.
In other words, investors figure Facebook still has plenty of growth. And maybe it has. But with a big premium priced in, investors have big expectations.
For example, let’s assume over time Facebook’s value will move closer to Google’s of 20-times earnings. In order to justify a market cap of USD$75 billion, Facebook will need to grow profits to USD$3.75 billion.
That’s a 275% increase on today’s profits.
But that doesn’t mean the Facebook share price would go up. As we say, the share price already reflects future growth. And if it doesn’t achieve the profit growth… oh boy, the share price of Facebook would soon take one heck of a beating.
And of course, investors won’t want the Facebook share price to stay still. Investors will want the share price to go up. For that to happen it needs profits to keep growing… USD$5 billion, USD$7 billion, even USD$10 billion or more.
In other words, it has to follow the same earnings growth as Internet giant, Google. That’ll be tough… but not impossible.
Online advertising is growing at more than twice the rate of non-online advertising. For instance, a report at the start of last year by MagnaGlobal projected the following ad growth rates:
As you can see, every single “new media” ad channel is outgrowing the four “old media” ad channels.
Of course, some of the “new media” is growing from a low base. Such as online video, which only received USD$2.2 billion in ad dollars in 2009 compared with USD$109.5 billion for network television.
But the point is, online ads have plenty of room for growth. You can’t say the same for print advertising. You only have to look at revenues for the big media companies such as Southern Cross Media Group [ASX: SXL] to see how sales and profits have stagnated for the past five years.
So, yes, Facebook does “diminish the quality of thought”. And it is a vacuous, inane and shallow media. And the shares are likely to begin trading for an obscene premium over current profits. But…
It’s also a great company.
It’s the perfect example of how a free market gives consumers a service they didn’t know they wanted. Remember, when businesses such as Facebook (and just a year before it, MySpace) were created, there was no guarantee of success.
It took guts by the company’s owners and investors to put time and money on the line.
Today, Facebook is a success. And the share price will reflect that.
The only dilemma for potential investors is whether Facebook will follow Google’s lead and gain 588% in eight years. Or whether it will follow MySpace down the toilet (Ed note: News Corp paid USD$580 million for MySpace in 2005… and sold it for USD$35 million in 2011 for a 93.9% loss!)
As a punter, we like Facebook as a red hot gamble. You wouldn’t want to bet your retirement fund on it, because there’s little doubt to us the shares will either soar or slump.
Facebook is a high-risk punt. It isn’t a stock for investors. It’s a stock for crazy speculators.
If that sounds like you… we’d say, go ahead, buy some.
Cheers.
Kris.
P.S. Facebook isn’t the only punt I recommend investors make in 2012. At an exclusive gathering of investors next month, I’ll explain which stocks to buy this year for maximum gains. You can reserve your seat to this event by clicking here…
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