Buy Facebook? Wait Until Next Year

During the 18 years that I have been a professional money manager, I have witnessed a lot of Initial Public Offerings. I have seen some good ones, and a whole lot of bad ones.

I have learned to avoid IPOs unless I think they are an outstanding value, and that rarely is the case. Did you know that over the long haul, IPOs have underperformed the market by a wide margin?

Yes, I remember 1999 and 2000, when IPOs last hit a feverish pitch. It seemed that all a company had to do was get their venture to an initial public offering and everyone would cash in. Many IPOs during that time period would have insatiable demand by individual investors and normally rocket higher after the initial offering. Nevermind valuations, the company had a dot.com after the name, and they now were selling their goods on the internet. What more do you need?

I can still remember when K-tel announced in 1998 that they were going to expand their music business to the internet. The stock shot up from $3 to $7 per share in one day. The stock eventually peaked at $34 per share a few months later as an extraordinary short-squeeze ensued.

The company completed a 1 for 5,000 reverse stock split at a later date,  and was eventually de-listed. Imagine owning 10,000 shares and waking up with just 2 the next day! K-tel is just one of numerous examples of stocks that investors completely ignored the valuation on during that frenetic time in the market.

In the weeks leading up to the Facebook IPO, I had a number of clients ask me if I would be buying it. My answer was that I had absolutely no interest whatsoever, and here is the reason why:  I have found over the years that it is best to combine performance with value in evaluating a stock. I am neither a value investor, nor a performance (momentum) investor -- I am both. I have written many articles on this subject, including this one.

As we learned during the go-go years of the late 1990s, the stock market’s valuations eventually come home to roost. It was not uncommon during that period to see many triple-digit price-earnings ratios. Would you pay 150 times earnings for a local dry cleaning business that earns $50,000 per year? At a valuation like that, you would be paying $7.5 million for $50,000 in earnings. Oh, I know, what about growth? But still, $7.5 million?

Believe or not, we do have some consensus estimates on Facebook ( FB) already, and we can take a stab at a valuation. I like to establish five-year target prices, not the short-term ones that are much more common on Wall Street. I find  five-year targets to be a much more useful in determining whether or not a stock is undervalued. It also helps me focus a little more on the long term and not the short term.

As it stands right now, the consensus earnings estimate among analysts for next year is $0.66 per share. I don’t know if this is pre-downgrade or post-downgrade, we will find out over the next few weeks. The consensus five-year average growth rate currently stands at 35.9% per year. I don't know about that either. If Facebook is able to achieve these estimates, it would be earning $2.25 per share five years from now.

If Facebook is able to achieve an earnings growth rate of 35.9% over the next five years, it would definitely be rewarded with a premium multiple. Given the sex appeal of the stock, although a lot of the glamour is wearing off fast, and an expected superior growth rate, I think that the stock would deserve a multiple of 30X five years from now. That gives us a five-year target price of $67.50. Why is Henry Blodget’s valuation so much lower than mine? Because he is looking at a one-year target price, not a five-year target.

Here is what that valuation looks like:

Data from Best Stocks Now App

I like to buy stocks that have 80%-100% or more upside potential over the next five years. Facebook currently meets my criteria, so it is a buy, right? Wrong!

The other half of my equation is performance. I like to buy stocks that have good upside potential, but I also want superior performance. Facebook has absolutely no track record as a publicly traded company. I don’t begin to measure performance until a stock has a least one year of performance under its belt.

Mark Zuckerberg may be a visionary and a very rich young man, but he has absolutely no experience as a CEO of a publicly traded company. I like to own stocks that have delivered superior returns to their investors over the years. My clients don’t care if those returns come from a high-tech stocks, a tractor supply company, or discount retailers. Here are some examples:

Neither Tractor Supply ( TSCO) nor T J Maxx ( TJX) are sexy, glamorous stocks like Facebook, but look at the returns that they have delivered to their investors over the years! Would you be happy with returns like those? These CEOs have established superior track records.

Let's give Zuckerberg at least one year of stock performance, four quarterly earnings reports and 12 months of dealing with the media on a daily basis, before we even begin to pass judgment on the performance of the stock. Let's see if Facebook will consistently beat expectations or just turn in mediocre numbers.

Disclosure: At the time of publication, Bill Gunderson was long Tractor Supply and TJ Maxx.

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