Should You “Like” Facebook’s IPO?
Jason Zweig provided an interesting parallel between Facebook and the St. Petersburg Paradox. (“Facebook and the St. Petersburg Paradox”, Zweig, Feb 4, 2012, WSJ) The paradox is as follows:
In the 18th century, the Bernoulli cousins, Nicolas and Daniel, proposed to play a game of tossing a coin. Every time you toss tails, you double your prize and can toss again. You will keep tossing until you come up heads. At that point, you are paid whatever prize you have earned and the game ends. The prizes are $1 for the first round, $2 for the second round, $4 for the third and so on. The question is how much would you be willing to pay to play such a game?
In probability theory, we should be willing to pay at least the expected value or payout of the game. In other words, we should be willing to pay an amount equal to the sum of each potential payout multiplied by the chance that such a payout will be received.
In this instance, there is a peculiar result: E = ½*1+¼*2+?*4+… which can be simplified to E=½+½+½+…where you are adding ½ up to a sum of infinity. The result is therefore an expected payoff that is infinite. (Side note: coming up heads on the 35th toss would yield more than $17 trillion – enough to pay off our national debt!) Therefore, you would expect that someone would be willing to pay almost anything to play this game repeatedly. However, the paradox is a classic case where a seemingly rational decision process leads to a seemingly irrational solution due to oversimplification.
In real world studies, psychologists have found that most people aren’t willing to pay very much at all. The average willingness to pay seems to be around $20. It turns out that the high risk of a 50% chance of losing $20 on the first toss alone and not having the money to pay for another round is too much for most people, so they seem to ascribe a much smaller, and finite, value to the game.
Now, how does the St. Petersburg Paradox relate to the Facebook IPO? As Zweig mentions, high-growth stocks are very similar in that the potential expected payout may be huge, but their growth can also fall off the proverbial cliff too soon if things don’t go as expected. After all, projected results are only as good as the company and its Wall Street analysts’ forecasting ability . . . which is to say, not very good at all and generally wildly optimistic. Remember, they’re trying to sell you something!
Facebook is anticipated to IPO at a share price of $34 to $38/share, corresponding to a market value of $93 to $104 billion. At $1 billion in profits in 2011, such a valuation would have the stock trading at roughly 100 times trailing earnings! That compares with a trailing P/E ratio of approximately 19 for Google, which is arguably much lower when considering the boatloads of net cash sitting on their balance sheet. Another unique way to look at valuation is to compare market cap per employee. Google is about $6 million per employee, and, at $96 billion, Facebook would be at $32 million per employee.
We don’t doubt that Facebook will prove to be a great business. With over 900 million active users worldwide, the network effect is powerful. And while we believe the company will be able to monetize its business to some degree, we have to wonder if the hyper-growth implied by its multiple can actually materialize. Facebook became popular without a barrage of ads, so how will it fare when users are feeling bombarded by them? Or will users become turned off if they predominantly interface with Facebook through their smartphones and they are forced to view ads before messaging? There are only so many ad dollars being spent each year – how much of this potential revenue can Facebook actually capture? There is already evidence that suggests some executives question the effectiveness of ads placed on Facebook. In fact, after testing it out, some companies are actually cutting advertising dollars earmarked for Facebook, including General Motors and one of the world’s largest advertising firms, WPP.
Even so, let’s suppose Facebook is able to compound earnings at an average 30% per year for an entire decade (it’s possible they could do even better, but realize that 30% is a feat hardly ever accomplished). In this optimistic scenario, they would be earning near $14 billion a year, compared to Google’s current $10 billion or so. If we further suppose, at the end of this imagined decade, that the stock traded at a similar multiple to Google today (which has been publicly traded for a decade now), then the return on the stock would be less than 10% annualized per year (and that’s assuming no dilution from stock options). In other words, the valuation is so sky high that you’ve already sold all your growth away in the initial purchase price.
The fact is, it’s simply too dangerous to invest in high multiple, fast-growing businesses because the valuations assigned to them by bullish investors are incredibly sensitive to growth rates, and, if these types of companies just barely fall short of expectations, you could get burned badly. This is often the case with IPOs because they generally have great stories attached to them with exciting prospects leading to oversubscription and a dear price to pay. “For instance, in the United States the average IPO has underperformed the market by 21 percent per annum in the three years after its listing (covering the period 1980-2007). Similar patterns can be found in most countries” (“The Little Book of Behavioral Investing” by James Montier, page 123). As we often say around here: “Even a great business purchased at a high price is a poor investment.”
We feel if you can make good returns with a “bird in the hand,” why risk playing for the birds in the bush? If you’re feeling that bullish on Internet advertising, we think you ought to take a long hard look elsewhere before placing incredible faith that you can “toss multiple tails in a row” on Facebook…or you might become a victim of the St. Petersburg Paradox.
Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.