16 May 2012 09:00

Little room for error in Facebook valuation

In an equity theme that I wrote a couple of weeks ago, I pointed out how Facebook might turn out to be a winner stock - in terms of providing a better return on investment relative to the market as a whole. This judgement was based on the company's business case and an expected valuation of $75 billion, which was based on the assumption that weak markets would quell investor demand and drive the price down. However, the latest news suggests that the IPO values the company at $96 billion. I think that this is over-optimistic, and that Facebook has misinterpreted market sentiment, as demand does not seem strong at the proposed valuation.

In my earlier article, I calculated that Facebook could return 17.2% annualised growth until Q1 2016 based on my expected valuation contraction and earnings growth slowdown, which was derived from the experience of Google shares. This model was based on an IPO valuation of $75 billion and near-perfect execution of its business plan. Using the current valuation of $96 billion, the potential annualised return falls to 9.7% over the same period, bringing the potential return closer to what you might expect by investing in an index such as the S&P 500.

This gives a very small margin for error, an due to the fact that there is a good chance the execution will not be completely flawless, the annualised return could turn out to be even less. A valuation of $96 billion is just too tight to justify the risk. As I have already indicated, a valuation of $75 billion makes more sense, and a valuation of $55-60 billion would be the ideal valuation, as identified by fellow TradingFloor contributor Matt Bolduc.

For more on this topic visit Tradingfloor

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