Friday, May 18, 2012

Is One Apple Really Worth Less Than Four Facebooks?

Lots of wealth has been created by the smart people at Facebook in what has been a relatively short amount of time. Bravo to Facebook's early investors and especially to all the people who helped to build the business.

Quite an accomplishment.

It's all very impressive and the company certainly seems to have no shortage of great prospects.

None of this means (and you probably guessed this was coming) its current valuation makes sense. At the price it is selling at as I write this, Facebook's (FB) enterprise value is more than one quarter Apple's (AAPL).

So market participants who plan to buy the stock today (with the idea of owning it longer term), have to be hopeful that somehow one Apple being equal to roughly four Facebooks is justified.

Also, they are obviously hoping Facebook can grow that value substantially from here. If not, why put the capital at risk?

Let's look at this a bit further. Facebook's enterprise value (market cap minus net cash) is around $ 100 billion based upon what it initially began trading (~ $ 42/share) at earlier today. According to Facebook's S-1, here's how Facebook performed in its most recent quarter.

Revenue grew an impressive 45% from $ 731 million in the 1st quarter of 2011 to $ 1.058 billion in the 1st quarter of 2012.

Earnings declined 12% from $ 233 million to $ 205 million.

Free cash flow was negative in both periods.

Apple's enterprise value is roughly $ 390 billion. Here's the same numbers for Apple:

Revenue grew 59% from $ 24.7 billion in the 1st quarter of 2011 to $ 39.2 billion in the 1st quarter of 2012.

Earnings grew 93% from $ 6.0 billion to $ 11.6 billion.

Free cash flow grew 124% from $ 5.6 billion to $ 12.5 billion.

Unlike other posts, I won't waste any time comparing the ratios.

To me, the chasm between those relative numbers speak for themselves.

Having seen this movie (unfortunately too many times) before, I know I'll still hear many tortured justifications in the coming weeks about Facebook's valuation.

I'm guessing some will discount the Apple comparison as just one mere inconvenient real world special case.

So Facebook may be a company with an incredible future, but it does not seem worth more than a fraction of its current valuation.

At least not yet.

I don't doubt it may grow into its market valuation and more someday. It's just tough to make great risk-adjusted returns paying now what something may be worth someday.
(I'm more a fan a paying a meaningful discount to what something is plainly worth now, especially if it has a good probability of growing that value over time.)

Now, let's say Facebook grows earnings (hopefully someday backed by free cash flow) 30% a year over the next five years. If Facebook does grow that much, it will produce, in total (adding the five years together), roughly $ 12 billion of earnings.
(again, I'd use free cash flow but they have none to grow yet)

So, in that scenario, they'll earn over five years roughly what Apple earned in just the past 90 days or so.*

Think of it this way: Apple could stop growing today and, at its current run rate, have $ 370 billion of cash to return to owners at the end of that five-year period (whether they actually return it is another question). Also, at least presumably, Apple should still be a halfway decent business with substantial intrinsic value at that point five years in the future (capable of producing even more cash for shareholders going forward).

It's worth noting that the aforementioned $ 370 billion of cash is nearly equal to Apple's current enterprise value. So if you believe, as I do, in the principle don't pay too much for promise (ie. a premium paid for a promising future not realized is costly) then there are plenty of alternatives to Facebook that offer attractive risk-adjusted returns. As always, the price paid is the best way to manage the risk of permanent capital loss.

The alternatives, at least some, may lack Facebook's upside (and downside) but that's just the nature of the principle. At a minimum, those who like Facebook can't just ignore some of the other large cap tech stocks with relatively modest valuations and not exactly terrible prospects. I'm not even convinced that some of the large cap tech stocks with relatively low P/Es don't have superior future prospects.

Most technology businesses lack the kind of clear durable advantages that I require to invest. Their nature is inherently unpredictable. Technology change, shifts in consumer behavior, and a changing competitive landscape assures it. As I said here and on other occasions, there's just no technology business that I'm comfortable with as a long-term investment. Yet, at least the prices of some large cap tech stocks seem to provide a decent or better margin of safety. What's unattractive at one price often becomes interesting once low enough.

In a few years, Facebook's long-term strengths may become more apparent (well, at least apparent to me).

Others might already see its potential vividly. If it turns out I'm underestimating Facebook (and I certainly may be), the stock is just something I don't mind missing near its current valuation considering alternatives.

The near term market voting machine may produce some rather remarkable price action in Facebook's stock but, as always, I'm not talking about trading here. Those in the business of playing the price action game are working with a very different time horizon.

Adam

Long position in Apple established at much lower than recent market prices.

Related posts:
Facebook Drops Ahead of IPO: 1st Quarter 2012 Results
Facebook Files for IPO: What the S-1 Reveals
Facebook's IPO: $ 100 Billion Valuation?
Facebook's 1st Half Revenue Doubles to $ 1.6 Billion
Is Facebook Worth $ 100 Billion?
Technology Stocks

* To be clear, I can think of many businesses that I'm more comfortable with than Apple. This comparison is just a useful way to look at relative valuations.
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