Saturday, June 2, 2012

Here's What The Smartest Investor I Know Thinks Will Happen To Facebook Stock

By Henry Blodget

I was talking about Facebook stock recently with one of the smartest investors I know.

The investor has owned Facebook stock for years--since it was a small private company.

But the investor has also been shoveling his shares out the door for years. So much so that he no longer owns much.

Because the investor thinks the same thing will happen to Facebook that has happened to other big technology companies.
Now that the company's "momentum years" are behind it--the years in which the company's results astounded naysayers and blew away expectations--the investor thinks Facebook's stock multiple is likely to continue to contract, even as earnings continue to grow.

Let me explain that.

Stock prices are a function of two variables:

Earnings per share

The price the market places on those earnings per share (the "multiple")

In the years in which a company is growing frantically and blowing away consensus expectations, the market generally assigns a very high multiple to earnings.

Eventually, however, the company matures, growth slows, and the market's expectations come into line with reality.
And as that happens, the stock's multiple contracts.

Why is this relevant for Facebook?

Facebook revenue growth.

Because Facebook's business is decelerating rapidly--advertising revenue grew only 37% in Q1--and the company is no longer "beating expectations." Facebook is also already a big mature business, with more than $4 billion of revenue and $1 billion of earnings.

Google, in contrast, was much smaller when it went public. So much of the stock upside that that would have accrued to Facebook if it had gone public when Google did has already been captured by Facebook's early investors (whereas, in Google's case, the post-IPO upside was captured in part by public-market investors).
The market's expectations for Google, meanwhile, came into line with reality in 2007...and the stock has basically moved sideways ever since.

As we'll show in charts below, Google's earnings have increased a huge amount since 2007, but the stock's multiple has contracted.

So Google has now been "dead money" for more than half a decade.

The investor I spoke with thinks the same thing will now happen to Facebook's stock.

He doesn't think Facebook is a disaster, or anything. In fact, he thinks it's an excellent company. He just thinks that the market is overestimating Facebook's future growth prospects, and that, as the market gets more sober, Facebook's stock multiple will contract.

In other words, the investor thinks that, although Facebook stock will go up and down (just as Google's has), it will basically be "dead money" for years.

Read the rest here.

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