Is Facebook overvalued?

March 5, 2014: 5:00 AM ET

The social network is growing through acquisitions. But investors may want to take a second look at how they are valuing that growth.

By Lauren Silva Laughlin


FORTUNE -- Is Facebook overvalued? The social network's shareholders have fared well since the company went public in mid-2012. Shares are up more than 80% since its IPO and have climbed steadily over the last six months. But investors have paused since Mark Zuckerberg, Facebook's founder, announced on his page two weeks ago that his company was buying WhatsApp, a young but popular social network. The price tag: a shocking $19 billion.

It's not just a matter of digesting the news. Investors already have lofty growth expectations built into the company's stock price. And as the WhatsApp acquisition shows, Facebook (FB) is working hard to justify those assumptions partly with acquisitions -- and it has good reason to do that. Based on at least one metric, a small blip to investors' forecasts could skim nearly a tenth off the stock price.

In many ways, the WhatsApp acquisition makes sense. Scale is important to social networking. Bringing WhatsApp into the fold only makes Facebook that much harder to touch. "The large and rapidly growing user base attracts new advertisers and retailers," Laura Martin of Needham recently said in a report. "We believe the scale of Facebook's network represents a significant competitive advantage and a significant barrier to entry."

MORE: Does the SEC force its employees to insider trade?

However, paying top dollar to grow can turn into a dangerous cycle. "It can be like a dog chasing its tail," said Lawrence Hrebiniak, emeritus professor at The Wharton School of the University of Pennsylvania. If more interesting social networks photo-bomb this growing family portrait, Facebook will have to continue to purchase other companies to keep up.

Jim Chanos, the prominent bearish investor who runs hedge fund Kynikos, is skeptical that scale matters in general. He says he is worried "about the inability of these businesses to 'scale' profitability." "Everyone points to Amazon as their valuation framework safe-harbor, not the scores of Internet road kill." (Chanos is not currently involved with Facebook or similar companies.)

Investors don't necessarily have to choose a side just yet. But it helps to consider how delicate Facebook's stock price actually is, considering the outsize growth expectations for the company. Following Facebook's acquisition of WhatsApp, analysts started to kick around a metric different than one that's often used. Rather than value WhatsApp based on a revenue multiple, analysts showed how much Facebook was paying to acquire each individual WhatsApp user. That magic number was $42 per user ($19 billion for 450 million users).

It seems like a lot considering WhatsApp's business: It takes in 99 cents per user one year after they have signed on. But Facebook's users are worth $122 apiece at its current enterprise value of $167 billion, assuming the company hits Evercore's expectations of around 1.4 billion users by the end of this year.

The hope is that Zuckerberg will add some kind of magic sauce to WhatsApp users so Facebook can jack up their value too. But it may not be that simple. First, Facebook's users are worth more because they bring in more money for the company. Each Facebook user currently adds $6.73 to the top line. Evercore assumes this number will grow a quarter by the end of this year to $8.44, making each Facebook user worth some 14.5 times the revenue they contribute.

MORE: eBay (slightly) changes its Skype story

Add that to the 16% more people Evercore assumes will join Facebook, and investors have to hope things continue on the up and up.

Say those estimates are a bit off: Revenue per user grows 20% to $8.08. It is still a lot, but not what investors currently assume. And say that users grow a tenth rather than 15%. Each Facebook user at the same multiple (14.5 times) is worth $117, and there are fewer to boot (1.3 billion users), valuing the company at about $151 billion. Add back Facebook's $7 billion of cash, and the market cap of the company is about $158 billion, nearly 10% below its current price.

Small tweaks to a business model that needs to be scaled can be dangerous, especially when investors are paying top prices based on lofty growth assumptions

  • It might be time to talk double-dip recession

    In normal times, the default setting for the U.S. economy is 'expand.' But these aren't normal times.

    By John Cassidy, contributor

    FORTUNE -- Last year I dropped by a birthday party for Nouriel Roubini (a.k.a. "Dr. Doom"), the New York University economist who shot to fame after predicting, in 2006, a housing and credit bust. Somebody brought out a cake. On top of it was a big frosted "W," representing the double-dip MORE

    Jun 8, 2011 5:00 AM ET
  • The good news on weak jobs

    The good news out of Friday's jobs report is that everyone's favorite economic villain, commodity prices, may be about to change sides.

    The weak jobs report Friday adds to the sense that U.S. growth is slowing. That's yet another setback for the 13.9 million people out of work, and an unhappy thought for anyone gunning for better wages or more hours this year.

    You can blame the past year's surge in prices for MORE

    - Jun 3, 2011 11:26 AM ET
  • The flight to Citi trade

    In the truth is stranger than fiction department, Citigroup is now the U.S. banking sector's shining beacon.

    Shares in Citi (C), the giant bank that took the most bailout money during the financial meltdown, rose modestly Monday, even as other financial stocks were hammered by Standard & Poor's decision to cut its outlookon the United States' credit rating to negative.

    Why the sudden flight to Citi? The New York-based firm reported its fifth MORE

    - Apr 18, 2011 10:45 AM ET
  • Summers says U.S. starved for growth

    The U.S. economy is in dire need of faster growth, Larry Summers said.

    Summers, the director of President Obama's National Economic Council, said Wednesday at the Council on Foreign Relations that the speed at which the U.S. economy grows will make the difference between solving many of our problems and letting them become almost unbearable.

    "The most important question is does the growth rate pick up significantly in the next three years," Summers said. MORE

    - Nov 17, 2010 11:29 AM ET
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by VIP.