Should You Buy Or Sell the Facebook Rally?

Meena is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Facebook (NASDAQ: FB) seems determined to claw back to a reasonable performance before 2012 closes. In the last month, the stock is up almost 40%- against a 5% rise in the NASDAQ index- though it is still about $10 below its IPO price of $38. The tone of coverage of the stock has begun to shift from “failed IPO” to “company that is waking up and realizing that it needs to make money”- though we’re not sure whether that shift has been driven more by actual news and developments, or by the increase in the stock price itself. Read about e-commerce opportunities at Facebook and Facebook's potential plans to develop its own games.

The results for the third quarter of 2012 suggest that Facebook has far from a revenue problem: the company reported a 32% increase on the topline from the same period in 2011, roughly in line with the growth rates from the first half of the year. Costs have been more of an issue, as pretax income came in about flat. Much of this was due to increased share based compensation; this came in $100 million higher for the quarter than a year earlier, and was particularly notable in explaining the rise in R&D cost. If we strip out share based compensation, however, operating costs were still up 50%- not a good point.

With its market capitalization back above $60 billion- despite net income being technically negative for the year- Facebook trades at 43 times analyst consensus for 2013 earnings. Specifically, expectations are for 65 cents per share in earnings; even if the company achieves that target, the multiple looks high unless earnings growth is very, very good. While short interest seems to have cooled about, about 12% of shares outstanding are held short. There have also been insider sales at Facebook (see a history of Facebook's insider sales). Chances are that this doesn’t mean anything, as it is usually rational for insiders to sell stock- insider sales actually aren’t that predictive of anything for this reason- but it is at least possible that some insiders don’t like the valuation.

Technology and services focused hedge fund JAT Capital Management, managed by John Thaler, owned 6.2 million shares of Facebook at the end of September (check out Thaler's favorite stocks). Tiger Cub Andreas Halvorsen’s Viking Global initiated a position in the stock during the third quarter (find more of Halvorsen's stock picks).

Career-oriented social network Linkedin (NYSE: LNKD) and social gaming company Zynga (NASDAQ: ZNGA) are two of Facebook’s closest peers. Facebook actually has the lowest forward P/E multiple of these three companies, with these two stocks trading at 87 and 131 times their respective forward earnings estimates. Of course, this is because all three companies are battling with profitability but current investors are piling in hoping for growth (or, as may be more likely in Zynga’s case, an acquisition). Zynga has of course plummeted from its own IPO price, and most of its market capitalization now consists of the value of its cash. LinkedIn has been reporting very strong revenue growth, and the stock is up 70% in the last year, but we think that we’d still avoid it based on valuation.

Facebook also can be compared to Apple (NASDAQ: AAPL) and Google (NASDAQ: GOOG). These large tech companies, similarly to Facebook, are dependent on finding ways to monetize consumers’ move to mobile devices (Google, of course, operates the Google Plus social network). Apple and Google were the two most popular stocks among hedge funds for the third quarter of the year (see the full rankings), and as more mature companies they have considerably lower growth rates. Google actually saw a decline in net income last quarter versus a year earlier, though that was due to its addition of Motorola Mobility Holdings. With Google’s forward P/E multiple being 15, and Apple’s being only 9, we’d think that these are better value plays.

We don’t see the current Facebook rally holding for much longer, based on the fundamentals. Even if we ignore share based compensation, expenses have been growing faster than revenue, and even if the company does bring that trend to a halt it will need high earnings growth to justify its current valuation. There are better value stocks elsewhere, including in technology, for investors to buy.

This article is written by Matt Doiron and edited by Meena Krishnamsetty. Meena has long positions in AAPL and GOOG. The Motley Fool owns shares of Apple, Facebook, Google, and LinkedIn and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Apple, Facebook, Google, and LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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