This Company is Richly Valued- But Well Worth the Risk!

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

When Facebook (NASDAQ: FB) came public, I recommended all my friends they stay several car lengths from an IPO I anticipated would crash and burn.  Anytime you have that much hype, that many retail investors clamoring to purchase the equity, the company and the not known for their lack of greed Wall Street bankers have almost no choice but to fleece the sheep. In this case, they not only raised the IPO price, but also the amount of stock being sold (the float) to meet public demand, driving up valuations across the board.

Therefore, it should be no surprise that Facebook sits nearly 50% below its offering price of $38.00 a share.  In the meanwhile, there have also been concerns about Facebook's mobile penetration, the effectiveness of Facebook ads, as well as Zuckerberg's desire to reward shareholders. (To his credit he specifically stated that he would not undertake any short term options to increase profits at the expense of his long-term vision before the company's IPO.)

Facebook Cons

Many analysts rightly point out the company is arriving late to the mobile party.  In turn, Facebook points out that it's a mobile ads are statistically much more likely to be clicked than the desktop.  I completely discount this explanation, as when pop-ups first originated (way back when), people were intrigued by their novelty, until they became a ubiquitous, time wasting, computer crashing irritation across the net.  Obviously Facebook will not allow advertising to become an "irritation," lest it lose its entire user base and cool quotient. My point is the novelty that leads to an increased click rate will quickly wear off.

Also, personally, I continue to shake my head at the one billion dollars spent on Instagram, a company with almost no revenues, and zero profits.  I sincerely hope I'm wrong, but I find it hard to believe that this investment will pay off, especially since other than its quickly grown user base, the app itself seems easy to replicate.

It should be pointed out I am a Google (NASDAQ: GOOG) bull, and I very much enjoy the Google Plus platform; however, I do not use it as often as Facebook, mainly because all my friends are on the social networking giant.  This "stickiness" factor, the ubiquity of use, is Facebook's greatest competitive advantage. The threat of Google Plus however does act as a break on Facebook, tempering ad growth and hence revenue, lest people switch over to big G.

Dilution: Zuck is known for his generosity to employees, and shareholders will see continued dilution of their ownership as stock options are granted to employees. To quote the Wall Street Journal: "Investors have expressed concern about the high levels of stock compensation paid to staff, the relative youth of 28-year-old CEO Mark Zuckerberg and the company's slowness to make money from mobile traffic."

So why is my once bearish stance shifting, despite all this?  

The Pros

As Facebook continues to decline in price, (currently $19.52) the company's potential for leveraging its now one billion users, begins to trump my concerns mentioned above as well as its short term valuation - a P/E currently standing at 68 with a not so hot projected quarter upcoming.

First of all the original IPO price of $34 a share didn't come from outer space.  For sure, Wall Street and Facebook got greedy, but any time there's an IPO, the Investment Bankers want to make sure that their best customers receive a fair price to insure their continued business.  As simplistic as this sounds, it makes me slightly less wary that I'm overpaying for the stock.

Secondly, the company's story hasn't changed that much in the last few months.  Its potential to monetize its gigantic user base is still massive.

1) Facebook continues to play with and advance its ad serving.  They recently introduced an ad exchange which, through the use of cookies, tracks users web browsing history, and will serve up similar ads when the users return to Facebook.

To quote the following article on Gigamom, "In the three-month test period, Triggit found that ads served through the Facebook Exchange generated an average of four times the return on ad spending compared to traditional display retargeting and resulted in a click-through conversion rate that was 2.2 times higher. The cost per click-through order for Facebook Exchange ads was also 6.5 times lower, the company said."

Regardless of whether or not this succeeds in a broader test, this clearly demonstrates the company will continue to experiment until it gets the formula right; and even then, it will likely experiment some more.

2) Facebook is getting into social search-  soon.  The ability for Facebook to incorporate social data into its search is the whole reason Google created Google Plus, as well as its recent acquisition of Zagat, the restaurant reviewer.  Facebook is the one company which scares the bejeesus out of Google.

The company already handles one billion search queries a day, as compared to the three billion done with Google, without much concentration on it (at least currently.)  The ability to search for local restaurants which your friends have enjoyed, has the potential to upend search as we know it.

3) In his first public interview since the company went public, Zuckerberg admitted the company made a major misstep in not concentrating more on mobile in the past.  You really have to give him credit for his candidness, unlike other CEO's who might have danced around it.  Through admitting their mistakes, it gives the company an opportunity to correct them.

4)  A couple of weeks ago I wrote about Facebook's entry into gambling.  I believe that this is a nod from Zuckerberg to shareholders.  Although certainly offering gambling has no socially redemptive qualities, it’s my belief that this decision was made to buoy the short term stock price, perhaps more so for employees who have stock options which currently sit under water, an effort to boost morale and keep his talent.

That being said, offering slots, bingo, and eventually what I foresee as poker across the world has the potential for massive profits.  If the billion-users on average contribute $2 a year (with obviously some dummies contributing far more, and some zero) this is an extra two billion dollars in cold hard cash annually, which will send the stock price soaring. 

I do anticipate the legalization of poker in the United States.  Slots and bingo are already being offered in Great Britain via the Facebook website.  I believe the street is vastly under valuing this potential.

5) Lastly I believe that Facebook's stock has a bottom.  Reach a certain price, and cash rich Google will certainly be screaming, "Buy! Buy! Buy!" Of course, the stock structure might complicate this, but there is no other company Google would rather own, not Microsoft, not Apple, not Amazon.

The bottom line:  It's very difficult to gauge/calculate Facebook's value by a mathematical formula because its potential is so huge.  If only one of these projects (search, ad serving, mobile, or gambling) is a hit, profits will be rocket fueled. It might take a year or two, but at as shares sink lower and lower, the odds get better to throw the dice. At this point, I believe Facebook is worth the risk for a long-term investment.

I also recommend the following article, which will give you an insight into Facebook's corporate and engineering culture. If you have any thoughts on this analysis, please leave me a comment below.


margiecfl has positions in Google and is about to go long Facebook. The Motley Fool owns shares of Facebook and Google and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Facebook and Google. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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