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1 big number that will burn Facebook investors

Two weeks ago, Facebook shares changed hands on a private market at an implied valuation in excess of $100 billion. That’s wonderful news for Facebook’s employees and venture backers – the only constituencies Mark Zuckerberg is concerned with in the impending initial public offering (the prospectus is explicit on this point). But if you’re considering buying shares when the company goes public, it’s awful news: The higher the pre-IPO valuation gets, the lower your expected share returns.

I stand by my prediction

At the end of last June, I predicted that Facebook would close its first day of trading with a market capitalization in excess of $150 billion. The private market value at the time was $70 billion. At the company’s current valuation, my prediction is beginning to look conservative. And yet there are plenty of excellent reasons to remain sceptical regarding this IPO.

High-profile companies that go public with a low float (the percentage of shares being offered) have a poor track record in terms of shareholder returns. Facebook certainly falls under “high profile” – I can’t think of any IPO that has generated as much hype (Blackstone and Google came close).

Tom Gardner weighs in

Motley Fool CEO Tom Gardner countered that, in light of the expected dollar size of Facebook’s issue ($5 billion-$10 billion), the float percentage is irrelevant – that is, given the absolute dollar amount of supply, a squeeze that would produce an overpricing is unlikely.

That argument has merit, in theory, but my guess is that the pent-up demand for these shares is such that the issue will be heavily oversubscribed. I’m expecting that the market will gobble it up before going to Mark Zuckerberg, basin and spoon in hand, to ask: “Please, sir, I want some more.” There is already anecdotal evidence of ravenous demand for the shares, with qualified investors going to great lengths to obtain shares in private markets.

Paying a premium on top of the premium

Let’s imagine that the current $100 billion private market valuation holds until the IPO. The offer price will be set at a premium to that valuation. Once the shares hit the secondary market, the stallion is out of the gate – who knows how far or how fast it will run? If LinkedIn (NYSE: LNKD) shares can double on their first day of trading, who’ll be foolish enough to argue that Facebook shares can’t gain 30%, 40% or 50%?

Still, the number $150 billion holds no specific significance. There is no law that says a company can’t go on to produce decent returns from that level and, if any company can, I can’t think of many better candidates than Facebook (but that doesn’t mean I think it’s likely). It’s a big starting number, but it must be possible – Apple’s market value has increased by over $100 billion since the beginning of the year! Of course, Apple generated over $10 billion in cash flow last quarter.

Facebook vs. Google

I’ll admit I thought Google (Nasdaq: GOOG) looked very pricey when it came public in 2004 and the company subsequently proved me wrong, delivering superb operating results and share performance. However, while the situations share some similarities, there are a couple of important differences between the two flotations:

First, Google went public earlier in its growth cycle. Secondly, the valuation multiples we are currently juggling for Facebook are significantly higher than Google’s were.

You can’t ignore size as a limiting factor. With 800 million users there is natural ceiling on the growth Facebook can still achieve and that ceiling may not be all that far off, as the total number of Internet users globally at the end of 2011 is estimated at 2.3 billion (of course, that number is growing also). Proponents will argue that the company has merely scratched the surface in terms of monetising its existing user base, let alone its future user base, and that argument isn’t without merit.

I couldn’t imagine how Google was going to monetize my web searches, either, but sure enough, I did end up using the search engine to find certain products. I use Facebook every day, but I find the ads deeply irritating (and poorly targeted, for the most part). I’ve never even considered buying anything. As for spending time and money growing virtual vegetable patches or rubbing out Mafia rivals, either we are on the brink of a new Dark Age or Zynga’s (Nasdaq: ZNGA) games are the Cabbage Patch Kid of the digital age (maybe I’m just too old to understand).

Bottom line: I fear the odds of disappointment are climbing with every uptick in Facebook’s private-market share price.

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The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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