Thought for the day

Sometimes controversial, sometimes quirky but always thought-provoking. Michael Baxter, freelance journalist, provides his personal insights on current economic and business issues - essential reading for investors interested in fuel for the mind.

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18/05/2012 - The problem with Facebook IPO lies with equity Q

How much is a company worth? Well, there are two ways to answer that. You can guess or you can work out how much it would cost to replace all the company's assets. And can you imagine what that second method tells us about Facebook, or tells us about equities in general for that matter?

Facebook has a lot of customers, that much is obvious. And many of those customers love it. Even so, look at the maths. The valuation on IPO will be around $107bn. The company has 900 million users. I make that $1,758 dollars a user. That means to justify its valuation the company must generate slightly over $100 per user per year in advertising.

I mentioned here the other day that Facebook seems to be more relevant to PR than advertising. See The great Facebook IPO nears, is it time to run for the hills? Facebook is a very powerful marketing tool if you can get someone to 'like' your product, because all their friends see the 'like'. But advertisements on Facebook don't have the same viral potential.

You can see Facebook in terms of the difference between PR and advertising. The best explanation I ever heard is this. Advertising is what you say about yourself, PR is what other people say about you. Facebook is a PR person's dream; it is not like that for ad men and women. Perhaps that explains why WPP's Martin Sorrell has frequently stated he has fundamental doubts about Facebook's valuation.

But today I am moving beyond that. Facebook may or may not find a way of monetising its product to apparently justify its valuation, but I am stepping back and taking a different view.

There are several ways to try to judge whether a company is valued correctly. One method is to take an estimate of future earnings, giving us forward earnings multiples, p/e ratios etc. If we were to check the valuation of an index or sector, the cyclically adjusted p/e ratio is useful. This takes into account average earnings over a specific period of time, such as the last ten years.

But another method for valuing an index is equity Q. This is derived by taking the market capitalisation of corporations, and dividing by the fundamental value or the cost of replacing assets. According to Capital Economics, the level of equity Q for all US non-farm corporations was 0.82 at the end of Q3 last year. Markets have risen since, and a couple of months ago Capital Economics said it estimated that it is now around 0.96. The average since 1900 was 0.65.

So by the equity Q yard stick, equities are overvalued. How does this relate to Facebook? I will tell you.

The problem with equity Q is that for technology companies the measure is less relevant. How do you measure the cost of replacing capital, when much of a company's strength lies in its ability to innovate, or in the case of a company like Facebook, in its user base?

If we were to use an accountant's definition of capital, I would say the Facebook is clearly grossly overvalued. It would cost a fraction of $100bn to create the expertise, or products that the company currently has.

But instead, let's look at the cost of replacing its user base. How much would it cost Facebook to build up 900 million users from scratch? Or for that matter, how much would it cost for a rival, such as Google Plus, to create 900 million users?

I would like to suggest it would cost a lot less than $1,000 a user. Indeed, a potential rival could pay people to use their product, I am sure most would more than happily migrate from Facebook to an alternative if there was, say, a $300 sweetener.

And that's why I think the Facebook stock is overvalued.

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