post Tuesday January 10, 2012
Facebook, Inc. announced last month that they are considering a $10 billion initial public offering for some time in 2012. The offering would mark the largest internet IPO in history. This $10 billion would represent a release of 10% of Facebook’s total stock, meaning the overall company would be valued at $100 billion. Since the $100 billion valuation reflects an estimate of what the market is willing to pay for the stock, the question is, what process did the valuators use to arrive at such an amount?
Facebook has traditionally been quite secretive when it comes to their finances, but we can speculate that advertising sales have sustained fairly high revenues for the company over the years and that these revenues will continue. We can also estimate that Facebook’s expenses, such as hosting the website, paying programmers, etc., are most likely small in proportion to revenues. Year-on-year revenue growth coupled with sustained low expenses will lead to a high business value such as Facebook’s. One anomaly is that given the current revenue structure of the business, growth in revenues required for such a high valuation would need to be increasing significantly year to year. Facebook’s revenue growth, it seems, have and will remain fairly stagnant.
For a stock valuation such as this, an easy go-to method to value a stock for an IPO would be the discounted cash flow method. The DCF method relies on future free cash flow projections, based on forecasted growth rates. These forecasted free cash flows are then discounted back to a net present value (normally using a weighted average cost of capital). If the arrived at net present value is higher than the current price of the stock, this is an indication that the stock price may rise over the next few years. In Facebook’s case, however, since free cash flows (within the current business structure) seem to not have much potential for significant year on year growth, a DCF valuation may not be appropriate given the current business structure.
Another approach to valuation of the Facebook stock could be the multiples approach in which comparable firm prices can be used to value one firm based on the value of another. But even using comparable IT companies, the growth rates for Facebook to arrive at such a valuation would be significant.
As the possibility for Facebook’s IPO looms and speculation surrounds the business’ future revenue growth, we have to wonder, do the Facebook valuators know something we don’t? This $10 billion would represent a release of 10% of Facebook’s total stock, meaning the overall company would be valued at $100 billion. Since the $100 billion valuation reflects an estimate of what the market is willing to pay for the stock, the question is, what process did the valuators use to arrive at such an amount?
Facebook has traditionally been quite secretive when it comes to their finances, but we can speculate that advertising sales have sustained fairly high revenues for the company over the years and that these revenues will continue. We can also estimate that Facebook’s expenses, such as hosting the website, paying programmers, etc., are most likely small in proportion to revenues. Year-on-year revenue growth coupled with sustained low expenses will lead to a high business value such as Facebook’s. One anomaly is that given the current revenue structure of the business, growth in revenues required for such a high valuation would need to be increasing significantly year to year. Facebook’s revenue growth, it seems, have and will remain fairly stagnant.
For a stock valuation such as this, an easy go-to method to value a stock for an IPO would be the discounted cash flow method. The DCF method relies on future free cash flow projections, based on forecasted growth rates. These forecasted free cash flows are then discounted back to a net present value (normally using a weighted average cost of capital). If the arrived at net present value is higher than the current price of the stock, this is an indication that the stock price may rise over the next few years. In Facebook’s case, however, since free cash flows (within the current business structure) seem to not have much potential for significant year on year growth, a DCF valuation may not be appropriate given the current business structure.
Another approach to valuation of the Facebook stock could be the multiples approach in which comparable firm prices can be used to value one firm based on the value of another. But even using comparable IT companies, the growth rates for Facebook to arrive at such a valuation would be significant.
As the possibility for Facebook’s IPO looms and speculation surrounds the business’ future revenue growth, we have to wonder, do the Facebook valuators know something we don’t?
