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Facebook IPO separates investors from speculators

Like many, I have been watching the Facebook public market debut and post-IPO activity with great interest. While watching from the sidelines I came across an article regarding regulatory inquiries about what went wrong with the overhyped IPO.

There may be some real regulatory concerns. But it's interesting that the undertone of some articles suggests that Facebook's falling price is shocking and a sign that something went wrong. A look at the expectations baked into Facebook's IPO prices helps explain why its fall so far is no great mystery.

IPO valuation One of the reasons our firm seeks managers with some sensitivity to valuations is because many investors get seduced by a company's story while ignoring how much the market is paying for the 'story'.

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In Facebook's case, its IPO investors ponied up $38 (U.S.) per share for $0.43 of earnings per fully diluted share (on a weighted average basis) and $0.49 of free cash flow per share. That's a trailing price-to-earnings ratio of more than 88 times and price-to-free-cash-flow of more than 78 times.

Embedded expectations Given these figures, IPO investors hoping to earn a long-term annualized return of 10 per cent would need Facebook to grow its earnings and cash flows by 25 per cent to 30 per cent annually for the next decade. In other words, Facebook's earnings and cash flows would have to grow to 9 to 10 times last year's levels. And this is just to deliver a 10 per cent annualized return to shareholders.

Those who purchased the IPO with the hope of higher returns -- say 15 per cent per year for the next decade -- need Facebook's financial performance to be nothing short of miraculous. Growth in earnings and cash flow would have to hit 32 per cent per year for a decade.

Miracles happen from time to time. Google didn't just achieve this kind of earnings and cash flow growth; it comfortably exceeded this high bar. But this kind of performance is rare. And even if Facebook does really well as a business, it doesn't guarantee that IPO investors will be happy.

Share prices don't follow earnings alone Cisco Systems is the poster child for valuation risk. It's tough to argue with its corporate performance. Its earnings per share have grown more than 400 per cent over the past decade on a more than doubling of revenues. Yet, its share price is roughly where it started a decade ago (with many ups and downs along the way).

I'm not here to opine on Facebook's investment merit. I'm merely putting some financial context to the Facebook's investment story. The price paid for an investment has a significant influence on the ultimate return to investors. Sometimes it's worth paying up for growth. But being seduced by a company's story without considering valuation (i.e. buying at any price) is pure speculation.

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