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Why a lofty Facebook price could still be a bargain

When Google Inc. went public in August, 2004, the business reporters at the newspaper I was working for did a little internal poll: What will Google shares, debuting at $85 (U.S.) and zooming to $100 their first day, trade for in one year?

As I recall, my answer was not particularly bullish; I may have even predicted a small decline. Another colleague forecast a collapse to $50.

And yet another of my co-workers, believed to be relatively unsophisticated in business, said the shares would top $250. How foolish, the rest of us said, dismissing the hype and the absurdly high price-to-earnings valuation.

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Of course, my optimistic co-worker was right; the skeptics were wrong.

I recall this story today because it offers, I think, a valuable lesson. (No, not that journalists are stupid.) It is that there are rare occasions where buying in to a company at sky-high prices turns out, in retrospect, to be a bargain buy.

Which leads us, unsurprisingly, to Facebook, which will price its initial public offering Thursday night and begin trading Friday.

At the high end of the new $38 range, the company has a valuation of roughly $100-billion. And with just under $1-billion in net income in the previous 12 months, that suggests a trailing price-to-earnings ratio of 100.

And if the shares double in Friday's trading, an easily conceivable scenario? That would be a trailing P/E of 200.

Absurd, absurd, absurd. And yet: Still a level at which early public Google shareholders made money.

In August, 2004, Google had just put up four quarters totalling 72 cents in earnings per share. And with the stock on a steady rise above $100, the trailing P/E was never lower than 134. At one point it hit 252, according to Standard & Poor's Capital IQ.

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If you'd bought on the day of that P/E of 252 in December, 2004, when the shares were $197, your return over the next seven-plus years to today would be a nifty 215 per cent.

In 2005, Google's first full year as a public company, the P/E averaged 113. The high price that year was $446, and while there were opportunities to lose money on Google if you bought it at that level and then sold at less than $300 in the financial crisis, you'd be up 40 per cent if you held it to today.

What happened, of course, was that Google delivered on its promise, producing a near-tripling of earnings in 2005 and a doubling in 2006. That meant the trailing P/E wasn't nearly as important as the forward P/E in how Google eventually would be valued. (My colleague Simon Avery pointed out how this relates to Facebook in Wednesday's Globe.)

Now, let me be clear before I become so contrarian as to contradict myself: Do not dismiss the P/E. Under my stewardship, VOX has sworn off plenty of companies, many great and others not as great, on the basis of high multiples. Just about a year ago, Green Mountain Coffee Roasters had a trailing P/E of more than 100, and, well, that didn't turn out so well.

The point I want to make is that there seem to be rare cases where investors don't end up getting punished for the risk of buying at nosebleed levels. And Facebook … well, maybe it's one of them, and maybe not.

Sorry to be so equivocating, but the reservations I expressed in February when Facebook filed its IPO registration statement are still relevant.

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At the time, I noted that Facebook already had 845 million users, but relatively little revenue to show for it. Extrapolating December, 2011, usage to the full fourth quarter, I figured it took Facebook almost 800 minutes of user time, more than 13 hours, to get one dollar in revenue.

The numbers have actually gotten worse: With the number of users and user minutes increasing in January, but revenue falling sequentially in the first quarter, it took more than 900 user minutes to generate a dollar of sales.

That's important to know when evaluating the Facebook hoo-ha: The company is nowhere near properly monetizing its user base, and it remains an open question how many folks will stick around as Facebook experiments with ways to do so.

But I'm going to stop short of embracing the advice of Chuck D. of Public Enemy, who famously advised, "Don't believe the hype." Skeptics who shun the risks of Facebook's high valuation will indeed avoid potential losses. Bulls, however, may win in the next several years by betting that this is indeed the biggest thing since Google.

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