I Know Why Facebook Keeps Plunging

Remember back in the late nineties when an internet company would go public and the stock would triple in the first day? Ah, the good old days.

The really neat thing about many of those companies is that they had no revenue, no earnings and no business plan.

Now we have an IPO from a dominant internet company (Facebook (FB)) that has a huge moat around it as it has captured an astounding half a billion users, yet the stock price has gone from $38 at its IPO down to $26 and change today.

What is the problem? I thought these internet IPOs were the hot things to get into. And this one has a real business behind it.

Seriously though, I know what the problem is. And I bet you do to.

These days valuation means something to investors. Unlike the late 90s we aren't in euphoric times. Instead we are in an investing world dominated by fear. Housing crashes, sovereign debt crises and recessions.

Investors are willing to give the US Government money and expect nothing in return. Retail investors who were killed in the 2008 financial panic still haven't returned. There aren't many people around who are simply going to buy something because they hope it goes up. And if you aren't paying attention to valuation, hope is all you've got.

These days I'm afraid buyers actually want to receive some value for what they are paying. And there wasn't much value in Facebook at the IPO price.

Today I was reading the annual report from the value investing firm Tweedy Browne. Interestingly, in its letter to shareholders Tweedy Browne brought up Facebook and its valuation.

No longer will you have had to be a preferred customer of an elite investment bank to get your hands on some privately placed shares. But unfortunately, it comes at a price. While it costs you nothing to "friend" Facebook's founder, Mark Zuckerberg, to become his business partner as a shareholder along with him is an entirely different matter altogether.

For that privilege, you will pay dearly. At what some analysts believe could be a market capitalization of $100 billion, Facebook's day one valuation will likely be nearly 100 times the $1 billion Facebook was thought to have earned in 2011. This is about 9 to 10 times the multiple of earnings we generally like to see when we are considering investing in a new security. What is causing investors to chomp at the bit for this stock? What else but exuberant expectations about accelerating levels of growth and profitability? We are all for growth and love to uncover it, particularly when it is reasonably priced, but at this kind of multiple, we think that the chances for investment success become a high stakes gamble.

The good folks at Tweedy Browne are looking pretty smart today as this was written before the Facebook IPO after which the company lost almost a third of its market capitalization.

To further illustrate the point, Tweedy Brown noted that the IPO market capitalization of Facebook ($100 million) matched the combined market capitalization of eight of Tweedy's portfolio holdings (also $100 million).

The Tweedy Browne eight companies being Heineken (HINKY.PK), Daily Mail (DMTGF.PK), Devon Energy (DVN), Emerson Electric (EMR), G4SPlc (GFSZF.PK), NGKSparkplug (NGKSF.PK), Teleperformance (TLPFF.PK) and Torchmark (TMK).

But while the market capitalization of Facebook and Tweedy's eight were the same, the amount that each group earns is radically different.

While Facebook had an estimated 2011 earnings of one billion dollars, the Tweedy eight had combined 2011 earnings of almost ten billion dollars. For the same price, an investor can either purchase one billion, or ten billion of earnings.

The investment choices thus being:

Option A Facebook - Pay $100 billion for one billion of earnings

Option B The Tweedy Eight - Pay $100 billion for ten billion of earnings

The clear choice for me would be option B, but then of course I don't really fancy paying much of a premium for growth.

It is possible that Facebook can grow earnings at a high rate for an extended period and prove that this valuation isn't excessive. In the current investment environment however, investors seem to want to see that growth before they believe it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.