Facebook's IPO: Should You Buy?

By Ryan Snefsky

The most common question I’m asked right now is, “Should I get in on the Facebook IPO?” This question isn’t being asked now for the first time. I originally started getting this around the time of the LinkedIn IPO.

I heard people say, “I’m not getting in on the LinkedIn IPO. I’m going to wait and get in on Facebook.” But, does this way of thinking make financial sense?

Let me ask you this. Would you buy a house without getting an appraisal or taking a walk through to see what’s inside? To say, right now, that you are definitely going to get in on Facebook’s IPO is to do exactly that, because Facebook has not yet released their financial statements.

What does Facebook’s share price actually represent?

Many people don’t realize that when you buy a share of Facebook, you are actually buying an interest in Facebook’s stream of cash flows (specifically, what is known as “free cash flow”) from now until eternity. That sounds pretty strange, right? But it’s absolutely true.

The price investors pay for Facebook shares represents an estimate of what is known as the “present value” of Facebook’s free cash flow. While this sounds like a bit of technical jargon, it’s actually more simple than it sounds.

What is a simple way of understanding the present value of a stream of future cash flows?

Take for example some lucky individual who wins a few million bucks in the lottery. I’m sure you’ve heard that the winner can either take a one time lump sum payment, or they can take a payment of, say, $50,000 per month for the next several years.

If the winner took the lump sum payment, they could theoretically put that money in some type of savings account and earn interest on it, right? At some point in the future, their payment would be worth more than it is today. This means that the “future value” of the lump sum is higher than the “present value.”

While this is true for the lump sum, it’s also true for a stream of payments. Each payment in the future is worth somewhat less today. In the case of the lottery winner, there is no theoretical difference mathematically between taking the stream is cash flows of $50,000 for a certain period of time and taking the lump sum payment right now.

How does this apply to Facebook's stock price?

The same concept applies with stock prices! Facebook hopes to generate additional streams of cash from now into the future. So if we make a reasonable estimate of how much cash flow Facebook will bring in, we can calculate an estimate of the “present value” of those future cash flows by plugging some numbers into the right equation.

Once we have an estimate of today’s value of Facebook’s projected future cash flows, we can divide that number by the number of shares of Facebook stock that are in existence (a number we also don't yet know), and that’s how much Facebook shares are theoretically worth.

If the shares sell for more than our calculated present value, it doesn’t make sense to buy them because you’re paying more for an asset than what you think it’s actually worth. If the shares are selling for less, then it makes more sense to buy. Accordingly, it makes more and more sense to buy shares as the current market price gets lower and lower compared to your calculated value.

What is the present value of Facebook’s future cash flows theoretically worth?

Here’s the problem. Until Facebook formally files for their IPO, they do not have to release their financial statements, including their statement of cash flows, to the public. Once their financial statements become public, we can take a look and see what their current cash flow is like and see what the growth of their cash flow has been in the recent past.

Until we can take a look at the numbers, it is impossible to get a good idea of what Facebook’s future cash flows could look like. Without an estimate of future cash flows, we have no idea whether or not it actually makes sense to get in because we have no way of knowing a fair price to pay.

An investor who currently says, “I’m definitely going to buy shares of Facebook,” is actually suggesting that they are going to buy something of value regardless of the price they have to pay.

Imagine walking by a house that was being built and saying to yourself, “I have no idea what that house will be worth when it’s done, but I’m going to buy it at any price.” That would be completely irrational! But, that’s exactly what some investors are lining up to do.

Conclusion

Should you by the Facebook IPO? Until Facebook releases their financial statements, it is impossible to know.

The only thing I know for sure at this point is that this IPO is one of the most talked about IPOs in history. Demand, possibly even irrational demand, will likely be huge. But, I’m not going to let the hype seduce me into paying more for the shares than they’re actually worth.

In the meantime, I’m going to patiently wait for the numbers to be released. Then, I will make a rational decision.