Reality check for Facebook investors
The stock must have an aggressive growth rate to meet sky-high expectations.
By Mark Hulbert
Can Facebook's earnings grow fast enough in coming years to justify the $40 per share price at which it is currently trading in the secondary market?
That question strikes most investors as hopelessly unquantifiable, and they therefore don't bother to try answering it. In fact, however, given a few conservative assumptions, it's simple math to calculate an answer.
And it turns out that the required growth is incredibly fast -- faster, even, than almost any other growth company in history. This doesn't guarantee that Facebook will be unable to do so, but does indicate how high the hurdles the company must jump over to succeed.
To illustrate, I will focus on the next five years -- though you could do this exercise using any other time frame as well. To solve for Facebook's required growth rate, you need to answer two preliminary questions:
1. What will be its stock's average return between now and May 2017?
2. What will be its P/E ratio in five years' time?
Let's tackle the first question first. Though the stock market historically has returned about 10% per year on an annualized basis, Facebook's stock will be far riskier than investing in the overall stock market. It therefore will need to provide a return significantly greater than 10% annualized in order to compensate investors for this greater risk.
To be conservative, let's say that Facebook's stock produces a 20% annualized return over the next five years. Assuming the company comes to market in mid May at $40 per share, where it is currently trading in the aftermarket, this means that Facebook shares will be trading at around $100 in May 2017.
Post continues below.
Now let's tackle the second question. Given what Facebook recently paid for Instagram, we can deduce what the company's market cap would be -- $104 billion -- if its initial offering price is where its stock is currently trading in the secondary market. And if we annualize the company's latest quarterly net income of $205 million, we arrive at a P/E ratio of 127-to-1.
This ratio will surely come down in coming years, of course, and as it comes down the company's earnings will have to grow even faster to prevent that declining P/E from translating into a lower stock price. This presents a high hurdle indeed for Facebook, since companies with market caps as large as Facebook's, even the fastest-growing ones, typically do not have P/E ratios higher than around 30. Google, for example, to which Facebook often is compared, currently trades at a P/E ratio of 16.6.
To again be conservative, let's assume that this ratio in May 2017 will still be as high as 50.
Guess what: With those two assumptions, Facebook's earnings will have to grow at an average rate of 43.4% per year for the next five years.
That's a huge growth rate, of course.
Don't like this answer? Go ahead and try playing around with the numbers. You'll be hard pressed to come up with an answer that you'll like any better.
Take a look at the accompanying spreadsheet. Each of the cells lists the required EPS annualized growth rate over the next five years to support the assumptions that are listed.
Annualized return of stock over next 5 years
May 2017 P/E = 30
May 2017 P/E = 40
May 2017 P/E = 50
May 2017 P/E = 60
To give you an idea of how unlikely such growth rates are, consider a landmark study that appeared several years ago in the prestigious Journal of Finance. Entitled “The Level and Persistence of Growth Rates,” it was written by three finance professors: Josef Lakonishok and Louis K. C. Chan, both of the University of Illinois at Urbana-Champaign, and Jason Karceski of the University of Florida.
The professors studied the earnings growth rates of U.S. publicly-traded companies between 1952 and 1997. One of the things they were looking for were companies whose earnings grew for five years straight at more than the median rate. That's not asking much, since that median was around 10% per year -- far lower than the 21% to 59% growth rates that appear in the above table.
Yet, the professors found hardly any companies that were able to meet even this modest precondition. This was true even among tech companies, furthermore.
To be sure, there have been companies that have beaten these odds. The most celebrated example of recent memory is Google, of course.
But, given the sky-high growth rates necessary to support Facebook's current price, along with the professors' research, Google's experience is very much the exception that proves the rule.
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