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Mark Hulbert Archives | Email alerts
April 25, 2012, 12:01 a.m. EDT
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By Mark Hulbert, MarketWatch
CHAPEL HILL, N.C. (MarketWatch) "” 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 /quotes/zigman/8607696 FB 0.00% 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:
. What will be its stock's average return between now and May 2017?
. 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.
Apple's quarterly profit nearly doubled thanks in part to strong sales of its iPhones and iPads. MarketWatch's Dan Gallagher talks about the results and potential market reaction.
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.
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 /quotes/zigman/93888/quotes/nls/goog GOOG +0.61% , 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.
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Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD... Expand
Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD became a service of MarketWatch in April 2002. In addition to being a Senior Columnist for MarketWatch, Hulbert writes a monthly column for Barron's.com and a column on investment strategies for the Journal of the American Association of Individual Investors. A frequent guest on television and radio shows, you may have seen Hulbert on CNBC, Wall Street Week, or ABC's World News This Morning. Most recently, Dow Jones and MarketWatch launched a new weekly newsletter based on Hulbert's research, entitled Hulbert on Markets: What's Working Now. Collapse
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