the Facebook IPO
I’ve had a couple of requests to write about the upcoming Facebook IPO. So I’m slogging through the preliminary prospectus. I’m not sure I’m going to come out with a final conclusion, but I think I will be able to highlight important points. Today, book value.
In the prospectus, Facebook (NASDAQ ticker: FB) makes what I regard as an unusually strong effort to point out that the company has very little tangible book value. As of March 3, 2012, the figure is $2.85 per share. The expected inflow of cash to the company from the IPO, calculated at a purchase price of $31.50 a share (the midpoint of the expected pricing range of $28-$35) will raise that to $5.15 a share. So FB really wants buyers to be aware they are paying a little over 6x book for the stock.
What does this mean?
book value
Every investor looks for bargain stocks. Techniques differ, though. One of the main tools used by early 20th century securities analysts was looking for stocks that traded at steep discounts to the net asset value shown in the company’s official accounting records.
The measure is “net” in the sense that it is arrived at by subtracting the carrying value of everything the company owes to others (its liabilities) from the carrying value of all its assets. The resulting number is also called book value, because it’s derived from the official accounting ledgers.
an example
The idea is simple: say a firm starts with a single asset, $1 million in cash, and has 100,000 shares of stock outstanding. Book value is $1,000,000/100,000 shares, or $10/share. If the company spends all the money to buy land and build a cement plant, it still has book value of $10, but now it’s all in land and plant and equipment.
Suppose shortly after this, the stock market turns down–for whatever reason–and the company’s stock falls to $5 a share, or 50% of book value.
The plant is still there, however, and would still cost $1 million, or $10 a share, to duplicate. So you can now buy $10 worth of assets for $5!! How can you go wrong? (You can, but that’s a story for another day.) At the very least, the idea that the company holds valuable assets that can–at worst–be sold should act as a cushion against further declines.
One other thing about book value: it also includes, as plusses, profits made and retained in the business, as well as losses, as minuses. So for a successful company, book value gradually rises; for a consistent money-loser, it gradually falls.
Warren Buffett and intangibles
Fifty years or so ago, Warren Buffett had the idea that made his investing reputation. He noticed, far ahead of his contemporaries, that some companies–Coca Cola, for example–had substantial advantages, like famous brand names, efficient distribution networks, a reputation for high quality, that were “intangible” in the sense that they weren’t reflected directly on the company’s accounting records at all.
Nevertheless, these intangible assets have a value. They are predictors of longevity of a business and of higher than average profit margins. Companies that possess them fetch high prices in mergers and acquisitions. Buffett was the first one willing to pay a little bit extra for companies that had strong intangibles. Nowadays everyone does.
most IT is all about intangibles
In the early years of the computer industry, tech companies were allowed to “capitalize,” or list as assets on the balance sheet, the salaries and expenses of their research and development efforts, instead of subtracting them from current revenue in the income statement. But by the time I arrived on the scene in the late 1970s, the practice had led to such horrible abuses (it made profits a lot higher than they should have been) that it was banned.
Like advertising expenditures, R&D is treated as an expense, and reduces income, even though, if successful, it creates an important competitive advantage for a firm. The more R&D, the lower profits are–which means that book value doesn’t rise very quickly. But the intellectual property is at the heart of what makes tech companies valuable.
the Facebook case
As the prospectus indicates, pre-offering, FB has book value of $2.85. The largest chunk of that is cash, generated both by operations and prior sales of stock. The book value of other assets is slightly over $1 a share.
In addition, the inflow of cash from the IPO will almost double that number, creating a tremendous benefit for pre-IPO shareholders. An IPO participant’s $31.50 becomes a claim on company assets worth $5.15. Prior owners will have their claim on book value of $2.85 boosted a lot.
significance?
1. Unlike the cement company, in the FB case there’s no safety net of salable assets to fall back on if the company is unable to make money. In that sense, FB carries with it a large amount of risk.
2. For FB, it’s all about intangibles–the brand name, the goodwill imbedded in the huge number (900 million) of users of the service, whatever patents the company may have. Traditional accounting statements aren’t built to showcase these attributes. So analysis of the statements may not get you very far in understanding the company or its potential.
What about other tech companies. How do they trade versus their book values?
Here’s a sample:
Priceline.com 12x book value
LinkedIn 12x book
Amazon.com 11x
Netflix 7x
Microsoft 5x
Google 3x
eBay 2.5x
Yahoo 1.5x.
It’s hard to generalize from these instances. For fast-growing firms, trading at huge premiums to book value doesn’t appear to be a problem. On the other hand, Yahoo traded at 8x book in 2004, when its future appeared to be more promising–and 6x book when it turned down Microsoft’s takeover bid. So the fact of a large premium to book doesn’t guarantee anything.
All in all, this implies to me that evaluation of FB will be a much more subjective, and difficult, process than for a typical IPO.\
More tomorrow.