How much is Facebook's innovation worth?

Saxo Bank's Equity Strategist Peter Garnry, one of my colleagues on TradingFloor.com, wrote a great piece about Facebook today - but it is very, very optimistic, as Peter tends to be.  As a value stocks investor, I'm a little bit more pragmatic.  I don't entirely disagree with Peter, but I wanted to break down the numbers a little bit more, particularly where it concerns innovation. What would make Facebook a great investment? 

Hypothetically speaking...
Let's say that over 5 years, Facebook grows to a market capitalization of $200 billion, basically doubling the share price or a 20% average yearly return on your investment. After all, that's all people really care about. I believe that the lack of visibility in Facebook's future revenue source definitely deserves a doubling of the investment over 5 years (or less), as it is a high risk/high reward proposition. I will also assume that 2 billion users could be on Facebook in 5 years' time, basically close to of 90% of all current internet users, and a 100%+ growth in Facebook users to base my case.

The zero innovation base case...
We can now also develop a base case concerning Facebook's current business model. Assume that Facebook has 2 billion users in 5 years. At the current revenue per user level ($5 of revenue and $1 of profit per user), we have a company with at the bare (very bare) minimum around 8-10 billion of revenues and at the minimum a 25% profit margin (Facebook's current margin). This would be the minimal or no innovation case.

Therefore from my rash assumption, for Facebook to be a good investment (20% average growth in the stock price for 5 years, doubling the price of the stock) the company would be valued at a P/S of 20 and P/E of 80 (market capitalisation). Additionally it would/could be expected to grow revenues at the 4% rate of growth of internet penetration. 

And although you made 20% per year on your investment, the stock is expensive for a more mature company and would probably subject to massive downside risk. If the stock price doesn't grow and the company stays at a 100 billion market cap., the company is still expensive at a P/S of 10 and a P/E of 40.

But as I have mentioned previously this is just a base case. I believe it to be an improbable scenario, but it does paint a picture of some sorts.

The high innovation case....
Obviously this is the hard one to even attempt to calculate but I will take a wild stab at it. So assume that Facebook has 2 billion or so users in 5 years, the same as the base case.

Now assume that Facebook instead of extracting $5 of revenue per user, can extract $25 (about what Google earns per unique user). Which basically means that Facebook has monetised its user base 5 times from the current rate, which would be very innovative but nonetheless possible. So basically I assumed that in the good innovation case, Facebook revenue has grown to $50 billion  (2 billion users * $25 of revenue per user) and net income has grown to $12.5 billion (assuming constant margins).

Again I assume that for Facebook to be a good investment, the market value would have to increase 20% per year on average, valuing the company at $200 billion, the same as the base case and doubling the investor's investment. So the company worth $200 billion, would have a very reasonable valuation of 4x P/S and 16x P/E for the company.

Obviously the problem with the high innovation case is that Facebook needs to find a way to gain more revenue per user and this where innovation comes in, and the reason why investors will be putting their money in Facebook.

Facebook has massive potential, so we will just see how management responds, but it does appear that the valuation might not be as extreme as people think. Although for value investors like me who are looking for a rather large margin of safety, Facebook has good upside but also potentially a much larger downside if the company cannot innovate or innovate enough to warrant the large price tag. I believe that Facebook will most likely fall between both scenarios. So if you believe in the high innovation case, you are betting that Facebook's innovation is probably worth about about $20 of revenue per user at least, and if not you probably shouldn't not invest in it.

So the question which remains is: how much is Mark's innovation and genius worth to you? 

Facebook's IPO is creating a lot of lively disagreement among my colleagues at TradingFloor.com .  You can read some radically different points of view on our Facebook follow page.  If you'd like to be notified whenever we write a new article about Facebook, become a TradingFloor.com member - it's free! - and follow Facebook.  You will be notified by email when a new article is published.