Tomorrow I will be interviewed by Emily Maitliss for the Money Programme about the valuation of Facebook. Should you buy some shares in Facebook? How do you judge if a company is overvalued anyway?

Well the company will raise $10billion – that’s the most by a technology company ever. More than Google raised. It values the company as a whole at just under $100 billion. But is it overvalued as a company – as a stock?

There are only ever two reasons to buy a stock; either for the short-term where you think future expectations are not priced into the company’s share price and it will lead to surprises that will cause the shares to rise.

Or you think for the long term all the revenues it will generate, dividends it will pay, share prices rises it will as a consequence generate, are today being discounted too greatly and therefore the stock is undervalued. This is what we fund managers call the net present value or discount cashflow model.

The way it works is this – you treat a stock like any asset eg a house. What is all the income you will ever earn from it? That is then valued at having it today, because £10 in a year is not worth the same as having £10 today.

Let’s take the short-term. Surely no one would argue that the market is under-pricing the over-exuberant expectations for Facebook. Granted, at the IPO (initial public offering), when it first hits the market, it will rise, because retail investors, renowned for being wrong, will drive it higher. But then what? The clever institutions and smart money will start moving it lower I suspect by selling at this premium price driven by excited retail investors. So ride the bandwagon, but just make sure you jump off before the cliff – just like in the good ol’ dot-com era days.

What of the long-term? The maths is tricky. Essentially it comes down to how do you value a company? A company is simply worth, as mentioned above, the net present value of all its future cash flows discounted to today. That means we need to know a discount rate – which can be thought of as the return someone wants for investing in something as risky as shares. Let’s say this is 10% per annum. And we also need to have an idea of growth of the company. Let’s say sales growth for the next seven years is maintained at Google’s average over the past 8 years which is roughly what Facebook grew last year – namely 80% per annum. What is the company worth? By my estimate around $75 billion – assuming sales growth of 80% per annum – which Google has maintained.

That would mean Facebook at IPO is pretty well valued or slightly overvalued.

Alpesh Patel

www.InvestingBetterBlog.com