Decoding share prices

30th May 2012

The sky is not the limit – if you control the universe

Deciding whether to start with the good news or the bad is an eternal dilemma. With Facebook, which some have already rebranded as Fadebook , it is only fair for the upbeat to be the point of departure – after all poor Mark Zuckerberg and his billionaire team have been on the receiving end more than a normal share of investor "dis-likes".

The good news is that the share price seems to have settled for the moment at around $32. It appears to be behaving in line with the technology sector.  And the early trading problems  are now in the past.

It's not all unalloyed joy, however. Those trading problems will prove lucrative for lawyers for years to come – one firm has already demanded some $5bn as it starts a class action for disappointed IPO investors. Possibly the price has stabilised simply because optimistic holders refuse to sell, holding on in the hope of recovery and the avoidance of a near 16 per cent loss. Facebook bulls are talking of a return to $40. But bearish forecasts go all the way down to $6.

Fair value or foul pricing

Investors, including fund managers, often talk of a "fair value" for equities. But this has any many definitions as there are shareholders in the company concerned. A share trades "above fair value" if an investor wants an excuse to hold it and "below fair value" when a reason to buy is needed. It is not over-cynical to say share prices rise when buyers outnumber sellers – and vice versa. 

There are, however, generally some parameters, notably the performance of other stocks with a similar business model (compare BP with Shell with Exxon, for example) or the comparison of a ratio (such as price to earnings or price to book) with the sector, the market or what it was in the past.

But when it comes to technology mega-stocks, whatever rules they are break down. 

This worries the author of this blog who questions how can an investor can decide on whether a price is expensive, cheap or just right without the wisdom of Goldilocks and her ability to try the beds and the breakfasts.

Act of faith

Writer Jean-Louis Gassee says "buying a share is an act of faith in the company's future earnings. The strength of this belief manifests itself in the company's P/E (Price/Earnings) ratio. The stronger the faith, the higher the P/E, an expectation of increased profit."

So far, so good. It is when it comes to the likes of Facebook that the model breaks down. It was launched on a rating that assumed that even if profits multiplied ten-fold, investors would still need a decade or more to earn back their initial subscription. Bulls believe times ten is easy; the bears see this as a hurdle never before leapt by social media.

Gassee turns his real attention on Amazon's valuation. This, he says is "an extreme price/earnings number" that "beggars belief, inviting a deeper look into the thoughts and emotions that drive prices." 

According to Gassee,  Amazon – AMZN  –  trades at more than 174 times its most recent earnings. Amazon's position is such it has no easy comparator. But, for what it maybe worth, Google's P/E hovers around 17 times, Apple and Walmart are on 14, while Microsoft is a down to earth 11.

Amazon has stated earnings per share of $1.22 per share – and a share price of $212.89. If Amazon earnings stay static, investors will not see their money back until 2186.  It would be unfair it this was a blip – a one-off before earnings went up to $12.20 a share.

But somehow this circle has to be squared with its profit margins, plunging over the past eight quarters from 4 per cent to under one per cent. Now that would not matter if sales soared to compensate. But revenues are only up three times at best. So to get to a value in line with technology competitors, it would have to increase sales perhaps 20 times or puff up margins to such an extent that other retailers could shoot it down.

So why do traders bid Amazon so high? How does chief executive Jeff Bezos appear to walk on water?

Unless there is a secret plan of such depth and breadth that no one outside the Amazon top executive suite could even dream it up, the Amazon strategy may be that of the ultimate hypermarket – sacrifice margin to build sales so that eventually all competition gives up. At that point, the monopolistic Amazon rebuilds margins. The company is worth 174 times present earnings if it becomes the dominant world retailer – increasing margins and sales exponentially.

The Amazon model may envisage swallowing sales from Wal-Mart, Tesco, Carrefour and other retailers – it has little interest currently in food and other groceries – creating an effective world monopoly.

Facebook looking to be Onlybook

The only way that the Facebook valuation – even down 16 per cent from the IPO – can be justified is if it manages to create an online monopoly.  If it could replace Google on search engines, and Apple on hardware and content, then the present $32 is bargain basement.

Apple's own grip on its marketplace is weakening thanks to Android (powered by Google) phones and tablets. But as it engages in a battle of the Titans with Google,  the Facebook hope must be that both are fatally wounded.

Law of large numbers

But all these companies must either become real monopolies or succumb to the Law of Large Numbers.  This states that mega concerns cannot continue with the high percentage growth that smaller companies are capable of.  For instance,  if Facebook multiplied users ten fold in an early period, it can never hope to do that again for that would imply it had every person in the world signed up – even the billions without electricity, let alone broadband.

Apple's success is partly down to mobile phone companies subsidising the handsets. If that model stops or the phone carriers switch their allegiance to Samsung or a Google-revitalised Motorola, then even its present valuation would be under threat.

The fly in the Facebook/Google/Apple valuation model is the ease with which currently unknown competitors with currently unknown ideas could move into their space.

Amazon does not have such a deep problem.  It has real bricks and mortar, real communications and real logistics.  As such, it has cost of entry barriers. That could explain the Amazon valuation. 


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