Blackstone Blog

May 16, 2012

New Faces, Old Themes: in Technology, Long-term Earnings Growth is Still the Key Determinant of Value

Ken Allen, Director, Blackstone Advisory Partners, L.P.

My colleagues and I in Blackstone’s Technology Advisory group recently hosted a series of dinners in San Francisco and New York to discuss the trends du jour with many of the thought leaders in the tech sector.  Invariably, given all of the excitement around the Facebook IPO, much of the discussion ended up focusing on this topic.  Facebook’s IPO, the third largest in U.S. history behind Visa and GM, is certainly cause for much discussion.  Here we have a company with $3.7 billion in revenues that last traded in the private markets at a valuation north of $100 billion.  That implies a trailing revenue multiple of over 27x, for those doing the math.  As such, Facebook, at eight years old, has eclipsed the valuation of such venerable U.S. brands as McDonald’s, Caterpillar, Boeing, American Express, and Amazon, and at pricing is expected to have a valuation higher than Dell, HP, and Adobe, combined

It is fashionable these days to doubt Facebook’s ability to deliver on its promise.  We have seen Zynga and Groupon shares work lower to trade at significant discounts to their IPO prices.  In Facebook’s case, the company’s user-base of 900 million+ people certainly provides a significant potential platform for future revenue and earnings growth.  But there is no guarantee that the reality will live up to the promise.  As described in the company’s most recent S-1 filing, average revenue per user declined in the most recent quarter.  The company’s Credits business, which many believe is one of the keys to Facebook’s future revenue machine, is nascent.  Facebook’s mobile platform is unproven.  And the list of “Risk Factors” goes on. 

While we can all debate what Facebook’s ultimate potential actually is, investor expectations, as reflected by the company’s valuation, are undeniably huge.  To put this in perspective, on a 2012 basis, Facebook, at the mid-point of its filing range, would trade at 49.9x 2012 adjusted net income (adjusted to exclude stock option compensation charges), by one broker’s estimates.  Compare this with Apple, which trades at only 11.5x, despite earnings growth in its most recent quarter that eclipsed 58%. 

But is Facebook’s expected valuation really that high?  Or is Apple’s low?  What about other high-growth companies in the tech sector such as LinkedIn or VMware?  Where do they fall on the spectrum?  To help answer these questions, we have attempted to quantify the drivers of valuation using the construct below.  This chart compares forward P/E multiples with consensus estimates for long term (5-year) growth in earnings, for a number of broad sectors.  We have run a regression based on the sectors below (excluding the individual companies such as LinkedIn, etc.), and overlaid some of the notable names in the technology sector on the chart.

The findings are not altogether unfamiliar; sectors such as Cloud Infrastructure, Software and Internet, which tend to grow at above average rates, achieve higher P/E multiples.  Sectors that grow less quickly, such as Hardware and IT Services, achieve lower multiples.  But the interesting aspect of this chart is how tight the correlation between the two variables is.  As indicated by the R2 above, nearly 93% of a sector’s valuation is described by a single variable:  long-term earnings growth.  Mega-trends such as Big Data, Cloud Computing, and Social Media have garnered massive private and public investor mindshare, leading to valuations that are beyond the comprehension of many.  But at the end of the day, on average, those valuations are tied to plain old fundamentals; these companies trade where they do because investors believe they can deliver high and sustained earnings growth over the long-term. 

This chart helps to put Facebook’s forward P/E of 49.9x in perspective.  The handful of brokers that have initiated coverage on Facebook estimate the company can grow earnings at between 30-40% over the next five years.  For the purposes of this analysis, we have selected a single estimate near consensus, which calculates adjusted EPS growth of 33%.  When viewed through this lens, Facebook’s valuation at the mid-point of its filing range is actually below that predicted by the regression line.  At the regression line, Facebook’s implied market cap is $144 billion, a 46% premium to the $98.7 billion valuation implied by the mid-point of the filing range. 

Of course, any valuation implied by the regression line is highly sensitive to investors’ growth expectations, which is why we often see high volatility in a stock in its first several months of trading following an IPO.  According to this model, small changes in investor growth expectations have big implications for valuation; precisely, a change in long-term EPS growth expectations of only five percentage points implies an increase or decrease, as the case may be, in the P/E ratio of 15.1x.  Even if investors do believe in Facebook’s potential, they may not give the company full credit for its future growth trajectory until it proves its ability to grow, for several quarters or even years.  

But make no mistake, the story that Facebook is telling on its roadshow is one consistent with massive growth over an extended timeframe.  It is telling a story much grander and more interesting than that of a communications tool, photo sharing platform, or social application.  Facebook is telling a story of a social platform akin to an operating system, upon which an increasingly greater share of future applications will be built, including those associated with commerce, payments, games, media, and mobile computing.  It is also telling a story that is far more comprehensive than one solely focused on transforming the display advertising business, which it has arguably already done.  The market Facebook is targeting encompasses offline branded, mobile, and performance-based advertising, in addition to display; e.g. a market approaching $500 billion in size.  Thus far, investors have liked (forgive the pun) the story, as indicated by the fact that Facebook on Tuesday increased its price range from $28-$35 initially to $34-$38. 

In responding to initial investor demand and increasing its price range, the company appears to be steadily marching upward toward the valuation implied by the regression analysis above.  The unprecedented nature of Facebook’s pricing dynamics is related to the unprecedented scale of its user base for a company its age and the growth potential investors anticipate.  The pricing on Thursday will begin another chapter in Facebook’s journey and will provide another historically significant data point on the pricing and trading of blockbuster technology IPOs. 

Ken Allen is a Director in Blackstone’s Technology Advisory Group and leads the Firm’s Digital Media and Internet practice.  You can follow Blackstone on Twitter at @blackstone. 

This commentary is not intended to be a recommendation to buy or sell any securities.  Blackstone is not involved in Facebook’s Initial Public Offering.