A share to buy instead of Facebook

At our MoneyWeek conference last Friday the main focus was on how to protect your hard earned wealth.

Meanwhile, most of the media had its eyes on social networking firm, Facebook.

For a few hours, people travelled back in time to the heady days of 1999-2000 and the peak of the technology, media and telecommunications (TMT) bubble. Newspapers had live blogs counting down the time until Facebook began trading on the Nasdaq, while investorsspeculated about how rich founder Mark Zuckerberg would be by the close of trading.

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Monday brought the wake-up call. The shares fell 11% to $34. So far this week they are down nearly 20%. Here's what's wrong with Facebook as an investment, and my alternative tip from the tech sector.

Facebook shares are massively overvalued

The famous value investor Benjamin Graham always advised people not to buy initial public offerings (IPOs). I tend to agree with him. The issue price is usually set too high and favours the seller at the expense of the buyer. Facebook is no different.

At $38 per share, the company had a valuation of $81bn. In 2011, Facebook's net profit after tax was $1bn. Facebook was therefore floated on the market at 81 times its trailing profits. History shows that very few businesses have ever justified such a high valuation.

The Wall Street analysts marketing Facebook to professional investors will have given a range of valuations based on different assumptions of growth. These assumptions will have been subjected to the holy grail of investment analysis discounted cashflow valuation, or DCF for short. This can get complicated but in summary it is where forecasts of future profits/cashflows are equalised and added up to give a value for the business today.

The trouble with DCF is that it is subject to the principal of 'Gigo' garbage in, garbage out: you can get any valuation you want from it, but it will be meaningless if the assumptions behind it aren't realistic. This crystal ball trick was used time after time during the late 1990s dotcom boom to say that businesses which were essentially worthless were worth fortunes.

I'm not going to get into the maths here, but suffice it to say the assumptions about Facebook's growth needed to get a valuation of $81bn are verging on the heroic.

Facebook's business model has a lot to prove

The case for buying Facebook rests with its 901 million active monthly users. These are supposed to be an advertiser's dream, and will allow Facebook to make lots of money.

But there are signs that advertisers are becoming uneasy. Some are concerned that they won't get the big banner ads that they want and so may pay less to advertise with Facebook. General Motors is a high profile example.

Besides, companies can set up a presence on Facebook for nothing, so why do they want to pay a lot to do so? The fact that the growth of Facebook's advertising revenues slowed during the first quarter of 2012 suggests that it may not be the advertising haven it wants, or needs, to be.

Apart from the advertising story, it seems that Facebook has very little else to offer investors. It is trying to make money from social games (mainly from Zynga) but this has yet to gain traction.

Meanwhile the history of the internet reveals that it's quite easy for new companies to enter some markets and destroy existing businesses, even big ones. After all who still talks about MySpace now? So who's to say that Facebook won't be knocked off its perch, or that users will become fed up with it and move on to the next big thing? It may just end up being a huge success but the problem is its flotation valuation leaves no room for doubt.

The success of Facebook will come down to an ability to deliver rapid profits growth. The initial signs are not good here: first quarter net profits fell by 12%.

Worse, it's difficult to know whether the management of Facebook is really focused on the profits the company needs to make. The fact that founder Mark Zuckerberg still controls 55.9% of the company raises questions as to whether other shareholders will be able to influence the way the company is run. And with only 20% of the company in public hands, it would not be surprising to see lots more shares coming onto the market in the future.

All in all then, there are plenty of reasons not to buy.

So what should you buy instead?

Google (Nasdaq:GOOG) is a company that has arguably taken ownership of the internet. It is also a company that has proven the naysayers wrong by building a business that millions of people use that is very difficult to compete with. This has allowed it to grow its profits very quickly.

Apart from its dominance in internet search, it boasts YouTube, Gmail, the Android operating system for tablets and smartphones, and Chrome. It also has its own version of Facebook in Google +. These channels offer a wider range to advertisers than Facebook's social network.

And how much do you have to pay for Google? A very modest 14 times 2012 earnings. Facebook shares look like they could still fall a long way from here. So why take the risk when you can buy Google for much less instead?

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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