Should you stay away from Facebook?

The price of Facebook's shares has more than halved since the social network website was floated, says Matthew Partridge. So, is this the time to buy, or should you steer clear?

High profile flops don't come much bigger than the flotation of website Facebook (NASDAQ: FB).At its peak in the immediate aftermath of its IPO, it was trading at $45. At the moment, it trades at just under $20, less than half this level.

With the end of the lock-up period arriving, even major backers are cashing out. Peter Thiel, the first outside investor, who had 44 million shares before it went public and still has a seat on the board, has now mostly sold up. Luckily for him, even after seeing the price plunge, he stands to make a huge profit since he bought the shares cheaply in 2004.

So should other investors follow his lead?

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This insider sale is a bad sign

Thiel's decision to sell, but still remain on the board (he still has a small stake) has angered those who think he should have quit having cashed out. However, the bigger issue is what it says about the company.

Insiders tend to know a lot more about a company than the average investor. Unlike institutional investors, they are playing with their own money, not other peoples'. And while the evidence is mixed on whether directors time their sales correctly, when someone like Thiel, with very intimate knowledge of a business, gets out, investors should take note.

Equally importantly, even at today's price the share is no bargain.

Facebook is still too expensive

The major problem is that Facebook is simply too expensive. Even with the recent falls, it is priced at around 30 times2013 earnings. This means that it has to keep growing quickly in order to justify its valuation. Sadly, as my colleagues John Stepek and Phil Oakley have both pointed out (A share to buy instead of Facebook), it is hard to see how it can do this.

One possible way is through more ads. The downside is that this risks losing subscribers. The trouble is that users are often unwilling to accept the sort of large banner ads that big companies want. It's an issue that all online media firms are having to grapple with but it matters more for Facebook, given its lofty valuation, than formost others.

The example of MySpace shows what can happen when the time comes to convert users into dollars. At the time of its sale to News Corp in 2005 for $900m it was second only to Facebook in size. However, the board found that they could only meet targets for ad revenue by inserting ads into every nook and cranny. Users rumbled the tactic and defected en masse to Facebook, leaving the firm to be sold last year for $35m.

There is also a big question mark about whether data on the number of Facebook users a key stat for advertisers - is even correct. A recent BBC report claims that many profiles may be fake. More worryingly, some advertisers are now alleging that many of the clicks that Facebook ads attract do not come from human viewers but rather from automated programmes.

The threat from competitors

While Facebook has managed to fend off similar websites, there is no guarantee that this will remain the case. It is not legally impossible to set up a Facebook clone. Rivals have also learnt lessons from the failure of early attempts to copy Facebook.

Already it has been unable to stop the network from dominating the Russian market. And if Microsoft or Apple decided to build a clone Facebook could be in serious trouble. Meanwhile Google are putting a lot of effort into making their users sign up to Google+, Google's own network. It's still growing whereas Facebook looks to have stalled, which is why we think Google is the better investment.

Buy Google instead

If you want to buy an Internet technology share, we'd suggest Google (NASDAQ: GOOG) instead. The company is trading at a far more reasonable forward price/earnings (p/e)ratio of 13.7. It has a proven track record of growth and a more diversified business model.

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. In short it offers an investor more than Facebook can offer, for less risk.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri