The Facebook (FB) Bubble.

Here’s my attempt at a Charlie Munger style “inversion” type thought process.

FB was selling the other day at about at $66.50 per share, and for FB to be a worthwhile idea, I’d like to see at least 10% or better annualized returns over the next 5 years or so, with a high level of confidence. So, at today’s prices, to achieve that desired 10% annualized return, FB shares would be selling for about $107 per share, or more, in about 5 years.

So what has to happen for FB to be rationally worth $107 in five years? What has to happen for FB NOT to be worth $107 in 5 or so years? Call me old fashioned, but I think it’s extraordinarily rare that a business is rationally worth paying more than 30x earnings for. So I’ll use 30x as my future multiple in this example.

[Let’s pause for a quick commercial. Yes, 30x is a highly subjective multiple. I encourage you to replace that multiple that of your own choosing, and then recalculate for yourself. And, please, PLEASE, if you can come up with a more rational future earnings or cash flow number, and accompanying multiple, that justifies the current valuation, PLEASE share it in the comment section. I’d love to hear it.]

So, I’ll assume FB is selling at 30x earnings in 5 years. $107 per share/30x = $3.57 earnings per share. Now I look at FB and say, ok, what are the chances that FB will be earning $3.57 or more per share in earnings and/or free cash flow in about 5 years? More importantly, what are the chances they'll be earning less? Is this a bet I really want to make?

Compared to $0.60 in EPS and $1.14 in fee cash flow, in the last year, we’d basically NEED Facebook to be bringing in AT LEAST 3 to 6 TIMES as much profit in 5 years than they are bringing in today. How many companies can you REALLY count on to grow at such an astounding rate? Are there any? Is Facebook REALLY that special?

I believe a rational bet on FB today requires a prospective investor to believe, with a high degree of certainty, that the odds are very LOW, that FB WON’T grow earnings and free cash flows by at least 300%-600% over the next 5 or so years.

You’re basically betting that FB will be the greatest company of call time.

With a bet like this, if ANYTHING goes even slightly wrong, you’re in VERY big trouble. While most investors concentrate on how much they will gain if their assumptions are correct, I think truly intelligent investing is as much, or perhaps more so, about how much you stand to lose if you’re wrong.

Great investors look for positive asymmetrical bets. (Heads I win big, tails I still do ok) Facebook, to me seems more like “heads I do ok, tails I lose A LOT of money.”

Facebook (FB) at current prices seems like a pretty crazy bet to me.

I would be utterly shocked if FB beats the S&P 500 over the next 3, 5 or 10 years.

I would not be shocked if we see FB shares drop from $66.50 to $20 or $30 in the next couple years.

Thanks for reading, -John