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What You Didn't Understand About Buying Facebook

By Larsen Kusick, analyst, Phase 1 Investor
Monday, June 11, 2012

Would you pay $880,000 for a rental home? 
You might... if it threw off $100,000 in rental income. With that yield, you'd make back your original investment in less than nine years.
But what if the house paid you just $10,000 in rental income? At that low yield, it would take you 88 years to make your original investment back.
It sounds insane that anyone would pay that much and agree to wait so long to get their original investment back. Yet that's what tens of thousands of people did last month when they piled into Facebook shares...
Over the past couple weeks, I've talked to nearly a dozen friends and family members about this. They know my job involves "the stock market." Facebook's initial public offering (IPO) was the first thing on their minds.
I'd like to boast that my family is full of great investors. In reality, they're normal folks who own a few mutual funds. They've read the headlines about the Facebook disaster. To them, asking me about it is like talking about a car accident they saw on the side of the road.
What shocked me was how complicated they thought it was. Someone asked me if Facebook was going bankrupt. Another friend wondered if the company is a fraud.
I said, "No... It's just an overpriced stock." 
It was overpriced because thousands of people were suckered by Facebook hype. While paying attention to the hype, they ignored one of the golden rules of investing: Don't overpay... for anything.
It's an odd thing about the stock market. Rational, intelligent people will agonize over the price they'll pay for a home or a car. They'll do a huge amount of due diligence. They'll look at a bunch of "comparables" to ensure they get a good price. They know not to overpay.
But that same person will run into the stock market and put $10,000 into a stock he hasn't researched at all. He won't pay a bit of attention to the price he pays for a slice of that company's assets and cash flow.  
So he ends up getting soaked... because he doesn't focus on getting a good price.
Of course, there were other things involved with the Facebook debacle. But the BIG reason most folks lost money was because they overpaid. After losing money buying the most-hyped IPO in history, they've got no one to blame but themselves. 
Back then, I said...
You can make money as an investor in growth stocks... but participating in popular IPOs is almost always a horrible way to go about it. Think about it: you're buying shares of often unproven companies from informed insiders at hyped-up, inflated prices.
"Inflated" is the perfect word to describe Facebook's valuation on its first day as a public company.
In 2011, Facebook earned $0.43 per share. Its opening share price on the day of its IPO was $38. That means investors were willing to pay 88 times earnings for Facebook. Put another way, they were willing to wait 88 years go get their original investment back (assuming no growth).
Granted, Facebook has plenty of growth ahead of it, but that's an absurd price to pay for a stock. If Facebook grew earnings by 15% every year (an astounding feat)... it would still take an investor more than 32 years to make their original investment back.
Facebook is a nice piece of "real estate," but not nice enough to wait that long.
As I mentioned, there was, and still is, a lot of complicated discussion about the Facebook IPO debacle. But the reason investors lost money is very simple: They overpaid. They paid a ridiculous price. If an investor would have stopped for five minutes to consider the valuation – like he would with any other purchase – he would have passed on the stock... and saved a lot of money.
The lesson is clear... and it's thousands of years old: Whether it's Facebook... a rental property... or any other asset, if you overpay, you'll get burned.
Good investing, 

Further Reading:

"Only idiots buy IPOs," a longtime investment professional told Larsen in November. "It rarely pays to buy what Wall Street is hyping..." Last year, for example, several "big name" IPOs – including LinkedIn, Groupon, and Pandora – wiped out investor portfolios. One was down 35% in less than a month... Get the full story here: A Serious Warning to Amateur Investors.

In The Daily Crux
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