Five Reasons to Avoid Facebook (FB) Shares

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This is the first of a seven-part series in which our own Ian Wyatt delves into reasons why investors should avoid Facebook shares. Parts 2 and 3 will appear on the Wyatt Research site later today. The remaining four parts will appear tomorrow.

In the wake of the Facebook (Nasdaq: FB) IPO, I’ve been inundated with questions about whether the stock is worth buying.

After all, everyone knows Facebook. Most people use the social network to stay in touch with friends, post photos, and share even the most mundane updates on life. In many ways, Facebook has replaced the personal web site by providing a platform that is so easy to use that even grandparents have embraced the site.

The great Peter Lynch – a mutual fund manager at Fidelity – delivered average annual returns of 29% to investors in his fund over a 13-year period by following a very basic investment principle: Invest in what you know.  Simply put, Lynch invested in businesses that he personally knew and understood.

In the wake of the dot-com crash of 2000 and the sub-prime mortgage crash of 2008, many individual investors have been sitting on the sidelines for several years. They think that the big banks rig the investment game and that the little guy doesn’t stand a chance. 

Because many individual investors missed out on the Google (Nasdaq: GOOG) IPO and the resurgence of Apple (Nasdaq: AAPL), they have a sense of urgency to get in on the next big thing. Many people today think that the next big thing is Facebook.

But – going back to the mantra of Peter Lynch – do they really know and understand the business of Facebook?

Last week, Facebook went public by issuing 421 million shares at $38 in a $16 billion IPO that valued the entire company at $104 billion. Net proceeds to the company were nearly $7 billion, making it the third-largest IPO in U.S. history.

Despite these massive and unprecedented numbers, I strongly recommend avoiding the stock. I’m not an expert on Facebook. I log in as a user a couple of times a week, and I like using the site to stay in touch with friends or post pictures of my kids. 

However, as a financial analyst, I’ve dug into the numbers – all are available through the company’s public filings with the SEC – and found a number of concerning trends that I’ll share with you.

I found five specific red flags that I feel make Facebook shares an unattractive investment today. Even though the concept may be great – and the service wildly popular – hot, trendy companies don’t always make great investments (just look at the recent stumbles of Groupon (Nasdaq: GRPN) and Pandora (NYSE: P)).

In summary, those five issues include:

  1. Facebook adoption in the developed world is already abundant, leaving little growth opportunity in the most lucrative advertising markets.
  2. Advertising results from Facebook ads appear to be mixed, highlighted by the decision of General Motors (NYSE: GM) to stop advertising on the web site last week.
  3. The company resisted an IPO in recent years, shutting out the average investor from the company’s greatest growth period.
  4. The rate of sales growth – while impressive – is quickly slowing, lending credibility to concerns about the advertising business.
  5. Facebook shares are grossly overvalued based on the company’s expected rate of revenue growth in 2012 and beyond.

To read Part 2 of our "Five Reasons to Avoid Facebook Shares" series, click here.

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