A Tale of Two Cities

Earlier this month, Facebook (FB) gained a lot of attention for being the fastest company to reach a $250 billion valuation in the history of the NASDAQ stock exchange. It’s not really a measuring stick that comes with an equal playing field, as Facebook was valued at over $100 billion at the time it went public. Is Facebook going from $100 billion in 2012 to $250 billion in 2015 better than Starbucks going from $400 million in 1992 to $83 billion in 2015?

Of course, what makes life interesting for investors is that we get to spend our time figuring out whether the rise in Facebook’s share price is deserved, as the company’s market cap goes barrelling past legendary investment titans like Wal-Mart Stores and Procter & Gamble.

There are less than a dozen companies in the United States that Facebook is yet to eclipse, and one of them is Berkshire Hathaway. The market cap at Berkshire is around $330 billion. And yet, the underlying profits at the two of them couldn’t be more different: Berkshire owns hundreds of entrenched business built alongside an extensive stock portfolio that has Berkshire set to make $21 billion in profit this year. The continued restoration of the Wells Fargo dividend (Berkshire owns a $26.5 billion stake in the company), the eventual dividends from Bank of America starting in 2021, the consolidation at Kraft-Heinz, and Buffett’s $5 billion investment into growth at Burlington Northern Santa Fe ought to auto-propel returns forward.

And that is not even the best part: Even after having to pay a $16.50 per share dividend as one of the terms necessary to fold Kraft-Heinz into a business that is 51% owned by Berkshire-3G, Berkshire is still sitting on $58 billion in cash. Not only do shareholders continue to profit from the growth at GEICO, See’s Candies, Nebraska Furniture Mart, and the growth of dividends at places like Coca-Cola, IBM, and American Express, but Buffett has set into motion a permanent infrastructure for perpetual acquisitions of marquee companies.

Berkshire doesn’t pay a dividend, so that $21 billion in incoming profits will need to get deployed somewhere, and if not, Berkshire will be sitting on $79 billion this time next year. I’m also becoming further convinced that people owning Berkshire for 10+ years will eventually see massive dividends, buybacks, and/or stock spinoffs unlike anything else the investment world has ever seen (it would look like the AT&T divestitures of yore without the massive debt attached to the balance sheets.)

Buffett is a huge beneficiary of the halo effect in which regulators and the media give him clearance in a way that I’m not sure anyone else would. Could you imagine if the Koch Brothers wanted to own Kraft-Heinz and sell ketchups to the fast food industry while also owning Dairy Queen? Could you imagine if they bought 400,000,000 shares of Coca-Cola and also sold $18 billion worth of merchandise at Wal-Mart while owning a large chunk of Wal-Mart itself? Could you imagine if the Koch brothers bought Duracell from Procter & Gamble while owning large stakes in developing Israeli battery technology? Could you imagine them also being permitted to build stakes in all these financial firms–American Express, M&T Bank, Bank of America, Wells Fargo, General Electric, and U.S. Bancorp? No, it would be shut down under an anti-trust theory.

Meanwhile, Facebook, which has a market valuation of $250 billion, makes $3.2 billion in annual profits. For some perspective, Berkshire Hathaway collects $1 billion in dividends from Wells Fargo alone per year, which is equal to about a third of Facebook’s current profits. The current valuation of Facebook stock is 78x profits.

I don’t think people understand the kind of growth necessary to justify a valuation like that. It is as if the entire investment world has forgotten the lesson from Oracle during the dotcom years. Oracle is one of the long-term winners in the tech industry. It has delivered over 20% annual earnings per share growth over the past 25 years, being one of the few companies that managed to deliver the kind of sustained staggering growth that got people so excited about tech stocks in the first place.

And yet, the actual returns achieved by investors varies considerably based on the time you made the investment. Bought the stock in 1992 when the company was trading at 38x profits? Great, you hit a home run. Your wealth compounded at 23% annually, turning $1,000 into $123,000. Bought the stock in 2004 when the valuation came down to 22x earnings? Great, you got to compound your wealth at 13% over the past 11 years. Not as great as the early days, but hey, you still managed to beat the 7.8% annual compounding rate of the S&P 500.

But the stock traded at $38 per share in 2000 while only making $0.35 in profits. That is a P/E ratio of 108. What happened to those investors? With the stock currently around $40, plus a few meager dividend payments since 2009, you are looking at a fifteen-year compounding rate of less than 1% annualized. And that is with a company that has grown earnings per share by 18% per year since 2000. Imagine the results if Oracle didn’t deliver on that growth over the past fifteen years.

Eventually, to justify a $250 billion valuation, you’re going to have to put up around $18 billion to $22 billion in profits to justify the valuation. Facebook doesn’t pay a dividend, and actually dilutes the stock each year due to management compensation, so a $500 billion market cap wouldn’t even double your investment because of the additional share issuance. And to be worth $500 billion, you’d have to make around $40 billion in profits for the valuation to be justified. Getting from $3 billion to $40 billion is the requirement for a doubling of Facebook’s stock price to be justified from here.

When you buy an overpriced asset in the stock market, there are three things that can happen. It can tread water for years on end, as earnings take time to catch up to what the price is worth. The price can fall sharply in a hurry to match the deserved fundamentals, and then owners would get fair returns from that point forward. Or, someone can come along and offer you an even more overvalued price for the stock. That’s what people currently buying Facebook stock are betting on. You don’t have to live that way. The Berkshires are out there.

Originally posted 2015-08-17 22:20:35.

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