Should Investors Be Worried About Facebook Inc.'s Valuations?

Facebook shares have climbed about 10% since the beginning of the year, easily outpacing the S&P 500's 7% decline. As of this writing, the stock has rallied 130% from its IPO price of $38 in May 2012.

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Facebook is the largest social network in the world, with 1.49 billion monthly active users, or MAUs. It's also the most profitable one, generating GAAP net income of $719 million on revenue of $4.04 billion last quarter. Its industry peers Twitter and LinkedIn are both unprofitable on the same basis. Analysts are also bullish on the stock, with a mean target price of $112, according to 44 analysts polled by Thomson Reuters.

I've discussed Facebook's positive qualities in the past -- its ecosystem growth, its mobile dominance, and high demand for its ads. However, the stock's valuations remain very high, which raises concerns that it might be overvalued.

Mismatched fundamentals and growthCompanies with double- or triple-digit revenue and earnings growth typically have higher P/S or P/E ratios, because investors are willing to pay higher prices for future growth. Facebook's multiples, however, don't match its recent top- and bottom-line growth.

Facebook's revenue rose 39% annually last quarter, down from 42% growth in the previous quarter and 61% growth in the prior-year quarter. Despite that slowdown, Facebook stock still trades at a whopping 16 times sales. Twitter, which posted 61% sales growth last quarter, trades at 9 times sales. LinkedIn, which also trades at 9 times sales, reported 33% revenue growth last quarter. The entire Internet information provider industry has an average P/S ratio of just 4.

Facebook's GAAP net income fell 9% last quarter because of higher investments on new products and services, marking its second consecutive earnings decline. Yet Facebook still trades at nearly 90 times trailing earnings, versus the industry average of 33 and the S&P 500's P/E of 20. Therefore, there's not much fundamental scaffolding actually propping up Facebook's shares. To be considered fundamentally cheap, the stock would have to be cut in half.

What about forward valuations?Investors in growth stocks often look at forward valuations instead of trailing ones. Yet Facebook's forward multiples don't look cheap, either.

Analysts, on average, expect Facebook's full-year revenue to rise 38% annually for fiscal 2015 to $17.2 billion, and then climb 35% in 2016 to $23.3 billion. At $90 per share, Facebook trades at 12 times 2015 sales and 9 times 2016 sales. However, Facebook's number of outstanding shares has also increased 32% since its IPO, which means those multiples could rise even higher as it issues more shares. By comparison, Twitter and LinkedIn both trade at about 7 times fiscal 2015 sales.

On the bottom line, Facebook currently has a forward P/E of 32. That looks significantly "cheaper" than its trailing P/E, but it still remains much higher than the S&P 500's forward P/E of 17. Facebook also has a five-year PEG ratio of 1.5, based on long-term estimates from analysts polled by Thomson Reuters. That ratio indicates that Facebook could see sluggish earnings growth over the next few years, since "undervalued" stocks generally have a PEG ratio lower than 1.

Don't fall in love with this stockFacebook is a "story stock" that lures in a lot of investors who don't check the numbers behind the headlines. But Facebook's user growth is slowing down, and its ability to monetize mobile users, who now account for 88% of its active user base, could eventually peak.

Facebook excels at driving up ad prices by throttling the number of ads it displays every quarter, but that demand could fade as user growth dries up. Instagram, WhatsApp, Oculus, and all represent new ways to reach and monetize more users, but it's unclear whether those revenues can offset a slowdown at its main site.

I'm not saying Facebook isn't a great stock to hold for decades. The amount of personal data its social network collects ensures that it will remain a top name in Internet advertising for years to come. However, investors should have realistic expectations about its potential growth and realize how lofty its valuations have become.

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Leo Sun has no position in any stocks mentioned. The Motley Fool owns and recommends Facebook, LinkedIn, and Twitter. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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