3 Reasons Buffett Should Buy Into the Facebook IPO

Throughout his sterling investment career, Berkshire Hathaway’s (NYSE:BRK.A, NYSE:BRK.B) Warren Buffett has avoided technology companies, focusing mostly on humdrum businesses such as Procter & Gamble (NYSE:PG) and Coca-Cola (NYSE:KO). These types of investments can certainly generate healthy returns over the long haul.

But last year, Buffett showed that he’s willing to change things up. To this end, he shelled out $10.9 billion for a 5.5% stake in IBM (NYSE:IBM). There were also smaller investments in companies such as Intel (NASDAQ:INTC) and DirecTV (NASDAQ:DTV).

Interestingly enough, Buffett mentioned on CNBC that he wishes he’d purchased shares of Apple (NASDAQ:AAPL). Two years ago, Buffett spoke with Steve Jobs, who thought AAPL was way undervalued. Buffett recommended a stock buyback.

So might Warren Buffett buy shares in the Facebook IPO? Well, he recently said he’ll pass on the opportunity (no doubt, the bankers would have willingly allocated him a block of shares). Buffett thinks it is simply too difficult to value the company, and he dislikes investing in IPOs because of the hype.

That’s fairly disappointing, as a purchase of Facebook actually would pass muster with some of Buffett’s key principles.

1. Stick With World Class Brands

In his 2011 letter, Buffet says he likes companies that “buy commodities, sell brands.” To understand this, take a look at Coca-Cola. It has the leverage to buy things such as sugar and water at dirt-cheap prices and then sell beverages at premium prices. It has meant that the company has been consistently profitable since 1886. Great business model, right?

The same goes for Facebook. The company essentially has a few thousand coders who create interesting features, which are delivered through data centers across the world. Then the company can sell advertising that commands high-margin rates.

What’s more, there’s the credits business. That is, Facebook gets a 30% cut from the sale of virtual items in games from companies such as Zynga (NASDAQ:ZNGA). Again, the operating margins are at incredible levels. Overall, they reached a staggering 47% in 2011.

2. Look for a Moat

Buffett likes a business that has huge barriers to entry. This is why he invested in utilities and railroads. For the most part, it would require huge investments by a new entry to compete.

Does the “moat” concept apply to Facebook? Keep in mind that when it comes to social networking, there’s no company that comes even close to its dominance. Facebook has 845 million daily monthly users (DMUs). Of these, 425 million are mobile users.

True, Google‘s (NASDAQ:GOOG) G+ service has been gaining traction. But will users find enough reason to move over to another network and abandon many of their friends as well as photos, videos and status updates? What’s the payoff?

3. Buy With a Margin of Safety

This means Buffett looks to buy companies at a steep discount — say, at 25% of the intrinsic value. While this makes a lot of sense, it’s tough to follow. Let’s face it, top-notch companies usually sell at hefty valuations.

As a result, Buffett has been willing to soften his viewpoint on the margin-of-safety issue. In fact, this appears to be the case with his investment in IBM. He has conceded that he’s late to the party here.

But isn’t Facebook overvalued? Based on current metrics, it does look expensive. For example, let’s assume earnings increase 70% this year, to $1.7 billion (which would be consistent with the current growth rate). At a $100 billion valuation, Facebook’s forward price-to-earnings ratio would be 58.

While this seems expensive, Facebook is still a young company with many opportunities for growth — especially with mobile — and it has done little to monetize this business so far.

Also, if Buffett buys Facebook shares in an IPO, he is likely to get a discount. (It’s generally 10% to 15% for a typical public offering.) No doubt, the returns may not be huge, but they could be enough to beat the S&P 500, which is his main goal.

Tom Taulli runs the InvestorPlace blog IPO Playbook, a site dedicated to the hottest news and rumors about initial public offerings. He also is the author of “All About Short Selling” and “All About Commodities.” Follow him on Twitter at @ttaulli. As of this writing, he did not own a position in any of the aforementioned securities.

Article printed from InvestorPlace Media, https://investorplace.com/2012/02/3-reasons-buffett-should-buy-into-the-facebook-ipo/.

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