LinkedIn announced today that it has reached 200 million members. It added an average of 6.5 million members a month in November and December 2012 and has doubled its membership since reaching 100 million members in March 2011. Meanwhile, Facebook back in October disclosed that it has passed the 1 billion users threshold.

On the surface it looks like Facebook dwarfs LinkedIn in number of users and more importantly in stock market capitalization. However, when you adjust for number of users, you realize that both companies trade at a much closer valuation per user. After rallying from under $19 a share in November to almost $30 this month, Facebook is currently trading at a near $63 billion market valuation if you use the widely used – but false – 2.17 billion share count on Yahoo Finance or $81 billion using our own calculated 2.8 billion share count. LinkedIn on the other hand trades at near $113 per share giving it a market capitalization of $12 billion.

So basically, investors are valuing a Facebook user at a minimum of $63 (we think its closer to $81) and a LinkedIn user at only $60. Do you think either is reasonable?

At the time of this post no staff member at the Wall Street Dispatch had any position in Facebook or LinkedIn.

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Facebook priced its shares in its IPO at $38 raising a little over $16 Billion after the company and selling shareholders sold 421,233,615 shares. The question is: what is the company’s market capitalization at $38 per share? Reporting on the pricing of the IPO, Bloomberg and Reuters pegged the market capitalization of FB at $104 Billion while CNBC “at over $100 Billion”.

Naturally, to know the market capitalization you need to know how many shares will be outstanding after the IPO on a fully diluted basis. The company states in its latest S1 filing that there will be 2,138,085,037 shares outstanding after the IPO but that excludes many items including shares issuable under its various employee stock options plans and other items including the shares to be issued for the purchase of Instagram. So looking at the S1 we crunched the numbers and came up with the diluted shares outstanding for Facebook and they are:

So to all journalists and analysts calculating Facebook’s market cap, we believe the shares outstanding number you should plug in is 2.822 Billion shares.

There is a lot of hoopla around the Facebook IPO and how to value the shares of the social networking giant. At an expected $100 Billion valuation, Facebook will be selling at around a PE of 100 and a Price to Sales multiple of 27 based on full year 2011 numbers of $3.7 Billion in revenues and $1 Billion in net income. Those are lofty multiples no matter what kind of investor are you.

However, when it comes to looking at Facebook you have to take certain considerations unique to the company in place. Facebook is not only the biggest social network it is pretty much a monopoly when it comes to social networking. It is also a platform for anything related to social networking. This is not to be taken lightly. The fact that it has 900 million users is a testament to the wide adoption of its platform. If you are an individual, brand, a company or if you represent a cause who wants to interact with a wide array of your friends or with the public then you HAVE to be on Facebook.

Right now the company has two primary sources of revenues: advertising and revenue sharing for facilitating payments for digital goods for the various Applications hosted on its platform. On Wall Street, company valuations are a straightforward exercise where you plug in certain revenue and expense growth rates to come up with a multi-year cash flow statement that will help you come up with a final terminal and present value for any company. This is a linear exercise and final valuations are highly sensitive to the discount rates and the growth rates you plug in based on your best guess-estimates.

However, when it comes to Facebook, a linear valuation model is not appropriate because Facebook’s earnings have a lot of optionality in them because of the company’s monopoly status. When estimating future earnings, you have to look at them with an options pricing model and not a simple linear discounted cash flow model. While the company relies on simple banner advertising right now for the bulk of its revenues, a prudent analyst cannot ignore the fact that Facebook can alter its revenue strategy and be much more successful given its wide adoption status and its monopoly power that translates into very high switching costs for its users.

As a simple illustration of the wide array of options that can be available to Facebook is the ability, if it so chose, to charge subscriptions to its users particularly its business users who use brand pages. A case in point is the recent announcement by General Motors that it will stop advertising on Facebook. Lost in that Wall Street Journal story is the fact that while GM spends $10 million dollars on advertising on Facebook, it actually spends 3 times that, $30 million, to advertising and public relations agencies just to maintain its presence on the various brand pages for its cars on Facebook. Think about it. Would a company spend $30 million dollars on a platform that it thinks is ineffective? Now consider this: How much do you think GM is willing to pay Facebook in subscription fees in order to maintain its various product pages on the social network? $1000 a month? A million dollars a month? 1$ per “Like” per month? Per year?

Perhaps, GM is not a good example because of its size. Think of any company’s presence on the internet. Right now the “proper” presence is to have all 3: a website, a Facebook page, and a Twitter account. A website will cost you around $15 annually to register your domain name and about $100 per year to rent space on a server to host your website online or a total of $115 to $150 for the most basic essentials for having a website. A Facebook page is free right now but how much would you pay for one if you are a business, a politician or a public figure? How much are you willing to pay if you already have a page with thousands of fans or customers? Yes you are stuck and Facebook has you by your you know what. Starting with a subscription model when you have 900 million users will lead to a certain adoption rate that is different than having such a revenue model when you start out the company and have a small number of users.

This is a simple exercise of the power of having a near universally adopted platform and having a monopoly in an entire category. For this reason, and the hoopla surrounding the IPO, I predicted yesterday that we will likely see a big pop in its first day of trading. A 100 PE off of 2011 earnings may be egregious but that can very likely be a 20 multiple off of 2013 or 2104 earnings. It’s caveat emptor if you are considering buying shares of Facebook but keep in mind that there is more to the valuation story than just a simple discounted cash flow model.

Facebook’s initial public offering will certainly be the tech IPO of the year if not the decade. Demand is expected to be strong with conflicting reports that institutional demand is weak but everybody agrees that retail demand is more than robust. In a sign of strong demand, the company raised its price range to $34-$38 from $28-$35.

When evaluating stocks there are three approaches investors and speculators take: 1) Fundamental analysis, 2) Technical analysis, and 3) Hope.

Evaluating shares of initial public offerings is no different than shares of any other public company when it comes to fundamentals other than the fact that many new offerings tend to be of companies who are relatively younger than companies who are public already. When it comes to technical analysis, IPOs do not have any trading history which is the backbone of technical analysis. When it comes to hope, there is not a lot of difference except that hope and enthusiasm among investors is very high for overly hyped IPOs. Saying that the Facebook IPO is overly hyped would be an understatement.

So what does this mean for Facebook’s shares once they start trading later this week? Fundamental value investors will shy away because Facebook’s valuation is hard to justify to an investor like Warren Buffett for example. However, there will be many growth investors who will clamor to the stock. Technical and momentum investors will take the initial demand, level of over-subscription, and opening price in consideration and will trade it accordingly. It’s the third category, investors who trade on “hope”, who will be the main culprits in any spike that we will see.

So when Facebook starts trading on Friday May 18, expect the shares to spike above $70 on their first day and possibly reaching $100 in the first hour or two of trading solely because of overanxious investors supported by growth investors who believe that Facebook will substantially grow earnings over the next 5 years. However, don’t expect that level to hold because of the large number of shares being offered – 337 million total – between the shares the company is selling and those being sold by insiders.

When trading IPOs, the number of shares being offered is the most important determinant of how high and how long a first day spike lasts. At the end of the day it is a case of supply and demand and the higher the number of motivated sellers available the less likely a big spike is maintained. The large number of shares being offered will likely make the stock less volatile over the medium term in the days and weeks ahead as it is easier to find an equilibrium price if there are many participants. Hence I do expect a nice spike on the first day to the tune of 100% above the offer price to around $70 or more but expect a price closer to a 50% spike or around $50 to be the more likely price over the medium term.