Facebook (NasdaqGS: FB) is a special IPO on several fronts:

• Largest U.S. IPO in history by market capitalization (beating UPS)
• Third-largest global IPO in history by market capitalization (behind two Chinese companies)
• Second-largest U.S. IPO in history by money raised (behind Visa and ahead of General Motors)
• Fifth-largest global IPO in history by money raised
• Largest U.S. technology IPO in history by both market cap and money raised
• Largest first-day trading volume in IPO history (Beating General Motors)

Bigger does not mean better, however. I like to quote legendary fund manager Peter Lynch who favored small-cap companies over large-cap companies because:

Big companies have small moves, small companies have big moves.

This reality is based on the “law of large numbers” which states that extraordinary growth becomes much more difficult the larger a company gets:

Also known as the golden theorem, with a proof attributed to the 17th-century Swiss mathematician Jacob Bernoulli, the law states that a variable will revert to a mean over a large sample of results.

In the case of the largest companies, it suggests that high earnings growth and a rapid rise in share price will slow as those companies grow ever larger.

Facebook’s IPO market capitalization of $105 billion makes it the 23^rd largest company in the U.S. right from the get-go!  In the past, most companies went public relatively early in their life cycle to raise capital for further expansion. For example, Google (NasdaqGS: GOOG) went public in 2004 at the young age of five years – three years younger than 8-year-old Facebook — and at a market capitalization of only $25 billion — one-fourth the size of Facebook’s $105 billion. But since the advent of SecondMarket and SharesPost – private equity stock exchanges open only to “accredited” investors — companies are waiting longer to go public. The result is that more of a young company’s price appreciation during its high-growth phase is generated during the pre-public stage.  Just look at how much Facebook’s restricted stock appreciated between April 5, 2010 and April 5, 2012:

Facebook’s Days of Outperformance are Behind It

Source: Bloomberg

No doubt about it, Facebook was a high-growth company a couple of years ago and one could argue that the company’s real IPO already occurred on SecondMarket and SharesPost. By the time Facebook decided to officially go public last week, its growth spurt had already sputtered. First-quarter revenues declined 6% from Q4 2011 – the first time revenues declined sequentially in more than two years – and earnings per share were down an even steeper 32%. Second-quarter revenue growth isn’t looking much better, with lead underwriter Morgan Stanley (NYSE: MS) having cut Q2 and full-year revenue estimates substantially during the IPO road show — something a lead underwriter virtually never does.

Looking forward, it’s hard to justify paying 80 times earnings for a huge company with decelerating growth. Press speculation that Facebook’s stock price could rise 50% on the first day of trading was absurd, in retrospect. According to former Merrill Lynch Internet analyst Henry Blodget, a fair value for Facebook is between $16 and $24 per share. In other words, investors who bought “Fadebook” at the $38 IPO offering price are “Zuckers.”

Facebook is a “Broken” IPO

Last Friday, Facebook closed its first day trading only a few cents above its $38 offering price. On the following Monday, the stock briefly collapsed to $33 (more than 13% below the offering price) before recovering slightly to $34.03 at the close.

Rarely does such a high-profile IPO break below its offering price the day following its offering. Lead underwriter Morgan Stanley has egg on its face because part of its job is to stabilize the stock price at the IPO offering price. Facebook is justified in asking for a partial refund of the $176 million in fees (1.1% of sales proceeds) it paid to the underwriters. Granted, it didn’t help Morgan Stanley that Facebook is such a huge offering or that it went public during the worst week of the year for the Nasdaq Composite (down 5.3%), but this excuse doesn’t explain why the stock collapsed on the following Monday while the Nasdaq rallied 2.5%. Book ‘em Danno!

Investors Can Do Better than Invest in Facebook

Rather than buy Facebook, you may want to consider buying stocks with higher growth rates and lower market capitalizations (i.e., below $10 billion). A PEG ratio below 2.0 – compared to Facebook’s 3.6 — would also be preferable, as would price-to-sales under 1.6. To weed out value traps, only stocks with both revenue and earnings growth above 20% made the cut. Using one of the Best Stock Screening Tools on the Web, I found a list of nine stocks that are potentially better investments than Facebook:

Nine Better Stocks than Facebook?

Source: Finviz.com