05/15/2012 04:56 pm ET Updated Jul 15, 2012

There Is Not a Bubble in Facebook's Shares, There Is a Bubble in Calling Bubbles

In tech, you can trace what sectors are overcrowded pretty well by following what the latest hip term is. For a while, it was just "social." Then it became "local," then "social local mobile." "Cloud" was hot in there somewhere, before giving way to "Big Data."

If there is a hip and overused term in tech today, it is "bubble."

The latest incident that has brought everyone from CNBC to the NY Times, Time, and thousands of blog commenters to question whether we are diving head-first back into the late 1990s is the Facebook IPO.

Of course, the tech journalist/blog elite has correctly predicted about 0 of the past 100 bubbles. The doomsayers were saying the same thing when Google IPO'd in 2004, when Google purchased YouTube for $1.65 billion in 2006, and even when Goldman Sachs invested in Facebook at a $50 billion valuation a couple years ago. Yet in retrospect all those transactions turned out to be remarkably undervaluing the acquired businesses.

But nevermind that. What is interesting today is that many of the bloggers, journalists, and blog commenters seem to be fundamentally confused about what the value of a stock actually means.

Many cite Facebook's expected valuation at an astronomical 100 times the company's earnings for the previous year and 25 times its sales as "proof" that things are getting "frothy."

But when you are buying a stock, you are not purchasing a share of a company's earnings last year, you are purchasing a share of the present value of its cash flows forever into the future. Rational investors in a category-defining, fast-growing company should be much less concerned about what earnings are today than about what they are going to be ten years from now.

Of course, figuring out what Facebook's earnings are going to be ten years from now is a highly speculative exercise that is much more difficult than looking at simple ratios. This inherent uncertainty is what produces such extraordinary volatility in the shares of many young companies. As investors adjust their future expectations as new data points come in, the value they assign to future earnings can change drastically.

So how would you even approach rationally valuing Facebook? It first helps to have an upper and lower bound for where the shares could trade.

Without getting into the numbers, most people would not blink at saying that ten years from now, given the huge size of its footprint with the consumer and the enormous network effects in its business, there is a chance that Facebook could feasibly be worth as much as a company like Google. Each will likely be champions of its own hugely influential mini-industry.

But if Facebook is going to be worth as much as Google 10 years from now, then it should also be worth as much as Google today. If that were not the case, then obviously the markets would react. Everyone would buy Facebook and sell Google, knowing that the two shares price will converge in 10 years anyway. That trading would continue until the two stocks were worth the same amount today. So let's call Google's market cap (about $200 billion) the upper bound of Facebook's feasible valuation today.

Of course it is far from certain that Facebook will execute effectively enough to one day be worth as much as Google, as it currently makes 10 times less profits. Facebook's core business today is brand advertising. While brand advertisers seem certain to continue shifting money away from print and TV to social media ads, with a deceleration in the growth of this business and negative implications from a mix-shift to mobile ads, Facebook seems like it needs to come up with one or more new ways to monetize its platform in order to justify a Google-like valuation.

If the company does not pull off a step-change in monetization effectively, then maybe it is only worth $50-$75 billion, as analysis from Henry Blodget would suggest.

So Facebook should reasonably be worth something between $50 billion and $200 billion. If you thought there was a 50% chance that Facebook comes up with a better monetization model and a 50% chance it doesn't, then you could average the two extremes together and get a fair mid-point of $125 billion, which is actually pretty close to where many speculate that the stock will trade to pretty quickly once it hits the public market.

Of course, these numbers are illustrative and somewhat hypothetical. Given the huge uncertainties surrounding monetization, it is perfectly reasonable to question whether Facebook is being overvalued. But overvaluation is not the same thing as a bubble. A bubble implies a valuation that is preposterous.

Is it really preposterous that reasonable investors would assign a company that is defining a whole new category of communication and sending a giant ripple across the universe as being worth one-half of Google, one-third of Microsoft, and one-seventh of Apple? Of course not.

There is not a bubble in Facebook shares, there is a bubble in calling bubbles.