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Buy Facebook's Stock?

Morningstar's top stock strategist thinks shares of Facebook are a bargain now that that they've fallen more than 50% from their peak.

It would be hard to find a stock that is more despised than Facebook (symbol FB). It has done so poorly that most investors would probably be embarrassed to say they owned it.

For Paul Larson, though, that's just one more sign that the stock is now a huge bargain. Morningstar's chief stock strategist thinks Facebook, which closed at $17.73 on September 4, is worth about $32 a share.

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Can he be serious? Before I summarize his case, here's a quick review of the Facebook story.

After months of frenzied talk about the stock's potential, Facebook went public May 18 at $38 a share. The initial public offering turned out to be a disaster, with long delays in order confirmations and other technical glitches. The stock traded as high as $45 that first day but has fallen steadily ever since.

Facebook has 2.7 billion shares outstanding. But 1.5 billion of those shares can't be sold by their owners until mid November. When that "lockup" expires, the stock could plunge further.

Businesses have questioned the value of advertising on Facebook. What's more, the site's mobile apps still have no ads.

Then, of course, there's Mark Zuckerberg, the founder and CEO of Facebook. He owns 57% of the voting shares -- effectively giving the 28-year-old wunderkind control of the company. "The company's management is a big negative," Larson says.

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An even bigger question: Is Facebook here to stay or is it, despite its seemingly enormous popularity, a fad? Rapid changes in technology have undermined, if not destroyed, many companies. Eastman Kodak (EKDKQ) is a prime example. Or consider Research in Motion (RIMM) and its once-ubiquitous Blackberry, or AOL (AOL), which once was the way nearly everyone accessed the Internet.

But Larson, whose long-term stock-picking record is excellent (see 5 Great Stock Picks and the ETF That Owns Them), is confident that Facebook "is the real deal."

The reason: the network effect. The more people who use Facebook, the more valuable it becomes to those who use it -- and to investors. When more of your friends join Facebook, it becomes a better service for you. It's difficult for a competitor to overcome the network effect.

And Facebook has a ton of users -- close to 1 billion worldwide, about half of whom use it every day. Many of these half-billion users spend more time on Facebook than on any other Web site.

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Morningstar says it could be years before Facebook realizes its financial potential. But, writes analyst Rick Summer, "We expect the company to offer an advertising network that may someday provide a similar reach to broadcast television."

Even at its current price, Facebook hardly looks cheap. It trades at 61 times earnings for the past 12 months and 9 times sales. Those figures are reminiscent of the prices paid for tech stocks during the Internet bubble of the late 1990s. Based on the average of analysts' earnings estimates for 2012 (49 cents per share), Facebook's price-earnings ratio is a still-lofty 36. And using estimated 2013 earnings of 63 cents a share, the P/E is 28.

But Summer estimates that revenue will grow 40% in 2012 and that it will expand at an average rate of 31% per year over the next five years. Those are seriously large numbers.

The company is already extremely profitable. Morningstar estimates that Facebook will produce an operating profit margin this year of 34%.

Is Larson right? Because of his superb track record, I think he just might be. "If you don't want drama, this is not the investment for you," he says. "But if you're willing to take a calculated risk, Facebook looks attractive."

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.

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