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Facebook offers up-front risk, chance for long-term reward

Some stocks almost always seem overvalued, and yet they keep beating expectations and rising further. So far in its short life, Facebook (Nasdaq: FB) has been one of those stocks. Its future is far more uncertain than that of familiar blue-chip companies such as carmakers and banks, but at recent prices, Facebook shares are intriguing for long-term investors who can stomach some risk.

The company’s price-to-earnings (P/E) ratio seems steep at 81, but its P/E based on next year’s expected earnings is a more reasonable 37. That’s still steep, but less so when you consider that Facebook is growing like gangbusters, with its revenue for 2014’s first quarter up 72 percent year-over-year (to $2.5 billion) and earnings nearly tripling. Its net profit margin tops 20 percent, it generates more than $3 billion in free cash flow annually, and it boasts more than $12 billion in cash, with no long-term debt.

(The Motley Fool has recommended Facebook and owns shares of it.)

Ask the Fool

Q: How is the “the Dow’s” daily value calculated? – C.J., Kalamazoo, Michigan

A: The Dow Jones industrial average (DJIA), launched in 1896, is one of the oldest U.S. market indexes. It’s essentially the average stock price of 30 companies, including General Electric, Intel, Boeing, Visa, McDonald’s, Coca-Cola, IBM, The Home Depot, Procter & Gamble and Verizon Communications. It doesn’t look like an average, however, as it has recently been hovering around 17,000, and none of its component stocks is selling for anywhere near $17,000 per share.

Here’s the catch, though: The shares, on average, actually would trade in the neighborhood of $17,000 – if they’d never been split, issued dividends, or undergone major changes such as spinoffs or mergers during their tenure in the index.

Thus, to arrive at the index number, the stock prices of the 30 component stocks are added together, and then divided by the “divisor” (which is adjusted frequently and was 0.15571590501117 last time we checked). To understand how each stock affects the average, know that if, say, McDonald’s falls by 2 points, you can just divide 2 by the divisor and learn that the DJIA will fall by 12.84 points (2 divided by 0.15571590501117 equals 12.84).

My dumbest investment

I invested in two Chinese companies, and it turned out that both cooked their books, producing phony financials, before stopping all communications. I found the Chinese securities-oversight agencies totally useless in policing these companies, leaving American investors helpless when it comes to protecting their investments. I am now, and will always be, wary of Chinese investments. – John B., online

The Fool responds: It’s good to diversify your investment portfolio geographically, but you need to do extra due diligence with foreign companies. Few countries have financial reporting standards as robust as the United States.

One way around some of these issues is to invest in American companies that generate much of their revenue abroad – or to stick to internationally focused mutual funds.