Summary:
We think Facebook has just scratched the surface of its earnings potential.
Let’s address the potential for a single stock bubble in Facebook, the company’s most recent results, and why we think it garners a very attractive Economic Castle rating.
We value shares of Facebook at $100 each, implying roughly 25% upside based on the firm’s most recent closing price.
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“Intrinsic value represents the conclusion to any and all stock research: What is the company worth? DCF valuation captures the expectations of a firm’s competitive advantages, growth prospects, strategic endeavors, and any other qualitative factor. No other process does this. Putting to numbers a plethora of advanced fundamental items in arriving at a fair value estimate is the cornerstone–and the most critical component–of any stock research analysis. Without an in-depth intrinsic-value assessment, research is but a story that has no ending.”— Brian Nelson, President, Valuentum Securities, 2011
Facebook (FB) has just scratched the surface of its earnings potential. Like other business pioneers in other times, the company is setting the bar with respect to its nascent industry, social media. Though the firm still has a somewhat skeptical stigma attached to it because it has only been public for a short time, we think long-term investors will be well-rewarded in considering shares. In fact, this skepticism is keeping many would-be buyers on the sidelines.
The firm’s significant network effect–when more users attract more advertisers which attracts more business–is a key reason behind its very attractive Economic Castle rating, or a reflection of its ability to continue to generate economic value for shareholders. We value Facebook at the century mark at present, $100 per share — which is in-line with what we had valued it in our previous piece. Shares are trading under $80 at present.
We expect the company’s stock to continue to rocket higher, even if the path may not linear but with ups and downs as expectations are inevitably tweaked and refined in coming years. There’s a lot the company has to offer with respect to new product lines and initiatives, many of which haven’t yet been established. We believe Facebook has the potential to become the next Apple (AAPL), where new initiatives, when launched, generate an ever-larger portion of its revenue. Let’s have a look at the company in more detail.
Facebook’s Investment Considerations
The ‘Investment Considerations’ segment forms the foundation of the Valuentum Buying Index rating system, where three key components out of the dozen or so displayed determine the rating itself. These three components are the company’s DCF valuation, relative valuation, and technical evaluation. Because our DCF valuation considers a range of probable outcomes, a fair value range, even though we expect upside from Facebook, shares, at present, can still be considered fairly valued (i.e. they fall within the fair value range, which we derive below). Valuation is not a precise exercise, but a range of probable fair value outcomes. There’s more of this in the article later.
On a relative valuation basis, Facebook doesn’t score that well because its forward P/E and PEG ratios don’t stack up that favorably versus peers. This shouldn’t be too surprising because Facebook is lumped together with other more “mature” online advertising peers. We think Facebook’s technical evaluation is also somewhat bearish, though we attribute most of the resistance at present levels to overall market trends, including panic selling related to falling crude oil prices. A fairly-valued DCF assessment, an unattractive relative valuation assessment, and a bearish technical assessment roll into a rating of a 3 on the Valuentum Buying Index. The flow chart of how we derive such a rating can be found .
Investment Highlights
• Facebook garners a very attractive Economic Castle rating. We think this rating makes our perspective quite unique and insightful. Very few other writers are considering how well Facebook is investing its capital to drive economic returns. Most may be looking at pure revenue and/or accounting earnings expansion, which doesn’t consider the capital costs of the invested capital. Facebook’s very attractive Economic Castle rating signals that the firm is a prudent user of investors’ capital, something that we give high marks for. For example, some analysts are valuing its recent $1 billion acquisition of Instagram at $35 billion. Simply incredible. Over the long haul, we think companies that have a focus on ROIC will do much better than companies that are chasing EPS outperformance. IBM (IBM) is the latest example of how EPS targets can hurt performance.
• We can’t write an article on Facebook without at least a profile of Facebook: the company’s stated mission is to make the world more open and connected. People use Facebook to stay connected with friends and family, to discover what’s going on in the world, and to share and express what matters to them. The company’s business model is continuously evolving, and its potential is untapped at the moment.
• As global data coverage improves, the number of mobile monthly active users (MMAU) will continue to grow. Facebook looks well-positioned to seize upon this trend, and the firm’s younger demographics are increasingly accessing its platform from mobile devices. For younger demographics in particular, advertisers may have to go to Facebook to find their desired target market. Recent acquisitions such as WhatsApp are also performing well. WhatsApp recently surpassed 700 MMAU, showcasing that CEO Zuckerburg knows how to identify assets that are in demand by users. Monetization will always be an important consideration, however.
• The range of potential outcomes with respect to Facebook’s valuation are astounding. Though its business model doesn’t have many comparable stories, we do recall a time when AOL (AOL) was also the Internet. With such low barriers to entry, the landscape could be completely different in five to ten years, posing both risks and opportunities. Facebook’s network effect helps insulate it from younger start-ups, but we cannot ignore Twitter (TWTR) and the myriad other social networking ideas that have hit the market in the past few years.
• Fundamental risks aside, the likelihood of a single stock bubble in Facebook is high. If talk of Facebook possibly becoming the new Internet starts to expand across social media, the trajectory of its share price rise will be meteoric (whether it comes true or not). We think this is the biggest promise for those speculators looking to make a quick buck in the company’s shares. Please note that we differentiate between investors and speculators. Investors view the firm as a long-term opportunity, but speculators rely on the “greater fool” theory, hoping that at some point in the future a “greater fool” will be shares at a higher price than what they paid for them. It’s possible that both investors and speculators have the potential to be rewarded by Facebook from here on out.
Most Recent Quarterly Results
Facebook recently posted better-than-expected third-quarter results. Savvy investors know that the future is all that matters, and once a quarter is complete, the only thing that matters is what the company says about its outlook. What Facebook said about the remainder of 2014 and 2015 wasn’t great with respect to spending guidance. Wise investors, however, will look to 2016 and beyond to assess the firm’s earnings potential.
From our perspective, Facebook’s third-quarter results were fine. In fact, we’d even say that they were excellent. Revenue for the third quarter totaled $3.2 billion, a near-60% increase from last year’s quarter. Mobile advertising revenue represented nearly two thirds of advertising revenue during the period, up from about half during the third quarter of 2013. The firm was able to leverage revenue growth into a 90% increase in GAAP income from operations, to $1.4 billion.
Facebook’s non-GAAP operating margin was 44% for the third quarter, up an impressive 7 percentage points from the year-ago period. This is phenomenal improvement and represents an enormous level of profitability. At the end of the quarter, cash and cash equivalents stood at $14.25 billion, as Facebook posted $766 million in free cash flow during the period.
However, the market is worried about excessive spending guidance. Facebook expects 2014 GAAP costs/expenses to rise 45%-50%, up from a prior outlook of 30%-35% growth. The company also expects to spend quite a bit during 2015. In fact, management is looking for non-GAAP spending to increase an incredible 50%-70% on a year-over-year basis in 2015. This means that, unlike the leverage we saw this quarter (where operating income expanded at a much faster rate than revenue), income will likely grow at a much slower pace than revenue in 2015. That is, unless such spending translates into significant revenue growth opportunities.
The stock market is (and has always been) very much near-term oriented, and it should not be surprising that investors are disappointed by the spending outlook over the next 12-18 months. Still, we think investors should be reasonable. Facebook’s stock has more than quadrupled since its September 2012 bottom, and unlike Twitter’s, Facebook’s growth will be profitable growth. Facebook is investing in “everything from the core service to ad tech to new products (source).” Instagram and virtual reality headset maker Oculus will also see considerable investments. By comparison, Twitter has yet to turn a profit on a GAAP basis, and only turned marginally profitable on a non-GAAP basis this quarter.
We like Facebook infinitely more than Twitter and other social media peers. The market always has had a way of reading too much into short-term events, and we think this could provide an entry point for shares. The bottom end of our fair value estimate range for Facebook is $75, and we would be very interested in shares should they fall below the low end of that level.
Economic Profit Analysis
Our proprietary Economic Castle analysis is based on the following work. In our view, the best measure of a firm’s ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. It is not just that companies should grow revenue or earnings over time, but that they should generate an annual return that is greater than the cost to generate that return.
The gap or difference between ROIC and WACC is called the firm’s economic profit spread. Facebook’s 3-year historical return on invested capital (without goodwill) is 43.3%, which is above the estimate of its cost of capital of 10.8%. This is a fantastic spread. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
How can we exclude an in-depth view of a firm’s cash flow generating capacity? From our experience, firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Facebook’s free cash flow margin has averaged about 39.3% during the past 3 years. Such a margin showcases the firm’s strong cash-flow generating capacity. As such, we rate the firm’s cash flow generation as relatively STRONG (this is one of the ‘Investment Considerations’ above).
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. Traditional free cash flow is typically used to gauge the cash-flow generating capacity of a company, but free cash flow to the firm (or enterprise free cash flow) is typically used to value entities, as it makes a number of adjustments to account for varying capital structures. Both are valuable in their own unique ways.
Valuation Analysis
This is where we outline our fair value range of the firm and its point fair value estimate. We value Facebook at $75-$125 each, a range that bounds the firm’s current trading price of about $80 per share. The margin of safety around our fair value estimate is driven by the firm’s MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. Readers should understand that all value is based on the future, and the future is inherently unpredictable. Because of this, value is not precise but instead a range that considers a variety of probable events. The midpoint of the fair value range for Facebook ($75-$125 per share) is our point fair value estimate, which is $100 per share.
Our three-stage discounted cash-flow valuation model reflects a compound annual revenue growth rate of 34.8% during the next five years, a pace that is higher than the firm’s 3-year historical compound annual growth rate. Our model reflects a 5-year projected average operating margin of 47.8%, which is above Facebook’s trailing 3-year average.
Our view in deriving near-term forecasts is rather straightforward. For one, there are dozens of analysts that cover Facebook’s equity, and we don’t think we can beat them at the quarterly earnings game. In fact, many of these analysts spend most of their time trying to predict quarterly earnings, and most will be wrong most of the time. Therefore, over the next few years, we believe consensus estimates (and/or management’s guidance) is most appropriate to use as a baseline forecast. Through years 3-5, we then fade our near-term expectations to mid-cycle assumptions. In Facebook’s case, we consider the firm’s ability to drive earnings leverage over the next 5 years, even as it invests in the business.
Beyond year 5, we assume free cash flow will grow at an annual rate of 12% for the next 15 years and 3% in perpetuity. Though these estimates may seem difficult to quantify, we can’t ignore them just because they are difficult to forecast. Within every valuation is an assumption for the perpetuity value, and even if multiple analysis is applied, an assumption for terminal value is made in every case. We like to be as transparent as possible. Transparency is a valuable attribute of the DCF.
For Facebook, we use a 10.8% weighted average cost of capital to discount future free cash flows, which is on the high end of the risk range for our coverage, but perhaps appropriate for a company with such a wide range of future possibilities. There are both upside and downside risks. After considering all of the qualitative criteria, we think Facebook is worth $100 per share.
But we can’t just stop at the DCF for valuation. For starters, there are many pitfalls of the DCF. First, there are thousands of assumptions within the framework. Even though multiple analysis or other valuation approaches implicitly make these assumptions, too, it’s sometimes difficult to get comfortable with an explicit forecast for 2018, for example. That makes sense.
However, the DCF, used in conjunction with a margin of safety, is a rather useful tool. At its core, the process is the best at identifying outliers. For example, if the DCF says a stock is worth $100, and the company is trading at $75 per share (as perhaps Facebook may do in coming periods), there is an adequate margin of safety embedded in such work. Users of the DCF do not need to be precise to uncover investment gems.
That said, however, one way of double-checking the DCF is to use a relative valuation overlay, the second pillar of the Valuentum Buying Index. We fully understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. For one, many institutional money managers – those that drive stock prices – pay attention to a company’s price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. Fair or not, this is a helpful check to use when scouring tens of thousands of stocks within one’s investable universe.
With this in mind, we can’t possible exclude a forward-looking relative value assessment in our process, as it certainly augments the rigorous discounted cash flow process. From our perspective, if a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint.
For relative valuation purposes, we compare Facebook to its peer median, which includes peers Baidu (BIDU) and Google (GOOG). In this light, Facebook doesn’t stack up as favorable versus peers, but that doesn’t mean that the company is expensive. The relative valuation process just provides us with more insight into the firm’s valuation dynamics. Said differently, Facebook may grow out of its relative overvaluation in coming years, and this is something that the DCF picks up that relative valuation measures cannot.
This is why using both a DCF and relative valuation approach is so important. Both shed light on a company’s valuation.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm’s fair value at about $100 per share, every company has a range of probable fair values that’s created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn’t see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock.
In the graph below, we show this probable range of fair values for Facebook. We think the firm is attractive below $75 per share (the green line), but quite expensive above $125 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Facebook’s fair value at this point in time to be about $100 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm’s current share price with the path of Facebook’s expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm’s shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm’s future cash flow potential change.
The expected fair value of $136 per share in Year 3 represents our existing fair value per share of $100 increased at an annual rate of the firm’s cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range. We’re expecting upside in Facebook’s shares.
Pro Forma Financial Statements
