Image Source: Christopher
Accounting representation of earnings per share, whether GAAP or non-GAAP, is not as important to the valuation context as future free cash flow. Let’s talk about this concept a bit more within our valuation processes.
By Kris Rosemann
Q: I have been considering investing in Facebook (FB). Your projected five-year operating margin for Facebook is 58%. Currently it is around 40% and has averaged about 38% the last three years. I was wondering if you would be willing to elaborate on those expectations.
A: Thank you for the question.
What you have noticed in our operating margin assumptions is the discrepancy on the income statement between GAAP and non-GAAP reporting. While our historical data is pulled on a GAAP basis, our income statement forecasts are done on a non-GAAP basis, in accordance with the presentation of consensus estimates, and Facebook’s operating margin has been consistent with our forward-looking assumptions in recent quarters. For example, in the second quarter of 2016, the firm reported a non-GAAP operating margin of over 58%, and in the full-year 2015 it reported a 58% non-GAAP operating margin.
In Facebook’s case, the differences between GAAP and non-GAAP operating income are share-based compensation expenses (and the related payroll tax expenses) and amortization of intangible assets. This is important to note since both share-based compensation expenses and amortization of intangible assets are non-cash expenses and are added back in the calculation of cash flow from operations. Cash flow from operations is then used in the calculation of free cash flow, and as you may know, the core driver of our estimate of Facebook’s intrinsic value, or any company in our coverage universe, is our projection of its future free cash flow stream. In light of this, making accurate free cash flow projections is where our focus is turned, not on getting GAAP or non-GAAP operating margin or earnings per share targets correct. Below I have pasted a link to Facebook’s second quarter 2016 report, in which you can see GAAP and non-GAAP reconciliation, as well as how operating cash flow is derived from GAAP net income.
https://investor.fb.com/investor-news/press-release-details/2016/Facebook-Reports-Second-Quarter-2016-Results/default.aspx
With all of that in mind, it is worth taking note of Facebook’s incredible free cash flow generating ability, which starts with its profitability. The firm has driven explosive free cash flow growth in recent quarters (driven by ongoing growth in its active user base and tremendous advertising revenue performance) on a year-over-year basis: more than a 65% increase in the second quarter of 2016 and nearly 68% growth in full year 2015. Such tremendous free cash flow generation allows the company to maintain a fortress-like balance sheet–Facebook had cash, cash equivalents and marketable securities of ~$23.3 billion and no debt as of the end of the second quarter of 2016. This cash position not only adds a significant amount of value for the company in a literal, valuation sense, but also gives it tremendous financial flexibility, something that may prove to be invaluable as it continues to push the envelope in becoming the ‘new Internet’ and works to develop innovative products such as its virtual reality platform Oculus. We’re big fans of the company on a fundamental basis and have been nothing short of pleased with it since its addition to the Best Ideas Newsletter portfolio.
Jul 28, 2016
Facebook Flying, Twitter Tumbling
Facebook blew through another set of quarterly estimates, while Twitter still can’t seem to get a good handle on how to capture the full potential of the monetization of its platform.
Jul 27, 2016
Our Reports on Firms in the Internet Content & Services Group
We’ve adjusted our fair values for firms in the Internet Content & Services industry. Reports include AKAM, ANGI, BIDU, FB, GOOG, GRUB, JD, LNKD, SOHU, TCEHY, TRIP, TWTR, TZOO, ULTI, WBMD, YELP, YHOO.