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Overview

Facebook (FB) stock has certainly seen its share of volatility since going public earlier this year. The stock has seen a high of $45.00 and a low of $17.55 in the space of only 6 months. While some of this is to be expected of one of the most anticipated IPOs in the history of financial markets, this rollercoaster ride has no doubt been sickening to FB shareholders. In this article, we will take a look at Facebook's valuation and see if the company's value is closer to $45 or $17.

Facebook is undoubtedly in a dominant market position. They don't have much competition to speak of as they have crushed all other entrants in the social media space. Of course, there are countless other social media sites but I don't consider any of them to be true competitors to FB; they are completely dominant in the space.

Facebook has been steadily adding users at a ludicrous pace for the past several years, as seen in the chart below from the most recent 10-Q.

The problem is that FB needs to actually collect some revenue from all their new users. Adding users is great but doing so costs FB money because of SG&A, data storage, software needs, etc. Unfortunately for Facebook shareholders, adding revenue is proving to be much more difficult than just getting people to sign up. The chart below shows revenue for the past several years and notice the trajectory of users versus the amount of revenue Facebook is collecting; they are adding cost drivers at a much faster rate than they are able to recognize a benefit from all those users. See the chart below also from the most recent 10-Q.


(Click to enlarge)

The theory, of course, is that FB will be able to monetize these users sometime in the future. While that sounds great, how exactly are they going to do that? It is well documented that PCs are not exactly a growth industry anymore (to put it lightly), and that mobile is the wave of the near future. Facebook has openly admitted problems with monetizing mobile users, which are making up larger and larger portions of active users. My fear, therefore, is that Facebook is building necessary infrastructure for millions (or even billions) of users that it cannot effectively monetize at the same rate it used to. The implications of this are great; it means that Facebook's costs as a percentage of revenue will continue to increase and they may struggle to even break-even in the future. While this is an extreme case, their earnings potential is almost certainly diminished.

Stock Analysis


(Click to enlarge)

Let's now turn our attention to the stock's valuation. At Facebook's current price of $27.46, it has a market cap of $59.49B. This is after a rocket ship rally off of the $19.00 line last month (see chart above). For a company that is expected to make $0.52 per share in 2012, I would consider that a pretty optimistic valuation. I fully realize FB is not priced based on the previous year; rather, it is priced on future growth expectations. However, it is certainly worth noting.

Facebook's current PEG ratio is 1.95, which is nearly double the PEG of 1 I would look for in a company to invest in. Facebook's forward PE of 42 is also significantly higher than I would want, but could be justified given the growth potential of the company; they have consistently exhibited revenue growth north of 30%. One more potential catalyst; institutional ownership clocks in at only 48%, leaving plenty of room for the big fish to add to FB once insiders unload their shares.

Facebook is extremely well capitalized with total current assets of $12.285B and total current liabilities of only $1.080B. Obviously, they will have no trouble financing whatever they want to with this type of liquidity and flexibility. In addition, FB's book value is $14.174B (just over $6.50/share) and they have generated $966M of free cash flow in the first 9 months of 2012. Facebook also has no debt other than capital leases. These are obviously robust numbers and are definitely strengthening the bull case for FB.

Lockups have been a well-documented topic for FB shares and the schedule looks like this (from the most recent 10-Q):

  1. 10/29/12: 229 million shares by insiders other than Zuckerberg
  2. 11/14/12: 804 million shares by insiders other than Zuckerberg
  3. 12/14/12: 155,953,746 shares by insiders other than Zuckerberg
  4. 05/18/13: 47,315,862 shares by early investors of Facebook

None of this includes the 500+ million shares owned by Mark Zuckerberg. While lockups aren't negative by themselves, they can soak up huge amounts of volume if the insiders decide to sell, making it difficult for bulls to push the price up. Again, this is not a reason to buy or sell the stock by itself, but it is worth noting.

Discounted Cash Flow Valuation

Let me start by saying that any DCF analysis requires assumptions and estimates and that those are subject to personal viewpoints. You may not agree with all of my assumptions but I believe they are realistic estimates of what might happen to FB in the future.

Now let's take a look at the assumptions for the DCF:

  1. No debt
  2. Equity Risk Premium of 10%
  3. Earnings growth of 25% each year out to Year 6 (generous)
  4. Perpetual earnings growth of 7% after Year 6 (also generous)
  5. WACC of 10% (equal to equity risk premium since they are 100% equity financed)
  6. Earnings for 2012 and 2013 are Yahoo! Finance sourced analyst estimates (which vary pretty substantially)

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$0.52

$0.65

$0.81

$1.02

$1.27

$1.59

x(1+Forecasted earnings growth)

25.00%

25.00%

25.00%

25.00%

25.00%

25.00%

=Forecasted earnings per share

$0.65

$0.81

$1.02

$1.27

$1.59

$1.98

Equity Book Value Forecasts

Equity book value at beginning of year

$6.53

$7.18

$7.99

$9.01

$10.28

$11.87

Earnings per share

$0.65

$0.81

$1.02

$1.27

$1.59

$1.98

-Dividends per share

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

=Equity book value at end of year

$6.53

$7.18

$7.99

$9.01

$10.28

$11.87

$13.85

Abnormal earnings

Equity book value at begin of year

$6.53

$7.18

$7.99

$9.01

$10.28

$11.87

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

=Normal earnings

$0.65

$0.72

$0.80

$0.90

$1.03

$1.19

Forecasted EPS

$0.65

$0.81

$1.02

$1.27

$1.59

$1.98

-Normal earnings

$0.65

$0.72

$0.80

$0.90

$1.03

$1.19

=Abnormal earnings

$0.00

$0.09

$0.22

$0.37

$0.56

$0.80

Valuation

Future abnormal earnings

$0.00

$0.09

$0.22

$0.37

$0.56

$0.80

x discount factor (10%)

0.909

0.826

0.751

0.683

0.621

0.564

=Abnormal earnings disc to present

$0.00

$0.08

$0.16

$0.25

$0.35

$0.45

Abnormal earnings in year +6

$0.80

Assumed long-term growth rate

7.00%

Nominal value of terminal year

$26.57

Estimated share price

Sum of discounted AE over horizon

$0.84

+PV of terminal year AE

$15.00

=PV of all AE

$15.83

+Current equity book value

$6.53

=Estimated current share price

$22.36

As you can see, even with my sanguine estimates of 25% earnings growth for another 5 years and 7% perpetual growth, FB is only a buy at $22.36 today if you require at least 10% return per year. Given the risk that Facebook might not execute perfectly forever, as I believe is priced in, I think 10% is a very reasonable demand. Obviously, my estimates could prove to be conservative (or not conservative enough) but I have disclosed my estimates fully and I would ask you to remember they are estimates and subject to error and personal opinion.

If you revise downward my optimistic estimates, the picture is much grimmer with entry points in the teens. Given FB's inability to monetize mobile users up to this point, their ridiculous expansion in SG&A, marketing and cost of revenue without requisite revenue growth, and a host of other factors, I can't see FB deserving your capital at this point in time.

I'd love to hear your thoughts in the comment section.

Source: Can Facebook Monetize Its Mobile Users?