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Facebook (NASDAQ:FB) has developed the product of a generation and has revolutionized the way hundreds of millions of people communicate, connect and socialize on a daily basis. With over 1 billion active users, 680 million of which are active on mobile, Facebook is the best positioned company globally to monetize the trend to mobile activity. Facebook's growth accelerated in the December quarter to over 40% as its mobile revenue increased from zero earlier in the year to 23% of its total advertising revenue. This trend, along with Facebook's potential to monetize other opportunities such as e-commerce, search and cloud should have Facebook flying high with a world beating multiple. Yet, Facebook's valuation has significantly lagged all of its high growth peers.

Table 1 details the current financials, analyst's forecasts and subsequent valuations of a peer group for Facebook. The peer group includes Salesforce.com (NYSE:CRM), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) and LinkedIN (NYSE:LNKD). I selected high-flying internet companies with fast growth potential focused in or around the target space of Facebook that are currently in "investment mode". All have a similar investment thesis, namely that they are uniquely positioned to lead an emerging on-line growth segment that will garner outsized profits and returns down the road. The class of four companies has an average trailing gross margin of 54% and forecasted 2013 net margin and revenue growth of 4.7% and 32.3% respectively. The average forward 2013 and 2014 P/E's are 141 and 70 respectively, and the PERG (2014 P/E divided by 2013 revenue growth) is a lofty 2.6. Facebook's financials and analyst forecasts both compare very favorably to the group. Facebook has a 2,100 basis point higher gross margin, over 4x the net margin of the peer group and a similar growth rate, yet it trades at about half of the P/E and PERG multiple.

Table 1: Facebook Peer Group Financials, Forecast and Valuation

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It is likely that Facebook will exceed analyst growth targets over the next few years as they are revolutionizing the advertising business with the largest potential targeted audience in history. They have the best proprietary information to create targeted direct marketing campaigns on a mass market scale for any consumer business. While their growth and revenues to date have been impressive, they are just beginning to understand mobile ad placement and how to optimize it (how many users, how much to different users and under what circumstances) without saturation by using direct feedback from users on what is working and what is not. For example, through different trials with News Feed they were able to increase ad viewing and effectiveness by 50% with only a 2% impact on page "likes". Add this to the additional potential of graph search, gifts, gaming expansion and cloud services combined with profit margin exceeding 20% and upside earnings is enormous.

So, even with analyst's current estimates, why has Facebook trailed its peers so significantly in valuation? It is simple supply and demand without a catalyst. Due to IPO share lockup releases between 8/6/2012 to 11/14/2012, Facebook floated an additional 1.837 billion shares on an existing 337 million float (an astounding 445% increase in supply). With the question of mobile monetization hanging out there, demand for the stock could not match this massive supply increase and plummeted from its $38 offering price in May to a low of $17.55 in September.

CEO Mark Zuckerberg provided the demand catalyst on October 24th by presenting a clear mobile strategy that gave confidence in the story to investors. That event coupled with the relief from the last large release of lockups on 11/14/12 propelled the stock up 85% from its low to $32.47 by the end of January. A post Q4 conference call retrace to $28.11 (at its 50 day moving average) after such a powerful two month run should help propel the stock now that the supply gap is largely behind it.

Facebook should now be free to trade in line with its peer group valuation - one way or another. While I have a hard time justifying the peer group valuation numbers (I have written extensively about the bubble that is Amazon), Facebook has the potential for 2x upside on the current $28 price if the peer valuations hold at the current levels in a continued bull run. There is of course the potential the peer group multiples drop significantly and in that event, they would need to drop by 50% before Facebook looked fairly valued in a comparison to them.

Conclusion

Facebook's fundamentals and outsized potential make it deserving of a valuation multiple commensurate with its peer group. Its share price has been held back by too much supply from its series of IPO lockup releases combined with a lack of understanding of its plan for mobile monetization. Now that these two key issues are behind them, look for Wall Street's confidence to continue to build in Facebook leading its valuation to grow more in line with its potential and peer group multiple. If the bull market run continues I look for Facebook to reach $35 to $38 over the next few months, and once it breaks through the IPO resistance level, it should run much higher.

Source: Why Does Facebook Trade At A 50% Discount To Its High Growth Peers?