Take it from us at Valuentum, Facebook (FB) is no magic way to stimulate business (check out our Facebook page here). The social network has little to offer in the way of getting the word out for independent research firms and small businesses like us, but that doesn't get in the way of our work. Let's dig into what this social-network behemoth is worth on a discounted cash-flow basis.
Our Report on Facebook
• Facebook earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 24.8% during the past three years.
• The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $20, we'd take a closer look.
• Facebook's cash flow generation is below what we'd expect from an average company in our coverage universe, and the firm's financial leverage is somewhat elevated. If cash flows continue to be weak, we'd grow more cautious on the firm's overall financial health.
• The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.
• The firm experienced a revenue CAGR of about 87.1% during the past 3 years. We expect its revenue growth to be better than its peer median during the next five years.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). 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 24.8%, which is above the estimate of its cost of capital of 11.5%. 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.
We think Facebook is worth $25 per share. Our discounted cash flow model indicates that Facebook's shares are worth between $20.00 - $31.00 each. 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. Our model reflects a compound annual revenue growth rate of 26.1% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 87.1%. Our model reflects a 5-year projected average operating margin of 31%, which is below Facebook's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 23.7% for the next 15 years and 3% in perpetuity. For Facebook, we use a 11.5% weighted average cost of capital to discount future free cash flows.
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 $25 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 $20 per share (the green line), but quite expensive above $31 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 $25 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart to the right 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 $35 per share in Year 3 represents our existing fair value per share of $25 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.
Pro Forma Financial Statements