Facebook (FB) has been on a wild ride this year already. It peaked at $32.47 at the end of January, but has been on a basically downward trend since then hitting $23.32 as of the writing of this article. This is down about 9% for the year but even at this stock price Facebook has a market capitalization of a little more than $56 billion. Is this really what Facebook is worth? According to Fidelity.com the actual EPS for Facebook last year was $.53 and the P/E for the trailing 12 months is 803. Looking at the financial statements I see sales have grown by 37% but income has fallen by 95%, yikes! Net income was $53 million for 2012 but was $1 billion in 2011. This is a pretty dramatic fall in net income and makes me question the value investors have placed on this stock. There must be more to Facebook than meets the eye.
Looking quickly at Facebook's ratios it has a price to earnings for the trailing 12 months of 803, a price to sales of 9.98, and a price to book of 4.29 (Fidelity.com). The price to book appears reasonable for an Internet company but the other ratios seem too high suggesting the company is overvalued by the market. But Facebook is still in a growth phase and has been adding subscribers in all markets with the strongest growth in the markets outside of Europe and the U.S. (10-K). Yes it is true the U.S. and Canadian market is showing slower growth but even so Facebook is adding 3-4 million users every quarter so slow is still impressive. Facebook added 23% more Monthly Active Users (MAUs) this quarter year-over-year, which is still substantial growth for the company and really the value of Facebook comes from its 1.11 billion MAUs.
Facebook's management team appears to be getting better at monetizing these 1.11 billion MAUs. At Facebook's current monetization rate it earns $1.31 from each MAU, which is 12% more revenue per MAU then it earned this quarter last year. Actually there is a pretty clear pattern of improving monetization when we compare year-over-year results by quarter. The quarters ending 12/31 see almost 12% increases in the Average Revenue Per User (ARPU) each year from 2010 - 2012. The quarters ending in March see approximately 10% increases and small increases in the June and September quarters of 2 - 4%. When we look at each calendar year and compute the average increase in ARPU we get an average increase of $.04 every year. This might not sound significant but it is when incorporated into the scale of Facebook's social network. The 1.11 billion users currently using the service would generate an additional $44 million in revenues each year due to improvements in this metric and this is without considering the fact that Facebook has been growing its user base by more than 200 million each year.
So let's do a simple exercise. Let's assume Facebook can add an average of 50 million MAUs a quarter for the next five years. Facebook currently averages 58 million a quarter over all quarters data is available. Let's also assume Facebook continues to improve the ARPU by $.04 a year for the next five years. Based on those assumptions by the end of March 2018, Facebook would have 2.1 billion MAUs, an ARPU of $1.52, and annual revenues in excess of $12.7 billion. This is too simple of a model but it shows the potential of Facebook as it improves its monetization rate and continues to grow its user base. There are multiple factors that need to be considered when modeling future scenarios so clearly this exercise is not a model to be utilized for actually predicting the future value of Facebook. The point is the trends we are seeing from Facebook in the continued growth in the user base coupled with management's focus on continuing to improve monetization of that base can produce enormous value in the future. Of course all of this is unimportant if Facebook does not produce strong earnings on these revenues and this year we saw its earnings drop 95% from a billion dollars to 53 million dollars.
So let us turn our attention to the dramatic drop in earnings Facebook experienced from 2011 to 2012. Revenues actually grew from $3.7 billion to almost $5.1 billion or by 37% from 2011, to 2012, while net income fell from $1 billion to $53 million. I almost quit looking at Facebook when I saw those numbers because obviously something is wrong with the company to experience that kind of a drop in earnings. But I kept digging through the 10-K to try to understand what happened. I think the bulk of this issue can be traced to a bad decision by management, the overuse of stock-based compensation. A whopping $1.5 billion in stock-based compensation was expensed in 2012 as required by Generally Accepted Accounting Principles (GAAP). When you look at the statement of cash flows you will see that cash flow from operations actually increased year-over-year by 4%. The expenses are increasing and Mark Zuckerberg even stated in the latest earnings call that Facebook's headcount will continue to grow this year particularly in product development (Techcrunch). The increases in expenses are cutting into profits but the biggest blow to earnings was the stock-based compensation charge. This is the restricted stock units (RSU) that Mark Zuckerberg apparently hands out like candy. It is reported by Barrons that in 2011 Facebook issued $1.4 billion in RSUs and so far this year has issued another $1 billion (venturebeats.com). Management has to get control of the issuance of RSUs. The expense for these RSUs has increased by over 700% from 2011, to 2012. Even if this expense had been allowed to double it would have added a billion dollars back to the gross income of Facebook.
While I am unsure if Facebook is fairly valued at almost $56 million I do believe Facebook has a very promising future and could be a strong investment. It is still growing at over 200 million MAUs a year and is increasing its ARPU, which together could produce very attractive revenue numbers for Facebook over the next several years. Increases to expenses will lower the profit margin in the near term as management grows the company's revenue-generating products; however, this short-term sacrifice should lead to strong long-term revenue growth. One issue that must be resolved is the overuse of RSUs, which are playing havoc on the earnings of the company. If this trend continues I would not invest in Facebook but if the issuance of RSUs is curbed in the near future then the company could possibly double in value over the next five years.