After Facebook's (FB) latest quarterly report, much of the investing community has flipped sides on the long-short battle. Somehow, stronger than expected revenue and strength in mobile have changed most headlines about the company from screaming "overvalued" to preaching a growth or value opportunity. The cumulative gains chart below clearly reflects this shift in sentiment. Since its quarterly report, Facebook has gone from barely returning 12% in the past 12 months to returning over 50%.
(click to enlarge)
With this article, I hope to show investors that even though Facebook is a solid company that is quickly growing and improving, its current share price is much too high to warrant a smart, long-term investment. To make my point, I will first go over some of the developments that make me like the company (ignoring its share price); let me be clear, I don't agree with some of the FB bears that simply dislike the company at most valuations. I will then present why fundamental investors should stay away at these levels, and avoid falling into the trap of buying companies that they "like".
As a Business, Facebook is Doing Great:
Facebook is on a great run as a company. For any social network that makes most of its revenue from online advertisements, three things need to continually improve in order to deem its operation a success:
- The number of active members needs to rise continually.
- The existing active members need to remain engaged.
- The success of monetization should be steadily rising.
Facebook is succeeding at all three; I will explain this success without going into too much detail by using a few charts.
1. The number of active users is constantly increasing:
Facebook is becoming more global, and its size reflects that, with numbers booming in countries like India and Brazil.
2. Contrary to what many bears preach, existing Facebook users' engagement is increasing:
This trend is especially impressive when you consider the fact that most new users come from outside North America and Europe, where user engagement levels are lower, which should be putting downward pressure on daily active users as a % of monthly active users.
3. Success in monetization is on the rise too, with increasing ARPU:
While the chart above shows weak improvement in overall ARPU, this is due to most of Facebook's new users coming from countries with lower ARPU figures, which puts downward pressure on the overall average. A more accurate way to look at the improvement in ARPU is by looking at each region separately, as done below.
Again, overall, Facebook's core business is doing great, and is improving at a fast rate. However, this does not necessarily justify a $50B+ valuation.
Facebook Is Fundamentally Overvalued
It is very difficult to model a growth company like Facebook, so no valuation can be considered the most accurate. However, my main issue with Facebook comes from the fact that no matter what you decide to use as your inputs, it is extremely hard to justify its current valuation. Considering the fact that an investment would warrant the potential for at least a 15% upside in the next year to pay for the risk, this is an issue.
Below you can see some of the revenue assumptions in my valuation model. Many will disagree with my projections, and all I can say is try it yourself (you can download a valuation model here, coupon code "seekingalpha") and you will be surprised at how hard it is to justify Facebook's current valuation.
Below are the resulting revenue projections:
I consider these results to be optimistic, with an average yearly revenue growth of 26% over the next 10 years.
In the end we get to a valuation:
For my model specifically, I end up at about $16/share, though I do not think that Facebook will trade that low anytime soon. The result is just what the fundamentals show me when growing Facebook's current business at a fast rate, but without taking into account complete surprises like significant new ventures. More interestingly, this valuation graph shows us why Facebook may have such a high valuation:
As you can see, the DCF analysis strongly suggests that Facebook is overvalued. After all, a 6-7% terminal growth rate from 2022 onwards is a very optimistic projection. Interestingly, the public company comparables show a trend of high valuations for companies like Facebook. While the median multiples give a share price between $10 and $22, the multiples from the 75th percentile to the maximum give disproportionately higher share prices. This could indicate that Facebook's overvaluation is in part symptom of the overall overvaluation of social media/tech/online companies, which is another reason to stay away from this stock.
To conclude, Facebook is fundamentally overvalued, in part because of over optimism on growth, and in part because of the wider issue of overvaluation of companies of its kind. A long-term fundamental investor should not be tricked by the health of Facebook's fast-growing business, and should stick to the proven rules of ensuring margin of safety and of fundamentals-based valuation. I would discourage any long-term investor from buying at a price significantly above $20/share, unless new developments emerge that completely change the company's long-term potential, though even optimistic projections of new revenue streams and booming segments barely raise my valuation above $16-18/share. I encourage anyone interested in Facebook's stock to download their own valuation models to modify and adjust to their own projections (you can download them here, use the coupon code "seekingalpha" for a 50% discount).
Overall, those that have profited from the recent rise in share price should sell, and others should strongly consider shorting the stock. While shorts should be very careful, as we have been shown many times that these kinds of runs can continue for long periods of time, most methods of valuation show that even very positive new developments will not be enough to support this share price in the long run.
Stock price at time of writing: $37.69