Though Facebook (NASDAQ:FB) has certainly experienced its lows since the firm's "Faceplant" of an initial public offering, the company has rebounded and defended its spot as the largest social networking site in the world.
But first, a little background. We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy.
This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. If a firm is undervalued both on a discounted cash-flow and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Let's compare Facebook's chart to how we view things.
You can see that Facebook is now at the place where momentum investors are driving the company's share price higher (see image above first, and then image below second). As you'll see below in excerpts from our report on the company, the Valuentum strategy suggested to add Facebook to our Best Ideas portfolio when shares were undervalued (below $25) and just starting to exhibit strong technical/momentum indicators (the latter characteristic is why our strategy boasts the strongest profit potential).
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.
- Facebook's mission is to make the world more open and connected. People use Facebook to stay connected with friends and family, to discover what's going on in the world, and to share and express what matters to them.
- The range of potential outcomes with respect to Facebook's valuation are astounding. Though its business model doesn't have many comparable stories, we do recall a time when AOL was also the Internet. With such low barriers to entry, the landscape could be completely different in five years, posing both risks and opportunities.
- 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 gray 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 $32 per share. Our discounted cash flow model indicates that Facebook's shares are worth between $25-$39 each. Why such the large margin of safety? Click here. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRiskTM rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $32 per share represents a price-to-earnings (P/E) ratio of about -339.8 times last year's earnings and an implied EV/EBITDA multiple of about 51.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 28.9% 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 34%, which is above Facebook's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 20.5% 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 $32 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 $25 per share (the green line), but quite expensive above $39 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 $32 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below 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 $45 per share in Year 3 represents our existing fair value per share of $32 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
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.