The hardest thing about being an investor in the stock market is trying to figure out whether or not the investment is "too expensive." Analysts have been chasing after Facebook (NASDAQ:FB) raising price target after price target, but to no avail, as they continue to set up expectations that Facebook acrobatically jumps right over. Almost like setting up a one foot bar, just for an Olympic high jumper to go 16 feet above the bar. This is the pillar of growth investing. Not knowing the future, but expecting something either catastrophically good or terrible to happen at any moment.
Prior to Facebook even announcing earnings, I am very optimistic on the company's stock. After coming up with a quantitative method for predicting what Facebook may generate in future revenues and earnings, I become increasingly confident in my investment position on the stock, which will be gone over in great detail throughout the course of this article.
Visualization of potential
Currently Facebook is the most competitive advertising platform against other social networks. This is because YouTube ads are movie trailers, Twitter links aren't engaging, and Google+ has been a flop. There are fears of Facebook being another MySpace, but... anyone who has used MySpace knows that the user experience on Facebook is vastly superior to anything else out there.
Recently a report came out from Piper Jaffray indicating that the company is losing a bit of the younger demographic, which could be a telltale sign of a not so bright future for the social networking giant. However, investors shouldn't be so quick to jump onto the counter psychological bandwagon in front of earnings, because the historical data largely indicates that Facebook was a social network targeted at adults anyway. Losing the younger demographic is a trend that some want to emphasize more than the global average user metric, and daily average user metric. However, I find Facebook's DAU, and MAU statistic more significant for investors, especially at the current time.
There are a lot of features on Facebook that Instagram and Twitter simply do not have; while it's nice that Instagram allows for picture sharing, the fact of the matter is that its success hinges on users being able to share content on their Facebook newsfeed. Instagram allows users to filter out Facebook statuses and only look at pictures. After all, when you're a kid, listening to a 12-year old complain about life, is the last thing you could care to read about, especially when you yourself are a teenager. Bullying happens when you're young, and quite frankly, no one at the age of 12 wants to share their life in a way that would make them dissected. Therefore, the Facebook newsfeed, which is more like a blogging platform anyway, was geared for the older demographic. Facebook got its start by appealing to adults that were in University, not from kids taking 'selfies' on MySpace. Let's also not forget that adults prefer to blog, and kids prefer to tweet. I almost never see people under 18 talking about their life with me, or anyone else. The fact is, adults do that, and the newsfeed is a marketer's gold mine, because the content that is published along a newsfeed has greater value to readers than what's offered by snapping a photo or 140 characters.
Part of the appeal of Facebook is that advertisers are able to generate compelling click through rates. To be more specific, according to Spruce Media, Facebook was able to increase the cost of advertising on Facebook without diminishing the effectiveness. Also, Instagram will soon be advertising on a user's Instagram feed. Currently Instagram has over 150 million active users. To be frank, you can gain more air time on Instagram than advertisers could get with Superbowl ad placement (111 million viewers). Implying that the true market value of Instagram's advertising product is heavily under appreciated by the stock market. Each 30 second ad placement sold during the Superbowl costs a couple million dollars.
With Instagram advertisers get the same reach as the Superbowl but pay a significant discount. Which is why it's a no-brainer advertising strategy regardless of how ineffectively advertisers are able to utilize it. Plus, because Instagram users can log in with their Facebook account details, advertisers can technically target ad-placement using the demographic data that is cross-pooled between the two social networks, which largely contradicts some of the research that was recently released on Seeking Alpha.
Also, anyone worried about Facebook losing relevance should thoroughly reconsider as the company could easily buy out competitors before the website ever reaches significant economies of scale. This is why if a website can attract users it often gets bought out at excessively high valuations in order to protect the marketshare of pre-existing websites. For example, Google bought out YouTube, and Facebook bought out Instagram. Yahoo! bought a huge stake in Alibaba, and so on. This trend is likely to continue going forward.
Look through the crystal lens
Honestly, no forecasting method is perfect. A strong mix of quantitative and qualitative analysis tends to work the best. Hopefully, the company specific research can unveil a unique edge that the business may have that others do not. The preliminary research that I have done throughout the whole year largely indicates that Facebook is in the transition stage of being a phenomenal cash cow.
The global average revenue per user was $0.94 in Q2 2010. In Q2 2013, the global average revenue per user was $1.60. So in the course of 3 full calendar years, the global average revenue per user grew by a growth rate of 19.4%. Also, in Q2 2010 monthly active users was 482 million, currently the monthly active user figure is 1.15 billion. The total number of users grew by 33.62% on a compound basis.
In Q2 2011, the average total cost per user was $0.65 ($480 million in expenses divided by monthly active users of 729 million). Now, understand that in the second quarter of 2011, the company was spending less per user, because it was trying to manage costs. However, as a ratio, the company is spending more money per year per user each year, which we will factor into our long-term growth model. Between Q2 2011, and Q2 2013, the cost per user has gone up by 26.49% per year.
Over the next five years I expect the monthly active user figure to grow at its historical 33.62% compound growth rate. The actual user growth may vary from quarter to quarter, but I set an upper limit at 5 billion users. This is because I don't expect Facebook to penetrate China, leaving out 1 billion of the world population, and I don't expect the bottom 1 billion of the world population to have access to internet anytime soon. So the upper limit on Facebook users will be set at 5 billion, and based on current growth rates, Facebook should reach its upper limit over the next five years.
I expect sales per user to grow by 19.4% per year over the next five-years. Also, I expect operating expenses to grow at 26.49% per year over the next five years. So in other words, the cost per user will go up at a higher rate than revenues. This is based on historical trends in the data, which largely indicate that the company's efficiency per user will decline. By 2018 the average revenue per user is expected to be $19.4, and expenses are expected to be $13.71 per user for a whole year.
I found revenue by multiplying the average revenue per user, by the total number of users. I found operating expenses by multiplying the average expense per user, by the total number of users. This in turn leads to our forecast on both revenues and expense, on the basis of costs and revenues per user. I believe this method will be more accurate, because it's company specific. By 2018, I expect revenues of $97 billion, and I expect expenses of $68.5 billion.
This leads us to our final conclusion on what operating income will be. This is calculated by subtracting the annual revenue by annual operating expense. By year 2018, I expect operating income to grow to $28.511 billion. The net income figure is found by factoring in a 38% tax assumption on all operating income. Therefore, by year 2018, Facebook will generate $17.6 billion in net income.
The average growth rate for net income throughout the five-year period for my five-year projection is therefore 31.88%. This growth rate is above the consensus estimate of 29.63%. The qualitative accounting data largely correlates with what the street expects, and I believe that the expectations have not been fully priced into the stock, based on the lack of faith in the opportunity that is already presented.
I expect a much higher revenue figure for 2013, and 2014 than the rest of the street. This is because I calculate monthly average user growth at a higher rate, without a decay factor, using exponential growth. Plus, I factor in improving per user sales metrics. This resulted in an $18 billion revenue forecast for fiscal year 2014, compared to the analyst consensus revenue forecast of $9.9 billion. I estimate that analysts may be wrong by a factor of a 100% over the course of 6 quarters, implying a substantial beat on top line, which will be a significant catalyst to the price of the stock.
Finally, to top this discussion off, I will include my five-year price forecast.
By the end of 2013, I expect Facebook to trade at around $101.59 per share. This is due to membership growth, revenue growth, and better management of expenses. Over the long-term, Facebook will reach a point of market saturation. At this point, the stock will pull back, as the market will become fully saturated. Once the saturation point is reached, the growth rate will decline, and markets will sell the stock substantially lower.
If investors buy Facebook at an entry point at $51.95, investors will generate a compound annual return of 38.94% or a total return of 418% by 2018 ($269 per share). Of course there's a lot of uncertainty in the future, and I tried to factor that into my calculation. However, markets are random, and anything from war to a famine could cause stock prices to plummet. In other words, this is just an estimate, and it will offer long-term context on the value of the stock.
Can this thing really scale?
Also, some may wonder if a $100 billion revenue figure is even a reasonable number. After all, Facebook could get big, but it couldn't become that big, right? Personally, I think $100 billion is an extremely conservative estimate of what Facebook can saturate as a percentage of the global money spent on advertising.
To be more specific, the global advertising market is expected to grow to $515 billion by 2014. Now as a percentage of global GDP (84.97 trillion dollars), this figure is extremely small, so don't be deceived by $515 billion. Advertising isn't taking over the world, but it's an industry that is growing at twice the global GDP growth rate, and of all the advertising opportunities out there. The only company that can advertise to over a billion people is Facebook.
It may be the most opportune time to own Facebook. I think that the short-term catalyst of monetizing Instagram, margin improvement, and greater global scale will trump any revenue estimate analysts currently have on the stock. Though my forecast is higher than the rest of the street, and I believe it to be more accurate, it will be different from the actual numbers that Facebook will post. This is because there are many more factors at play than what I can reasonably calculate. However, given what we know about user growth, average cost per user, and revenue growth per user I feel more confident in my forecast than the one offered by the rest of Wall Street.
To conclude, Facebook is a buy. The risk to reward is extremely compelling, and investors should be able to double their investment over the next two years.
Disclosure: I am long FB. 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.