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Share price of Facebook (FB) has risen by more than 14% in the following day after the company reported better-than-expected Q4 2013 earnings. The share price momentum has been very strong recently as it has appreciated by 62% over the past 6 months, compared to only 6% return for S&P 500 Index. Despite the significant run-up, I believe the stock remains a lucrative investment due to the reasons discussed below.

Growth potential is significant and achievable…

Current consensus estimates call for a revenue and EPS CAGR of 35.8% and 36.5%, respectively, for the period from 2013 to 2015. Street on average expects the company can drive a long-term earnings growth rate of 33.4% in the next 5 years. On the margin front, market expects an EBITDA margin expansion from 48.5% in 2013 to 60.4% in 2015. At a first glance, these estimates may appear to be somewhat aggressive, but I believe the company is well positioned to achieve the expectations owing to the following:

  • Market's previous concern on Facebook's mobile business is now proved to be totally overblown. The company's mobile revenue in Q4 2013 increased by almost 40% sequentially and was ahead of Street's consensus estimate. The mobile revenue now represents more than half of Facebook's top line, indicating that the company has successfully shifted its core from desktop to mobile screens. It is believed that the mobile sales will continue to experience high growth as the gap between media time spent on mobile and advertising budget to mobile shrinks over time as well as Facebook's ads becomes increasingly valuable to marketers.
  • One of the company's initiatives to drive incremental revenue growth is through video advertising. Marketers would for sure favor video advertising given its increased effectiveness. According to management, early testing has shown that user engagement may increase with video contents. Bank of America Merrill Lynch expects that video ads could drive additional 10% to 15% growth in the company's advertising revenue over a medium term. The other major incremental revenue driver is Instagram monetization. Given the platform's large user base (approximately 150M users, representing 12% of Facebook's total user base), the monetization ramp-up will likely bring in a material revenue impact.
  • In the Q4 2013 earnings call, management highlighted their focus on improving ad quality. Given management's track record of solid execution, it is expected that this effort would likely enhance Facebook's bargaining power on ad pricing and boost the company's margin performance over time.
  • In 2013, Facebook managed to boost its annual EBITDA margin substantially from 23.3% at December 31, 2012 to 48.5% as at December 31, 2013 due to significant operating leverage. Provided that 1) The current uptrend for Facebook's ad pricing is likely to persist owing to management's effort in expanding the mobile business, improving ad quality, and ramping up video ads; 2) revenue derived from Instagram would demonstrate substantial growth due to monetization; 3) management continues to drive operating efficiencies in its server infrastructure, I believe the company's top line growth would continue to outpace the growth of operating expenses going forward.

Valuations are reasonable…

Facebook shares now trade at a 2015E P/E multiple of 58.7x, compared to the same multiple of S&P 500 Index at 14.9x. My view is that the stock's premium valuation is completely justifiable given the company's superior growth prospect and significant margin expansion potential. As mentioned, Facebook's consensus long-term earnings estimate is 33.4%, substantially above the average estimate of 8.5% for S&P 500 companies. After factoring in the earnings growth potential, the stock's 2015E PEG ratio of 1.76x is almost consistent with the level of S&P 500 Index at 1.75x.

The table below shows Facebook's revenue and EPS valuations relative to those of LinkedIn (LNKD) and Twitter (TWTR). It is noted that Facebook's 2015E EV/Revenue multiple to revenue growth ratio is fairly in line with the two peers', but its 2015E PEG ratio (based on EPS growth from 2013 to 2015) is notably below LinkedIn's at 1.0x, which appears to be very reasonable as the P/E multiple is in line with earnings growth.

(click to enlarge)

In summary, given Facebook's reasonable valuation level and my belief that the company is likely able to achieve market's expectations backed by the strong fundamentals, a buy rating is still warranted at the current price level.

All charts are created by the author except for the consensus estimate tables, which are sourced from S&P Capital IQ, and all financial data used in the article and the charts is sourced from S&P Capital IQ unless otherwise specified.

Source: Facebook Will Continue To Build Momentum