- Facebook has made two major acquisitions in 2014 and some believe that they overpaid.
- The deals were largely financed by stock, therefore the true cost to shareholders is not necessarily the reported dollar amount.
- By determining Facebook's fair value, investors can discover how much the acquisitions truly cost.
Recently, Facebook (NASDAQ:FB) made headlines with two large acquisitions. Facebook first purchased WhatsApp, a popular messaging service, for $19 Billion in February. In March, Facebook bought Oculus VR, a company that makes virtual reality headsets, for $2 Billion. WhatsApp was acquired for $4 Billion in cash and $15 Billion in stock and stock options. The purchase of Oculus was comprised of $400 Million in cash and approximately $1.6 Billion in stock. The large stock component of these purchases makes the true price paid by Facebook for the companies less clear.
By financing these deals primarily with stock, Facebook may have made their acquisitions on different terms than the numbers would indicate. The actual cost of these acquisitions is what matters to shareholders. Before going any further, I should mention that I do not like Facebook stock at current price levels. So long as the current valuation persists, I will likely never own shares of Facebook. My investing style is value oriented, so the idea of purchasing a company that trades at roughly 100x earnings seems unfathomable to me. Though I do not like the stock at current price levels, I'm intrigued by the way management has gone about these recent acquisitions.
Acquisitions Gone Wrong
In his 2007 letter to Berkshire Hathaway (NYSE:BRK.A) shareholders, Warren Buffett mentioned that the acquisition of Dexter Shoes was the worst mistake he ever made. He purchased the company in 1993 for $433 Million worth of Berkshire stock. He thought that the company was in possession of a durable competitive advantage. His thesis proved to be incorrect and Dexter Shoes withered. While a $400 Million loss is problematic, Buffett mentions that, "By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion." Reflecting further on the purchase, Buffett said, "In essence, I gave away 1.6 percent of a wonderful business -- one now valued at $220 billion -- to buy a worthless business." Berkshire's value has increased since Buffett made this comment, and so has the cost of his blunder to shareholders; at current prices, 1.6% of Berkshire Hathaway is worth around $4.9 Billion.
I mention the Buffett anecdote as it demonstrates how acquisitions using shares of stock can impact companies. If shopping for companies using undervalued shares hurts shareholders, then it would seem acquisitions funded by overvalued shares would be helpful to owners. By almost every conventional financial metric, Facebook appears overvalued. The PEG ratio is typically the gold standard for evaluating rapidly growing companies. Using data from Morningstar, Facebook's TTM P/E is 105.3. Further, analysts estimate that Facebook will grow its earnings at 31.82% for the next five years. Dividing Facebook's P/E by its growth estimates produces a PEG of just above 3.36. Many strict value investors believe that the P/E of fairly valued company is equal to its growth rate. As such, a PEG of 1.0 is used as an indicator of fair value. However, more aggressive investors focused on growth may be willing to buy a stock until its PEG exceeds 2.0. Taking the average of these two PEG ratios, we are left with a PEG of 1.5 as the cutoff for fair value. Some may disagree with this assessment, but for brevity's sake, this article will assume a PEG of 1.5 indicates fair value.
The next step involves calculating what Facebook's fair value would be using our chosen metric. In order to have a PEG of 1.5 at current growth and earnings levels, Facebook's share price would have to decline to roughly $28.05. If the intrinsic value of Facebook is around $28.05 per share, then Facebook has been making acquisitions for only 45% of the reported cost. Many have criticized the high price Facebook has paid for its recent acquisitions without considering that the purchases were funded primarily by shares of stock. Using my $28.05 per share intrinsic value estimate, Facebook has actually acquired WhatsApp for $10.75 Billion and Oculus for $1.12 Billion.
Things to Consider
Even these newly calculated prices do not necessarily make the acquisitions a good or bad idea. The value of Facebook's shares is only one half of the equation; the future earnings power of WhatsApp and Oculus will weigh heavily on whether or not these acquisitions were wise. Returning briefly to the Warren Buffett example, whether shares of Berkshire were undervalued, fairly valued, or overvalued at the time, the acquisition would have still been disastrous because Dexter Shoes ended up being worthless. Both Oculus and WhatsApp may prove to be worth far more than their nominal purchase price, or far lower than even the adjusted purchase price calculated in this article. A discussion on the proper value of these acquisitions is a separate topic. The takeaway should be that when a company makes purchases using stock, the intrinsic value of their stock needs to be compared to the value of the company being acquired.
Finally, it is important to note that this exercise can be modified depending on what you believe constitutes fair value for Facebook. I used a PEG of 1.5, though I concede that there are many other ways you can attempt to determine the fair value of Facebook. Further, the example I used indicated that Facebook shares were overpriced and consequently the real cost of their acquisitions was lower than reported. However, others may reach the conclusion that Facebook is currently undervalued depending on the criteria that they used. In this case, Facebook would have been paying more than the amounts reported by giving away their stock. The cost of this acquisition can change dramatically depending on how one estimates Facebook's fair value.
Acquisitions using stock are different than those that use cash. Assuming shares are overvalued, Facebook has been paying far less than it seems for their most recent acquisitions. On the other hand, if the intrinsic value of the shares is higher than their current market price, the true cost to Facebook will be greater than reported. Even after calculating the true cost to Facebook, one must still determine what WhatsApp and Oculus will ultimately be worth. Determining whether these acquisitions were a wise decision is possible only after deciding the value of both Facebook and the two companies that it acquired.