Questions with Acquisitions
In the first half of 2014, Facebook (NASDAQ:FB) has announced six acquisitions, including Oculus VR for $2 billion and WhatsApp for $19 billion. While these acquisitions may prove to be lucrative to Facebook's bottom line down the road, many questions still surround the timing and degree of impact yet to be seen. The fact that many of these acquisitions are startups brings unknowns and uncertainties which haven't been priced into the stock efficiently. In other words, certain risks to a public company's future should ultimately affect the market value on any given day. Eventually an efficient market will reward a stock price once the positive implications become known.
This is why the stock price of an acquiring firm will generally go down upon announcement unless the synergies of the merger are clear and the confidence brought with the acquisition is high. This is virtually impossible when making an acquisition of a startups. Therefore, the short-term impact (or lack thereof) regarding Facebook's acquisitions reflects a complete trust the due diligence performed prior to the transaction is completely accurate in its forecasting. While Facebook shares dropped around 4% upon the announcement of the WhatsApp acquisition, this hardly reflects the true decline Facebook shares might experience should the future prove they paid too much. Given the current levels of Facebook's stock price, the risks associated with a disappointing merger (or even less-than-perfect merger) have not been considered, and if true, would value shares at a discount to current price levels.
Priced to Perfection
For many in the investing world, the goal in achieving profitable investments is the ability to identify undervalued opportunities that have yet to experience a growth catalyst. The opposite is true for investors who wish to avoid overvalued situations. Therefore, the real game is to buy your investment before price realizes the positive impacts related to growth rather than purchasing an investment that is simply trying to maintain expectations without any room for error. Many of these expectations can show up in valuation metrics. In Facebook's case, its price-to-earnings ratio is currently 85.5 compared to the industry average of 42.7. Even its forward price-to-earnings ratio hovers around the industry average current levels of 37.3. In addition, its price-to-book ratio is around 9.9 while the industry is almost half as rich, coming in at 5.2. Finally, Facebook's price-to-sales ratio is an astounding 18.4, while the industry average falls in at 7.3. These metrics in and of themselves should not be individual reasons to sell the stock, however, the margin to maintain expectations becomes razor thin.
Valuation should never be placed on metrics alone. However using these metrics along with the likelihood or unlikelihood of business models bringing expectations to the bottom line can reveal valuations far different from current market levels. For example, the range of possibilities for Facebook's future revenue streams has become exceedingly complex with startup acquisitions. Using internal calculations, it becomes obvious Facebook's current stock price is at the top of the optimistic range. Even using some certainty regarding Facebook's debt situation does not match a fair value price with the current price. Using a conservative (or even cautious) outlook for future revenue streams places a reasonable valuation at around $51 per share.
While Facebook has maintained an impressive track record for growing revenues thus far, few corporations are spared a decline in revenues should the economic environment flat line or even begin to contract. Again, the particular point of the economic cycle we currently reside should not be the only reason to purchase or sell an investment. However, Facebook's revenue stream would most certainly be at risk should corporations decide to tighten their belts. In fact, Facebook's revenues have been 89% advertising. So if you fall in the camp that our economy is not nearly as strong as the published numbers might say and a contraction is on the horizon, a company's advertising budget is usually the first to be cut. Concentrated revenue streams can certainly make or break a company's growth outlook, and the outlook for Facebook remains extremely optimistic. As of June 21, 2014, Facebook has an average earnings estimate of $1.26 per share. Should slowing economic conditions occur, Facebook might see earnings in the low end of the current range, or $.95 per share. If you take the industry average price-to-earnings ratio of 42.7 and earnings of $.95 per share, Facebook would be fairly valued around $41 per share. If you take the high-end of current earnings estimates, or $1.47 a share for 2014, and place that against the industry average price-to-earnings ratio 42.7, you get a fair value target of around $62 per share (coincidentally close to current market levels).
In short, this article does not support the idea that Facebook is a bad investment; rather, current price represents valuation consistent with an exceedingly optimistic and favorable outlook. In conclusion, short to intermediate term investors might consider selling 50% to 100% of their current positions and begin re-entering at prices below $50 per share.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.