Seeking Alpha
Deep value, long/short equity, contrarian, hedge fund manager
Profile| Send Message|
( followers)  

It’s the tech boom all over again. Or at least, it sort of feels like it when the mention of Facebook and a potential IPO comes up. Investors have been clamoring to get their hands on hot social networking sites like LinkedIn and Facebook; this demand has yet to be quenched.

There have been recent moves towards the inevitable outcome, however. LinkedIn has announced plans for an IPO in 2011. Perhaps, the even bigger news was Goldman Sachs’ announcement of an investment in Facebook, which might be the first step towards an eventual IPO for Facebook, as well. All of this news has brought the question of privately-held Facebook’s valuation to the forefront.

Valuing Facebook

Facebook’s current implied valuation is about $50 billion according to most media sources. It has been reported that before Goldman Sachs Investment Partners made the investment in Facebook, Goldman Sachs Capital Partners (NYSE:GS) had access to the deal and declined an opportunity to invest in the company. GS Capital Partners’ head Richard Friedman was allegedly concerned about a high valuation, among other factors. While many wealthy private investors want to get their hands on Facebook, the question of whether the valuation is a bit too fat is definitely one worth asking.

Unfortunately, piecing together a probable valuation for Facebook is not an easy task. First off, Facebook does not file financial statements with the SEC, meaning we only have access to a limited amount of data in order to build a valuation template. Next off, high growth companies are, by their very nature, difficult to value. This is because it’s tough to decide on future growth rates. When will growth decline? When will it dramatically level off? Does this business have a limited shelf life? If so, what happens after that?

In fact, there’s nothing particularly simple or straightforward about Facebook’s valuation; but that’s why I’m intrigued by it. I like dealing with these difficult valuation scenarios and trying to come up with some modicum of a resolution.

For the record, this exercise is just for entertainment and educational purposes on my part. I have no interest in investing in Facebook; not now with Goldman Sachs; or in the future for a potential IPO. You can call me a disinterested party who wants to know more for curiosity’s sake.

Assumptions, Questions, and Complications

Here are some initial questions that I want to sort through before running any valuation models:

(1) How long does Facebook continue in “high-growth” phase and where does its growth level off?

(2) Is Facebook a “fad” that will eventually go away?

(3) How does one determine an appropriate discount rate for Facebook’s cash flows?

(4) While cash flows for the next few years might be relatively certain, cash flows further along the lines are much less so. How do I account for this?

(5) What if Facebook’s social media niche dies off? Can they use a massive cash hoard acquired during boom years and put it to good use somewhere else?

(6) How competent is Facebook’s management team in branching out the business into new areas?

(7) What are realistic future profit margins for Facebook?

(8) What incentives do people have to stay at Facebook if “something better” were to eventually come along?

Some of these questions are quite tricky. We can assume that Facebook will continue to grow rapidly for at least another year or two, but beyond that, it’s difficult. Unfortunately, there’s a pretty big difference between applying a 50% growth rate to revenues vs. a 10% growth rate in 2013.

The question of whether Facebook is a “fad” is an important one. Will it even be around in 2020? Will you care about it ten years from now, or will it be like hair metal and long been replaced by “hipper” things 10 years afterwards. Yet, even if it is a fad, it’s hard to deny the major cash flows streaming into the business over the next few years. Even if Facebook, the social network, eventually fails, who's to say that Facebook, the cash-cow conglomerate wouldn’t succeed?

Profit margins are a difficult issue, as well. According to the articles I’ve encountered, Facebook’s current profit is around $400 million. This is absolutely massive considering it comes on a mere $2 billion in revenues. That’s a whopping 25% profit margin!!! Is that sustainable?

On the face of it, Facebook has a moat about as wide as the Mississippi River, so it might not only be sustainable but expandable! Yet, things have a way of changing quickly in the tech world. Remember America Online? No one could touch AOL in the dial-up Internet game in the late ‘90s; even in spite of terrible service, constant gimmicks, and overly restrictive controls. A few years later, no one in their right mind wanted AOL’s terrible service, constant gimmicks, and slower-than-slow access speeds, when they could get DSL or cable internet and not have to deal with those headaches anymore. This is to say, moats in the tech world can shrink very quickly as new technologies and fads move in.

Google (NASDAQ:GOOG) and others have tried to break in on Facebook’s niche and have had virtually no success in doing so. Maybe the problem is that everyone is trying to be Facebook, rather than trying to be “what comes after Facebook.” And maybe one of these days, when someone figures that out, Facebook suddenly has more competition, and a massive 25% profit margin is in danger. So there’s another potential issue on the horizon.

All these issues bring me to the discount rate, which is tricky as all get out. Traditionally, investors will come up with some weighted cost-of-capital and apply it throughout a period in order to determine a rate to discount future cash flows at. I’m skeptical of this approach when it comes to Facebook. Those projected cash flows 2 years from now seem significantly safer to me than the projected cash flows 10 years from now. I’d go so far as to say that it might be prudent to discount all cash flows beyond Year 10 back to 0, due to the extremely high level of uncertainty surrounding them.

This is certainly a debatable issue, and some might say it’s insane to not count cash flows after the first ten years, but if I’m completely uncertain as to whether a company’s primary product will exist in 10 years, why should I create imaginary cash flows for it? For this reason, I have considered a few different approaches to the discount rate and the terminal value in a Discounted Cash Flow analysis.

One final note --- all social media sites seem to wane at some point when something better comes along. This happened to LiveJournal, Friendster, and even MySpace. The latter was essentially displaced by Facebook. What’s to keep Facebook from being eventually displaced, as well? There is very little in the way of incentives to keep people at Facebook if the winds were to shift. There is very little potential for cash for most users and very few derive major economic benefits. In this way, LinkedIn actually has a bit of an advantage over Facebook, because the possibility of obtaining vital job and business contacts constitutes a very real economic incentive for its user base. There’s nothing comparable at Facebook.

Scenarios and Valuations

I made one key decision for all my valuation scenarios. I would not compute cash flows beyond Year 10. The issue of whether or not to apply a terminal value is tricky, so for each scenario, I’ve attempted to come up with a terminal value. You can decide whether to apply it to the valuation or not.

Scenario #1: High Growth, High Discount Rate

For my first scenario, I assumed high revenue growth, 25% profit margins, and an increasing discount rate in the future. This rate becomes very high towards the later years. The model is below:

We end up with a valuation of $11 billion in this model. A reasonable terminal value might tack on another $2 billion. Either way, this leaves us well short of the market’s current $50 billion valuation.

Why this Might be Aggressive: Do you expect to be using Facebook in the year 2020? While Facebook might be “hot” now, there’s a significant chance that it will be one of those things we look back on and say, “hey, remember when we all used Facebook?” by 2020.

Why this Might be Conservative: My scaling discount rate is very untraditional, and if Facebook continues to produce major cash flows, they might be able to invest the money rather prudently. Hence, the future risk may appear higher to me than it would be in reality. Also consider that in spite of my “high growth rates”, they would appear conservative by historical measures. Perhaps I am underestimating the revenue growth potential, as advertising revenues may increase more in the future and the user base will continue to grow.

Scenario #2: High Growth, with Different Discount Rates

These scenarios are similar to the first scenario, except I took a more traditional approach to the discount rate. For 2A, I used a moderate 15% rate throughout the period. For 2B, I took a low 12% discount rate throughout the period. For 2C, I used a high 20% discount rate throughout the period.

Valuation is at $12.2 billion for 2A. A terminal value of $5-6 billion, would nudge that closer to $18 billion.

For 2B, valuation increase to $14.1 billion. With a $8 billion terminal value, that would push us up to $22 billion.

For 2C, valuation falls to $9.75 billion. $3 billion might be a reasonable terminal value, so you could up it to $13 billion with that.

Why this Might be Aggressive: Once again, are my growth rates realistic? Social network sites don’t tend to have long shelf lives, so it may be unrealistic to assume FB can produce major cash flows for over a decade. Also, the costs of capital in the latter years are actually quite low given the huge amount of uncertainty inherent in this business model.

Why this Might be Conservative: Maybe Facebook changes things. Maybe the moat is so big that a 25% profit margin assumption isn’t aggressive enough. Maybe Facebook is able to grow in new, unanticipated ways. Maybe FB can use the massive cash hoard to invest in new business lines, which are successful. There are quite a few ways that this could still be conservative, but it requires a lot of major “ifs” to get there.

Scenario #3: Moderate Growth

For both of these scenarios, I moderate the growth a bit. For 3A, I use a 15% discount rate throughout; for 3B, I use the scaled discount rate structure I used in Scenario #1.

This gives me valuations of $9.2 billion and $8.4 billion respectively. Terminal value for #3A might be around $4 billion, bringing the valuation closer to $13 billion. Terminal value for #3B would be closer to $1.5 billion, only jumping the valuation up to $10 billion (big difference on how we treat the later years).

Why this Might be Aggressive: Growth still might be too high. Margins still might not remain this high.

Why this Might be Conservative: Growth might be underestimated. Discount rates might be too high.

Scenario #4: Growth Wall, High Discount Rate

For this scenario, I assume that Facebook is a fad and that the company will hit a “growth wall” at some point, where it loses popularity as other sites start to move in on its turf. I did two different variants with this scenario; the first one only includes shrinking revenues. The second one also assumes declining profit margins over time.

We end up with valuations of $5.1 billion and $4.3 billion respectively. Terminal value in these scenarios might not be too important.

Why this Might be Aggressive: Believe it or not, this could still be too aggressive in treatment of profit margins. 25% margins are high. Maybe they shrink faster than I allowed them to in this scenario.

Why this Might be Conservative: For all the reasons detailed in scenarios above. Also another issue to consider is whether or not the early year cash flows would be enough for Facebook to transition into other industries, once it saw that its social media niche was dying out. In such a scenario, my revenue figures and terminal value would be highly unrealistic.

Scenario #5: Absurdly High Growth, Impenetrable Moat

Finally, just for fun, let’s try to come up with an absurdly bullish scenario. We will have absurdly high growth, we will keep the 25% profit margins, we assume FB’s moat is impenetrable, and that the entire business model is sustainable over a long timeframe.

Since this undermines my original assumption regarding terminal value, I went ahead and calculated this scenario on a more traditional model. However, I still only show the first ten years.

The valuation (with terminal value) is $34.8 billion.

Why this Might be Aggressive: Because I went out of my way to make some of the more ridiculously positive assumptions possible.

Why this Might be Conservative: I’m having a hard time coming up with a reason as to why this would be “conservative", but let's go with the stock reason that I'm 'underestimating growth.' Maybe Facebook becomes the next Apple and can innovate further; I view this as unlikely, but let's consider it.

Conclusions

As you can see, it’s fairly simple to alter our assumptions in a few ways and come up with valuations that are radically different. Our low-end valuation among the scenarios was $4.3 billion. Our high-end valuation was $34.8 billion. More realistically speaking, I’d view $22 billion as a more legitimate ‘high-end’ estimate. Either way, both of these figures come far short of the reported $50 billion valuation the market currently places on Facebook. People buying in now are paying a 43% premium to my already ridiculously-aggressive valuation model; and a 127% premium to my more realistically aggressive valuation.

Based on all of these scenarios, I would view a realistic valuation for Facebook to be in the $8 - $10 billion range. This is based on my view that it will remain a cash cow for a few years, before growth lags or possibly declines at some point. I have yet to see a company in the social networking business not fade as “better “ or “hipper” things come along. Therefore, I believe Facebook will be forced to use major cash flows and channel it into other areas to continue growing, and there is a lot of uncertainty surrounding that sort of future outcome.

Personally, being a cheapskate value investor, I would not buy into Facebook (assuming I had the option to) unless its shares were priced with a 25% discount to my most conservative valuation, which would put it around $3.5 billion. Once again, this is personal preference and has more to do with my distaste for investing in this industry; therefore, I would require a much larger safety net to become convinced.

Regardless, it appears to me that there’s a high probability that people currently buying into Facebook are overpaying, given the high risk and uncertainty down the line.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Is Facebook Already Overvalued?