Performance and Valuation Prime™ Chart
The PVP chart above reflects the real, economic performance and valuation measures of Facebook (NASDAQ:FB) after making many major adjustments to the as-reported financials. The four panels explain the company's corporate performance and valuation levels over the past 10 years plus best estimates for forecast years based on quarterly financials and consensus estimates.
The apostrophe after the ROA', A', V/A', and V/E' is the symbol for "prime" which means "adjusted." These calculations have been modified with comprehensive adjustments to remove as-reported earnings, asset, liabilities, and cash flow statement inconsistencies and distortions. To better understand the PVP chart and the following discussion, please refer to our guide here.
For Facebook, there are many failures of GAAP that lead to a low-quality earnings number and an unreliable balance sheet. One major issue is the failure to consistently require capitalization of research and development expenses, which tech companies usually have in abundance. The natural "lumpiness" of the roughly $2.67bn expenditure in R&D results in earnings, margins, cash flow from operations, and return on assets that can fluctuate up and down materially from year to year, unlike economic reality.
GAAP requires R&D costs to be either expensed or capitalized from acquisitions as in-process, or written off later. The goodwill and intangibles from acquisitions compound the issues when research and development expenditures are involved. For Facebook, goodwill in the $18bn-$19bn range also creates material inconsistencies.
These create inconsistencies when comparing one company to another, and from comparing a company to itself from year to year. It's worth noting that the handling of R&D under IFRS is even more of a problem than under GAAP as it can allow even more wiggle room for judgment by management from year to year as to what is capitalized and what is expensed.
As it stands, even the venerable Statement of Cash Flows is full of distortions and the expensing of R&D is just one of the many issues. When SFAS 95 implemented the Statement of Cash Flows in the late 1980s, three of the seven FASB members voted against it. It's almost unbelievable, and yet it's written into the actual Statement of Financial Accounting Standard. One would think that, for such a major change in financial statement reporting and disclosures, you'd require a unanimous vote or at least a super-majority.
Analysis shows that FB's GAAP net income was $2.94bn for 2014 when, in economic reality, FB's adjusted earnings was twice that at $5.81bn. The profitability of FB is therefore not as traditional metrics suggest.
Return on Assets Prime: Real Economic Profitability in the ROA'
The top panel of the chart shows ROA' (ROA prime, a.k.a. Adjusted Return on Assets). This measure is comparable from year to year and across peers as it "cleans up" the aforementioned GAAP accounting issues to provide consistent analysis.
Facebook's adjusted return on assets is forecasted to fall to 25% from 2014 levels of 33%. While their adjusted ROA is projected to fall in the near term, the forecasted figures are still significantly higher than the 11% GAAP ROA reported by most financial databases. In addition, the expected fall in adjusted ROA in 2015 is due to the disproportionate rise in adjusted net assets (43%) and adjusted earnings (10%). Furthermore, the company has spent significantly on acquisitions, leading to a large discrepancy between our adjusted ROA and FB's as-reported ROA as the GAAP method artificially punishes the company for goodwill and other intangibles. FB's adjusted ROA is 5x cost-of-capital levels and is approximately 3x the U.S. corporate average of 9% and the firm's traditionally-calculated 11% ROA. These are all real, not nominal, numbers, undistorted by varying levels of inflation from year to year or country to country.
Facebook's adjusted ROA has been fluctuating since its IPO, peaking at 39% levels in 2011 before falling to 28% in 2012. ROA' then began rising to a recent peak of 33% in 2014 and is expected to fall to 25% levels in 2015. While a falling ROA' may indicate that FB's profitability is fading, this is only a natural result of the firm's aggressive investment. In reality, Facebook is a massive cash flow generator that has been heavily investing in itself. That is a major difference in context and concept for evaluating Facebook's situation.
Growth in Business Assets - A'
In the second panel of the four-panel chart, Asset' growth stands for "Asset Prime Growth" and is the real annual growth rate of the cleaned-up and properly adjusted asset base of the company. This metric shows the management team's propensity to reinvest or divest over time. When viewed in context of the adjusted ROA, the growth rate explains a lot about management's intended strategies and even performance incentives.
Facebook has shown a history of significantly investing in the firm, which is the right thing to do when adjusted ROAs are well above and expected to remain above the opportunity cost of capital. Asset' growth rates range from 16% to much higher levels in the last decade, peaking at 131% in 2012. This is significantly above GDP growth rates as well as U.S. corporate average growth of 3% to 9% over the last ten years. By reinvesting in such high adjusted ROAs, the firm is compounding its returns. Valuations reflect that positive performance.
Valuation Relative to Adjusted Assets V/A'
The third panel of the four panel chart shows the Adjusted Value to Assets ratio. V/A' is a calculation comparing the enterprise value of the company to the asset level (A'). The V is the market capitalization of the company plus the total debt of the company, including off-balance sheet debt. The A' reflects the total operating assets of the firm, necessarily adjusted for problematic accounting standards for reporting of the balance sheet. V/A' can be thought of as a "cleaned-up" Price-to-Book metric. The A' is the same as the denominator of the ROA' calculation and the Asset' growth panel.
As Facebook's returns fall, we also see the asset multiple (V/A') fall. The firm's 33% ROA', when the as-reported ROA is 11%, may indicate that a V/A' of 10.5x may be too high. However, FB's continued investment growth ought to justify this multiple.
Valuation Relative to Adjusted Earnings V/E'
In the fourth panel, we have a third perspective of valuation to help triangulate the market's embedded expectations for company performance. We are seeking to determine "what's priced-in" to the stock price. In this case, we evaluate the enterprise value of the firm relative to the expected adjusted earnings (E') for the current year. The E' is the adjusted earnings resulting from the company's core business operations, regardless of how it is financed, and adjusted to its current dollar value. This is adjusted to eliminate accounting distortions and shenanigans, enhance comparability across different companies, industries and globally to determine potential mis-pricings. The value numerator is the same as that in the adjusted value to assets ratio.
Facebook's as-reported P/E is at 36.7x, indicating that the firm may currently be overvalued. Our analysis finds that FB has approximately a 38.0x V/E' that supports the suggestion that FB equity has an overly high valuation given long-term P/E averages of 15x to 17x, unless of course, FB can continue to grow aggressively, which they've shown the ability to do, while maintaining superior adjusted ROA levels.
As-reported financial statement information and financial ratios, which make up most of the publicly available financial databases, do not consider the extent to which distortions, mis-categorizations and misclassifications cause as-reported financial statements to depart from economic reality. Even the venerable "statement of cash flaws" - pun intended - is horribly distorted, as many items in the statement of cash flows are actually non-cash related. What is deemed cash flow from operations, investing and financing activities are inconsistently booked from company to company and even just from year-to-year at an individual company. The distortions are material and directionally changing, and the mis-measurements that result are decision-changing issues.
A far better picture of the economic reality of Facebook can be seen once those distortions are removed. The firm is generating returns at five times cost of capital and is successfully reinvesting in itself at levels far above the anemic GDP growth rates seen around the world. With that context of corporate performance and market valuation, we have a far better means for evaluating FB's prospects for the future of its stock. To better understand the discussion above, we suggest reading our guide here.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Caroline Cervillon. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
Disclosures: Officers of Valens Securities and Valens Equities are engaged and have positions in securities of Facebook, Inc., FB, as of the date of this report.
Officers of Valens Securities and Valens Equities are engaged and have beneficial interest in an investment management company, Kennebec River Capital, which has positions in Facebook, Inc., FB, as of the date of this report.
Disclosure: I am/we are 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.
Additional disclosure: Officers of Valens Securities and Valens Equities are engaged and have positions in securities of Facebook, Inc., FB, as of the date of this report. Officers of Valens Securities and Valens Equities are engaged and have a beneficial interest in an investment management company, Kennebec River Capital, which has positions in Facebook, Inc., FB, as of the date of this report.