One Word About Facebook's Free Cash Flow Generation Potential: Wow!

| About: Facebook (FB)

Summary

Facebook is generating billions in revenue and is turning a nice profit as it hauls in tremendous free cash flow. Long-term investors are taking notice.

As global data coverage improves, the number of mobile monthly active users will continue to grow. Facebook looks well-positioned to seize upon this trend.

Facebook's monthly active users (MAUs) and mobile monthly active users are growing at tremendous rates. We expect continued growth. The company is entrenched in the lives of millions.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

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By The Valuentum Team

Facebook's Investment Considerations

Investment Highlights

• Facebook's (NASDAQ:FB) mission is to make the world more open and connected. People use Facebook to stay in touch with friends and family, to learn about current events, and to share and express what matters to them. CEO Mark Zuckerberg is a true visionary, and his genius may not yet be fully on display. The company was founded in 2004 and is headquartered in California.

• It's simply unfair to lump Facebook in with other social media companies. Unlike other startups, Facebook is generating billions in revenue and is turning a nice profit as it hauls in free cash flow. Long-term investors are taking notice.

• Unlike its ill social-media brother Twitter (TWTR), Facebook is putting up tremendous revenue growth, earnings expansion, and phenomenal free cash flow generation, the latter to the tune of $6.2 billion for 2015 (it hauled in $2.1+ billion in the fourth quarter alone). We love its balance sheet health.

• As global data coverage improves, the number of mobile monthly active users will continue to grow. Facebook looks well-positioned to seize upon this trend, and the firm's younger demographics are increasingly accessing its platform from mobile devices. For younger demographics in particular, advertisers may have to go to Facebook to find their desired target market.

• The range of potential outcomes with respect to Facebook's valuation is astounding. Though its business model doesn't have many comparable stories, we do recall a time when AOL was also the Internet. With such low barriers to entry, the landscape could be completely different in five to ten years, posing both risks and opportunities.

• Facebook's monthly active users (MAUs) and mobile monthly active users are growing at tremendous rates. As of the end of 2015, MAUs rose to nearly 1.6 billion and mobile MAUs rose to ~1.4 billion compared to less than 950 million mobile MAUs at the end of 2013.

Business Quality

Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. Facebook's 3-year historical return on invested capital (without goodwill) is 74.9%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation rating of EXCELLENT.

The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does not consider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not.

Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.

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Image Source: Valuentum; EVA is trademarked by Stern Stewart & Co.

In the chart below, we show the probable path of Facebook's ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Facebook's free cash flow margin has averaged about 24.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Facebook, cash flow from operations increased about 239% from levels registered two years ago, while capital expenditures expanded about 48% over the same time period.

In fiscal 2015, Facebook reported cash flow from operations of ~$8.6 billion and capital expenditures of ~$2.5 billion, resulting in free cash flow of ~$6.1 billion, representing a 68% increase from fiscal 2014.

Valuation Analysis

This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.

Our discounted cash flow model indicates that Facebook's shares are worth between $98-$162 each. Shares are currently trading at ~$111, in the lower half of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at this time.

The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $130 per share represents a price-to-earnings (P/E) ratio of about 118.4 times last year's earnings and an implied EV/EBITDA multiple of about 53.6 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of 32% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 34.8%. Our model reflects a 5-year projected average operating margin of 53.2%, which is above Facebook's trailing 3-year average.

Beyond year 5, we assume free cash flow will grow at an annual rate of 9.6% for the next 15 years and 3% in perpetuity. For Facebook, we use a 10.8% weighted average cost of capital to discount future free cash flows.

Click to enlargeMargin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $130 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

In the graph above, we show this probable range of fair values for Facebook. We think the firm is attractive below $98 per share (the green line), but quite expensive above $162 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Facebook's fair value at this point in time to be about $130 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Facebook's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $177 per share in Year 3 represents our existing fair value per share of $130 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Wrapping Things Up

Facebook is putting up tremendous revenue growth, earnings expansion, and phenomenal free cash flow generation, the latter to the tune of $6.2 billion for 2015 (it hauled in $2.1+ billion in the fourth quarter alone), and with a healthy net cash position of $18 billion and no debt, it's hard not to like the company.

As global data coverage improves, the number of mobile monthly active users will continue to grow. Facebook looks well-positioned to seize upon this trend, and the firm's younger demographics are increasingly accessing its platform from mobile devices. For younger demographics in particular, advertisers may have to go to Facebook to find their desired target market.

We continue to be impressed by Facebook's overall growth and free cash flow generation. Its impressive balance sheet will play a key role in the firm's expansion as it becomes an increasingly powerful force in the Internet space. We like what we've been seeing, and what the future could hold for the firm, which has merited a position in our Best Ideas Newsletter portfolio. Facebook currently registers a 6 on the Valuentum Buying Index.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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

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: FB is included in the Best Ideas Newsletter portfolio.