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By Brandon Hunter, Jesse Fischer, and Shafiel Karim

Introduction

Facebook, Inc. (NASDAQ: FB) is the largest online social network in the world and currently boasts over 901 million unique monthly active users ("MAU"), over 500 million daily active users ("DAU"), and more than 125 billion user connections. Users upload over 300 million photographs every day and approximately 750 million photographs each weekend. And users click the "Like" button over 3.2 billion times daily, which allows Facebook to track the products and services its users prefer. Moreover, the Facebook platform is used for over seven million third party applications and is one of the largest online display advertisers in the world. In short, the Facebook social network is one of the "stickiest" and most popular websites in the world. (Click here for the company's amended SEC S-1 filing.)

Despite the fact that the company is expected to miss its Q2 revenue and profit estimates, its IPO is expected to value the company close to $100 billion. We believe such valuations exaggerate Facebook's ability to sustainably grow its user base and revenue. Instead, our valuation models and revenue forecasts value Facebook at much less than $100 billion. So, the $64,000 question remains: What is Facebook, Inc. really worth?

To begin answering the question, we need to understand how Facebook earns revenue and ultimately profits. Facebook earns revenues in two ways: (1) display advertising on its website and (2) royalties from third-party software developers that create original content for its platform. Unlike Google (NASDAQ: GOOG), the company's largest and fiercest competitor, Facebook claims it has positioned itself as a demand generator instead of a demand fulfiller. The premise is that when users search for a particular good or service on Google, its search algorithms display relevant advertisements to the user, which effectively fulfills that user's demand. However, when a Facebook user "Likes" a product, that user's connections are more likely to also prefer that product so that the implicit viral endorsement presumably creates new customers for a firm.

The $70 to 100 billion valuation figures are predicated on Facebook's ability to continue its exponential user and revenue growth. However, much of the company's user growth has been limited to emerging markets and mobile devices. While Internet infrastructure development in emerging markets will likely contribute to Facebook's user growth, average revenue per user, ARPU, is substantially less in those markets compared to their developed markets' counterparts. Additionally, Facebook has not been able to successfully monetize its mobile users, who represent approximately 500 million users of the company's total 901 million MAUs.

Separately, Facebook is prohibited from entering China, North Korea, Iran and Syria, which collectively represent 474 million users or 22.7 percent of the global population of Internet users. Even if Facebook were able to acquire users in those markets, only 2.1 billion of the world's 6.8 billion people are on the Internet, which still limits the company's exponential revenue growth, assuming ARPU remains constant.

Investment Thesis

We consider the $70 to $100 billion valuations possible but overly optimistic and far reaching based on the underlying fundamentals of Facebook's business, and the uncertainty associated with further monetization strategies. Our financial models and revenue forecasts estimate the company is worth $57.3 billion. Accordingly, we recommend that retail investors not buy shares at current market valuations and that they take a "wait and see" approach over the next 12 to 24 months.

Financial Model

Since Facebook does not have any true comparable rivals - Google being a possible exception - and market-based valuation approaches are a function of economic cycles and market euphoria, we decided to analyze the fundamentals and used a discounted cash flows method to value Facebook. However, we appreciate the inherent shortcomings of the discounted cash flows method. Therefore, we forecasted several revenue growth scenarios and computed Facebook's valuation using the model to obtain multiple valuation figures that could be juxtaposed with the speculative values reported by the mainstream business press. In order to gauge the practicality of our most basic assumptions, we examined (1) the five-year post IPO performance of Google, Facebook's most comparable rival; (2) performed a statistical analysis; and (3) used a global market penetration projection to predict Facebook's economic growth prospects to inform our revenue assumptions.

Our model projects the terminal values of Facebook in two different ways: (1) the exit multiple method, and (2) the standard perpetuity growth method. The exit multiple method calculates terminal value on the basis of a multiple of the terminal year's EBITDA. This multiple is based on current EV to EBITDA trading multiples for comparable companies where the median and mean are 7x and 13x respectively.

We used the median value of 7x because several outliers materially affected the mean value. The exit multiple method provides a contrasting market-oriented view of Facebook's value, which we compared against the more fundamental perpetuity growth method. Determination of the terminal value using the perpetuity growth method assumed a continuous 10 percent growth rate, which is based on a 14 percent CAGR of worldwide internet user growth. Since we believe sustained revenue growth to be the most critical driver of value, revenue estimation was given the most consideration in our analysis.

Facebook vs. Google

Facebook and Google have become fierce competitors in recent years. While Google's primary focus has been search advertising, it has publicly committed to becoming a leader in social media through Google Buzz, Google Wave and most recently, Google Plus. Similarly, Facebook is reportedly rumored to be working on a major search initiative to compete more directly with Google, and is also rumored to be working on a social smartphone.

In our first scenario, Google's five-year post-IPO financial statements served as a benchmark for Facebook's expected financial performance from 2012 to 2016. We focused on the components of Google's financial statements as a percentage of revenues, and we assumed Facebook's future financial performance would model Google's relatively stable COS, SG&A, depreciation and amortization, capital expenditures, and tax rates. Under these assumptions, we extrapolated Facebook's historical and current trends to predict future performance.

Similarly, in order to simplify our analysis, we inferred the value of current assets and current liabilities during the projection period as a percentage of revenues to determine our basis for changes in net working capital. Lastly and most importantly, we observed substantial increases in Google's revenue over the five-year post-IPO period. In this scenario, we modeled Facebook's revenue growth to mimic Google's over its five-year post-IPO period as a hypothetical "best case" scenario. In addition, we used a constant discount rate of 14 percent, which is Google's current 9.5 percent WACC plus a 4.5 percent risk premium to compensate for any uncertainty associated with Facebook's future operations. The revenue projects under this method are:

2012

2013

2014

2015

2016

Revenue (in millions)

$8,053

$15,462

$26,594

$41,486

$54,347

Under these revenue assumptions, we estimate the value of Facebook at $66.5 billion using the perpetuity growth method and $159.4 billion using the exit multiple method. The exit multiple method valuation implies a perpetuity growth rate of 12 percent versus the 10 percent estimate in our actual perpetuity growth calculation, and our perpetuity growth method yields an implied exit multiple of 2.8x versus 7x from our actual exit multiple method calculation. If we average the values of the two methods, we arrive at a valuation of approximately $113 billion. Since this valuation is comparable with the business press figures, we can infer that the market is expecting a "Google-like" performance from Facebook after its IPO.

Additionally, if we contrast our estimated 2016 EV/Sales and EV/EBITDA multiples of 2.2x and 2.8x (perpetuity growth method) and 5.5x and 7x (exit multiple method) to Google during the same relative year in our hypothetical scenario, we see that Google traded at EV/Sales and EV/EBITDA multiples of 8.5x and 24.3x respectively. Google's multiples at the same relative period were significantly higher than our estimated Facebook's multiples. Thus, our model predicts that Facebook's enterprise value appreciation, unlike Google's post-IPO performance, will not significantly outpace sales and EBITDA.

Regression Forecast

Our second revenue model utilizes regression analysis to predict Facebook's revenues, MAUs and DAUs by geography and forecast period. The independent variables for the regression equations were historical and projected global market values for the paid Internet search advertising industry from 2009 through 2016. We ignored regression results that defied reason or substantially exceeded market research growth expectations.

For example, the online social gaming market is expected to grow to $5.0 billion in 2015. Assuming Facebook continues to charge third-party developers 30 percent of all online social gaming receipts, its share of platform royalties cannot exceed $1.5 billion. Accordingly, we capped platform royalty revenues to $1.5 billion beginning in 2013 through 2016. Despite this hard cap on royalty revenues, the regression model predicts Facebook's revenues will grow from $4.0 billion in 2012 to $20.2 billion in 2016. Based on these projected revenue figures, our model estimates Facebook's value at $24 billion under the perpetuity growth method, and $59 billion under the exit multiple method.

2012

2013

2014

2015

2016

Revenue (in millions)

Advertising

$4,011

$5,833

$8,701

$12,922

$18,759

Royalties

871

1,361

1,500

1,500

1,500

Total

$4,882

$7,194

$10,201

$14,422

$20,259

MAUs (in millions)

1,065

1,245

1,381

1,457

1,460

DAUs (in millions)

730

870

987

1,071

1,160

Market Penetration Forecast

The market penetration revenue forecast model calculates the number of users that Facebook currently has in a specific country and the subsequent percentage of Internet advertising that they control in that market. The upper limits of those ratios are then tested to calculate revenue figures. For example, in mature markets such as the United States and United Kingdom, approximately 50 percent of the population is on Facebook, and as a result, Facebook controls 14 percent of the online advertising markets in those countries. We extrapolated these ratios and determined that a 28 percent share of the advertising market is equivalent to full market penetration.

The full market penetration was then used to forecast revenues by multiplying the latent demand for online advertising by 28 percent. The resulting figure is a maximum online advertising market of $7.3 billion. We used this maximum figure as Facebook's advertising revenue for 2016, the last year of our revenue forecast model. We calculated forecast platform royalties by applying the past four quarterly periods' CAGR to Q1 2012 onward. Again, the expected market for platform games is projected to reach $5.0 billion in 2015. So we assumed that Facebook would continue to charge third-party developers 30 percent royalties and placed a hard $1.5 billion cap on platform revenues once the model predicts a value greater than $1.5 billion. Based on the below revenue projections, the exit multiple method valued Facebook at $25 billion and the perpetuity growth method valued the company at $10 billion.

2012

2013

2014

2015

2016

Revenue (in millions)

Advertising

$4,247

$4,861

$5,563

$6,367

$7,288

Royalties

871

1,361

1,500

1,500

1,500

Total

$5,118

$6,222

$7,063

$7,867

$8,788

Summary

Facebook's proposed IPO price of $28 to $35 per share is based on aggressive user and revenue growth assumptions. These assumptions are predicated on Facebook's ability to successfully monetize mobile users, and a belief that increasing market share - even in emerging markets - will increase revenues and profits. However, the emerging markets' ARPU is substantially less than developed markets, and it is unlikely that Facebook will be able to successfully build revenue and profit models that justify a $70 to $100 billion valuation. Although Facebook has seen incredible growth in the last several years, it is quickly reaching its limit, and our models predict slowing in revenue and user growth. Each valuation method uses a different set of assumptions, and as a result, our valuations vary. The mean valuation is $57.3 billion, far less than the IPO valuation of $96 billion. Therefore, we do not recommend that retail investors buy Facebook stock. Instead, we recommend that they take a "wait and see" position.

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

Source: What Facebook Is Really Worth