Facebook And Its Wide Range Of Future Outcomes

| About: Facebook (FB)

At Valuentum, we embrace scenario analysis. In fact, the benefits of scenario analysis are many in that it allows investors to better react to new information and changes in the structural characteristics of industries. It also allows investors to better anticipate changes in a firm's fair value estimate based on changes in a company's fundamentals. In all of our reports (click here), we perform scenario analysis on the companies we cover. Further, we think an in-depth discounted cash flow assessment of a firm and a relative value assessment is core to any stock-selection process. Our methodology, the Valuentum Buying Index combines these two very important valuation approaches. With all this said, let's dig into how we look at a company like Facebook (NASDAQ:FB).

After the hype, the IPO, and the post offering fall, Facebook remains a controversial stock. And we can see why, as the range of outcomes for the company is beyond imaginable. In our view, this makes sense because, frankly, the meaning of Facebook is incredibly nebulous. We'll dig into a few scenarios and what we think the appropriate valuations are for each.

But first, let's take a look at what Facebook actually is.

What is Facebook?

Believe it or not, that's a very fair question. On its surface, it's a social networking site, but in reality, it means a lot more than that to many people. According to TechCrunch, users spend 441 minutes per month on Facebook mobile and 391 minutes per month on the traditional website. This equates to around 30 minutes per day.

The meaning of Facebook can greatly fluctuate based on the user's age. Let's take the 20-30 year old demographic. Most of these people were among the first Facebook users, the "early adopters." Depending on where one lies in this age group, they may have hundreds or thousands of friends, many of whom they may barely talk to and some that they may not even acknowledge in person. This demographic is really the sweet spot for Facebook.

For a lot of these users, Facebook was the first acceptable social networking site. MySpace, Xanga and others were seen as too self-indulgent and were underlying dating sites that anyone could join. Facebook offered exclusivity, connectivity and a filter against the random people seeking connections on MySpace-in 2006-2007, only high school and college students with confirmed school email addresses could even become members. During its inception, it was a hugely popular, new aspect of the social experience.

As time advanced, friends went separate ways, and users met new people, while networks for this "early adopters" age group grew. More importantly, for many of these users, their entire adult life is documented on Facebook. The new "Timeline" acts as a digital time capsule snapshot for certain periods of time. A user can go back and see how he or she has changed in attitude, personality, and appearance over a four or five year period. Facebook also stores photos that are prone to be lost by broken computers, failed storage devices, and accidental deletion. It also, perhaps most importantly, allows users to keep tabs on former classmates, colleagues and friends without really keeping in-touch. It helps eliminate the need for class reunions and allows users to stay connected with possibly hundreds of people they might not have otherwise.

One of the most prevailing problems with this demographic is the actual age. In the early days of the Internet, you simply didn't click ads because they were going to give you a virus and not that free iPod it promised. Years of anti-ad clicking conditioning will be hard to reverse.

For those under 20, Facebook has been a way of life. There isn't really any social networking competition or even memories of MySpace and the AOL (NYSE:AOL) chatrooms. Based on what we've noticed from some users in this demographic, Facebook is a little more MySpace-esque, sharing some of the noteworthy features like people taking pictures of themselves and more detailed profiles. The experience here is a lot more active than other demographics.

This demographic is a little less conditioned to fearing ads, but Facebook may struggle to keep its "cool" factor in this age group. We think the recent rumors that 13 year olds aren't salivating the days until they can sign up for Facebook shows some of the "cool" factor that Facebook could lose. We don't think it will be Google+ (NASDAQ:GOOG), but a new competitor could have tremendous success with this less sticky age group.

Another group that really seems to enjoy Facebook is the baby-boomers and beyond. We think actual users as a percentage of this age group are likely lower; however, users in this demographic see Facebook as a cool way to stay in-touch with each other and the younger age groups. This demographic, in our view, tends to like games like Farmville (NASDAQ:ZNGA) and is more willing to spend money for upgrades and bonuses.

Unlike the 20-30 year olds, users in this age group haven't accumulated a lifetime's worth of data, making it less useful as a digital time capsule. This could also mean that users can leave and revert back to websites like Classmates.com. We think this will also affect the amount of time these users spend on Facebook since a feature like Timeline is a lot less interesting when it isn't very historical.

Finally, there's the age group between the 20-30 year olds and the baby-boomers. They don't have as much free-time as baby-boomers, nor do they have the same Facebook footprint as younger age groups. In our view, these users aren't as likely to have strong feelings about the social network. However, this demographic has greater financial resources than younger generations and advertisers will court their attention.

What Will Facebook Be?

We think there are a few possible outcomes for Facebook, ranging from a revolutionary shift in internet consumption to completely obsolete.

Let's dig into them. If you'd like to try valuing Facebook yourself, we make available our discounted cash flow modeling template here.

Base case - Facebook is pretty much what it is now.

We think this is the most likely outcome-Facebook doesn't really change. The age groups continue to consume how they've always consumed, and advertisements are somewhat effective like they are now, but are not huge relative to the value of the company. In this case, we expect little user growth, but strong average revenue per user (ARPU) growth.

Our fair value range under this scenario is $16-26, suggesting further downside from current levels. This scenario assumes ARPU of $10.35 in 2015, up 150% from its current level of $4.11. This assumes that earnings grow at a compounded rate of about 22% over this period. Mainly, this assumes Facebook does little-to-no innovation, other than successfully integrating ads to its mobile platform. We are assuming no major competitor comes and shakes up the landscape.

We also see time spent on Facebook remaining flat, though several years of continued usage creates a powerful digital time capsule, making Facebook almost a necessity to some.

Pessimistic case - Facebook ruins mobile, people quit posting.

In this case, Facebook is exposed to a substantial decline in usage and popularity. Though we do not think this scenario is likely, we think it's important to take a look at the assumptions and implications of a fall for Facebook.

Under this scenario, Facebook simply just can't figure out mobile. Though we think most users prefer the traditional Facebook platform, mobile computing is growing substantially and often provides users with a path of less resistance. Apple (NASDAQ:AAPL) has indicated that iOS 6 will better integrate Facebook into its software, but we are unsure if that will translate to greater revenue and profitability.

In this situation, Facebook is forced to increase ads on mobile devices, alienating users and causing them to look at Facebook less. As a result, fewer interactions, i.e. "likes" and comments take place, making the user experience less satisfying. As content dwindles, ad space becomes less valuable, and ARPU doesn't rise as quickly. User growth levels off and begins a slow decline. A new upstart, "cool" competitor steals younger users, and Zynga also moves away from Facebook in its revenue model.

In this very pessimistic scenario, our fair value range is $5-$9. This model still assumes compound annual earnings per share growth of nearly 15% over the next five years, but the firm struggles to monetize thereafter. As we stated earlier, we think this scenario is unlikely, especially since CEO Mark Zuckerberg seems more concerned about the user experience than monetizing his firm's business model.

Optimistic Case - Facebook manages to become the new Internet.

Much like our previous downside scenario, we think the odds of this happening aren't incredibly high, but the possibility alone is enough to prevent us from shorting this stock (buying put options). It is possible Facebook is the new Internet, and we don't even know it yet.

Though firms like eBay (NASDAQ:EBAY) and Amazon (NASDAQ:AMZN) like to boast about how many users they have, the companies simply don't have the wealth of information and access to information that Facebook has. Facebook is composed of 900+ million users willingly sharing personal information about their tastes and likes/dislikes, while spreading word of mouth advertisements throughout their networks. Naturally, we think Facebook could enter e-commerce and revolutionize the industry. Under this scenario, eBay could potentially become a target for its PayPal platform.

Of course, this also assumes that users willingly go along with it. The technology may not be available yet, but we could see Facebook replacing traditional websites as ecommerce platforms. Say a user is looking at a friend's pictures, and he notices a pair of shoes he likes on someone in the picture that he doesn't know. It might be uncomfortable to message the stranger and ask him where he got the shoes. Instead, a user can just click on the shoe, see it's a Nike (NYSE:NKE) running shoe, click on it, and immediately add it to his cart and order via Footlocker (NYSE:FL), without ever leaving Facebook. Facebook then receives a processing fee or a fee for powering the site like GSI Commerce (a division of eBay).

Conversely, a different user can view shoes on Footlocker's Facebook page. Say she finds a pair of Adidas (OTCQX:ADDYY) soccer shoes she really wants, and Facebook has then already processed orders and scanned uploaded photos to identify friends and other people who have previously purchased the shoe. She can easily access reviews or see a picture to see how they look on feet. This brings a new social element to shopping that we've yet to really see on the Internet. Facebook could become the hub for social and shopping.

Of course, there's a chance users may not like this commercialization; however, we think it would be more favorable than pop-up or banner ads. We think there's a chance that Facebook truly reinvents ecommerce.

Under this scenario, our fair value range is $34-$56. ARPU grows three-fold, to $16.40 in 2016, but we see this number grow considerably after the company develops the enormous infrastructure required for this sort of innovation. The company solves Amazon's problem of selling things for a loss to take market share, and Facebook's service ends up aiding both large corporations and small businesses.

However, because we know how concerned Zuckerberg is with creating a rewarding user experience, the company uses its ecommerce platform to subsidize social, and it continually adds new features and makes costly acquisitions like Instagram. Nevertheless, the company actually becomes more valuable than its current valuation suggests.

All Things Considered

Overall, we think Facebook does have tremendous upside potential-but it does have downside potential as well. 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 years, though we think Facebook is very sticky in certain demographics. If Facebook is a digital scrapbook, then we don't see people deserting it-akin to burning physical scrapbooks.

Ultimately investors have to decide which narrative they think is likely to play out. We tend to be a bit between our base and optimistic cases, with our fair value range at $20-$34, suggesting that we think shares are fairly valued at current levels. We generally have a neutral view of Zuckerberg, but we do think, given his enormous control over the company, that he will have as much of an effect on Facebook as Steve Jobs did on Apple.

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

Additional disclosure: Some of the firms mentioned in this article may be included in our actively-managed portfolios.