Ever since the IPO in May 2012, Facebook (FB) has largely disappointed investors. Those who bought shares in May have lost roughly half of their investments, and the company has become largely out of favor, as there has been a damper on the initial inflated expectations that were placed on the company.
As a value-oriented investor, I take notice of companies that go out of favor. Often times, a few negative events can cause unwarranted drops in a company's stock price, and they then become undervalued.
Normally I do not look too closely at tech stocks in the social media space, as they have all gone public with "nosebleed" P/E levels. Indeed, even with the drop in price of Facebook's stock, the company still is trading at a trailing P/E over 67 and a forward P/E in the low 30s. Looking at my more preferred metric, EV/EBITDA, this is still over 30 based on earnings from the trailing 12 months. Definitely still quite a rich valuation. But as the stock has become more out of favor, I thought it still worth to take a look as whether we can now consider it a potential "value stock". In this article, I will argue that if you look at the total picture and all key aspects of the business, Facebook is still not a compelling value.
Note: For more information on my general philosophy for evaluating companies, please visit my website.
First let's look at the general prospects for Facebook. Social Media is continuing to growth at a rapid pace, and will do so for the foreseeable future. In the next 5 years, marketers expect to spend 3 times more on social media advertising than they currently do. Even then, spending on social media will only account for on average 19.5% of total available advertising spend. So in short, there will still be continued room for rapid growth after that. Also with the explosive growth of smartphones and tablet devices, people are online more and more hours of the day - which means they spend even more time browsing Facebook.
I won't focus in depth in this article on the business prospects for Facebook, but I think it is quite safe to say that at least in the coming few years, the potential for rapid revenue and earnings growth continues to be there, and business prospects are good.
I first used Facebook in 2004 when I was a college student. My university was one of the first 30 or so which Facebook expanded to after it began at Harvard. As I have mentioned in several other articles, including a recent one on Apple (AAPL), in the consumer technology space, usability is a major key to success. Facebook was always strong in this regard. Those of us who used it in the beginning, knew that it was something special and was going to grow rapidly. Now with over 1 billion users, it definitely has competitive advantages due to the sheer massive size of the user base. Advertisers will be willing to pay more to reach the largest relevant audiences, and the network effect of knowing that virtually all your friends and family use Facebook makes it a very powerful communication tool. Although other competitors have come out with decent social networking sites, for example Google (GOOG) with Google+, none have caught on to the scale of Facebook. As Facebook has gotten so large and well-established, users are reluctant to switch due to the network effects and this a pretty durable competitive advantage.
The only other social networking sites which I believe have quite strong competitive moats are Twitter and LinkedIn (LNKD). I won't discuss those in detail here, just to say that they both enjoy the benefit of being the first companies in their particular niches to grow to a sufficient enough scale to have the same powerful network effect as Facebook. I especially like LinkedIn in this regard, as it really has become a primary recruiting tool for enterprises. This makes its business model more sustainable in the longer term as enterprise notoriously changes much slower than typical consumers do.
In general, Facebook does have quite a strong competitive moat in my opinion. I don't really have any issues with the moat or business prospects - looking at those alone, Facebook is doing quite fine. However, let's now move on to look at some financials and the current valuation of the company.
I believe it's important to check the balance sheet of any potential company you consider investing in. It's not good to own companies which will have trouble paying heavy debt loads in economic recessions.
In the table below, we see the cash and debt figures from Facebook's balance sheet. Financially, the company is in strong shape - debt/equity is very low and there is a lot of excess cash. On this point there is a lot to like.
|Total Cash (mrq):||10.19B|
|Total Cash Per Share (mrq):||4.76|
|Total Debt (mrq):||706.00M|
|Total Debt/Equity (mrq):||5.31|
|Current Ratio (mrq):||11.57|
(Source: Yahoo Finance)
Another important aspect to check is how friendly the company's actions are towards common shareholders. This aspect I believe is still one of the weakest for the company, at least in the near term. Granted it will take time before they can demonstrate how shareholder friendly the company really is, but I prefer to invest in companies which have a proven past record of supporting shareholders. Some reasons listed below which I don't like:
- The company does not pay a Dividend
- Mark Zuckerberg maintains a lot of voting power
- Throughout 2012 and 2013, there are several lockout expiration periods where some shareholders are allowed to sell shares for the first time. Some of these have passed already, but the biggest one still looms on November 14th, when more than 1 billion additional shares can be freely traded.
There is a lot of uncertainty in the short term price of Facebook due to the lockup expirations.
- 10 year EPS growth rate: 27%
- long term growth after 10 years: 0%
- discount rate: 6%
- Starting EPS: 0.29/share
- How confident am I in these growth estimates?: 50%
This results in an intrinsic value of $19.20/share.
I'll take a minute to explain a bit how I have calculated this. First to be simple, I assumed the EPS growth rate the same as the average LT growth rate from analysts. This I believe is probably overly optimistic, especially over a 10 year period in the rapidly changing world of technology. In order to account for this uncertainty, I also like to use a confidence factor - in this case 50%. This means I am only 50% confident that these earnings will materialize. To be conservative, I take the resulting DCF intrinsic value and take only 50% of it - in other words, I assume the value of half the business is worthless, or zero.
As we can see, this conservative method still only gives us a value that is close to the current share price. Of course, if I had said I was 100% confident in those estimates the intrinsic value would have been double ($38.4/share), but that is much too unpredictable, in my opinion. It is worth noting that there is more than $4.00/share in cash, so this would provide some margin of safety. But overall, I would only be comfortable that a sufficient margin of safety exists if I could buy in for about 30-40% below my intrinsic value of $19.20. With a current market price of $19.52, that is not the case.
For any potential investment, it is important to see the whole picture of all aspects of a company. Following my value oriented philosophy, I look for companies which are priced cheaply in the market relative to their future business prospects. Facebook for sure has bright prospects and a strong competitive moat. However when future expectations of growth are high, there are a lot of expectations built into the stock price, and at the same time, many uncertain factors which are unpredictable. This is especially true in consumer technology companies - 10 years ago, Facebook didn't even exist, so who knows for certain that it will 10 years from now? Therefore, I would not consider investing in Facebook at this time, as I believe the company is priced only fairly, and I cannot be certain with a high enough margin of safety that it is a bargain today. I would only considering buying in if the price was to drop considerably lower - for example the $12-13 range.