Facebook Could See A Tremendous 2014

| About: Facebook (FB)
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One of the reasons our members love us is that we tell the story through the numbers. Every income statement says something, every balance sheet has a history and every cash flow statement reveals a firm's true intrinsic value. The numbers talk -- and we think every investor should listen to them. Let's see what they say about Facebook (NASDAQ:FB).

At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors.

If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Facebook posts a VBI score of 7 on our scale, reflecting our "undervalued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. We compare Facebook to peers Baidu (NASDAQ:BIDU), Yahoo (YHOO), and Google (NASDAQ:GOOG). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:

Investment Considerations

Investment Highlights

• Facebook earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 24.8% during the past three years.

• Facebook's mission is to make the world more open and connected. People use Facebook to stay connected with friends and family, to discover what's going on in the world, and to share and express what matters to them.

• 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 Facebook's younger demographics are increasingly accessing its platform from mobile devices. For younger demographics, advertisers might have to go to Facebook to find their desired target market.

• The range of potential outcomes with respect to Facebook's valuation are 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 years, posing both risks and opportunities.

• The firm experienced a revenue CAGR of about 87.1% during the past 3 years. We expect its revenue growth to be better than its peer median during the next five years.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital - ROIC - with its weighted average cost of capital - WACC. 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 24.8%, which is above the estimate of its cost of capital of 10.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of 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 -83.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. 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. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Facebook, cash flow from operations moved into positive territory from levels two years ago, as capital expenditures fell about 0% during this time period.

Valuation Analysis

We estimate the firm's fair value is $80 per share. Our model reflects a compound annual revenue growth rate of 34.7% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 87.1%. Our model reflects a 5-year projected average operating margin of 39.1%, which is above Facebook's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 17.1% for the next 15 years and 3% in perpetuity. For Facebook, we use a 10.7% weighted average cost of capital to discount future free cash flows.

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Speculative Considerations

We think the likelihood of a single-stock bubble in Facebook is equal to or perhaps even greater than that of InfoSpace during the dot-com era. In the latter, InfoSpace was expected to become a monopoly in emerging wireless technologies, bringing the Internet to everyone's cell phone (making it the first trillion-dollar company). If the talk of Facebook possibly becoming the new Internet starts to expand across social media, the trajectory of InfoSpace's price increase may look minor to what Facebook could experience. See more on this topic here.

Margin 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 $80 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. Our ValueRisk™rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Facebook. We think the firm is attractive below $62 per share (the green line), but quite expensive above $98 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 $80 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below 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 $109 per share in Year 3 represents our existing fair value per share of $80 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.

Pro Forma Financial Statements

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Disclosure: I 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. FB, BIDU, and GOOG are included in the portfolio of our Best Ideas Newsletter.