Why Facebook May Approach Triple Digits

| About: Facebook (FB)


Our fair value estimate of Facebook is $97 per share, representing over 30% upside from today's levels.

Were it not for its unattractive relative valuation versus peers, Facebook would register a 9 or 10 on the Valuentum Buying Index -- one of the highest ratings.

Be sure to read about a speculative buzz that can send Facebook significantly higher.

As part of our process at Valuentum, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. For Facebook (NASDAQ:FB), this isn't so easy given the wide range of outcomes and the myriad potential pathways of its future fundamentals, but we think the firm is vastly undervalued on a discounted cash flow (DCF) basis. In fact, our fair value estimate of the firm is $97 per share, representing over 30% upside from today's levels. For speculators, there's also an added kicker of information, which we save for below.

Let's offer a little background to help with the understanding of the article. At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators 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 (we like firms that fall in the center of the diagram below). More interest --> more buying --> higher likelihood of price-to-fair-value convergence.

At its core, if a company is undervalued both on a discounted cash flow (DCF) and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Facebook posts a Valuentum Buying Index score of 7 on our scale, reflecting our 'undervalued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. Consistent to our process, for the relative valuation assessment, we compare Facebook to peers Google (NASDAQ:GOOG), Baidu (NASDAQ:BIDU), and Yahoo (YHOO). Facebook is rather unique, as it's likely not going to get a very good relative value rating anytime soon given that it is trading at a relatively high forward price-to-earnings multiple. However, given its multi-year growth trajectory (even beyond our five-year discrete forecast period), the company's relative valuation should take a back seat to a discounted cash-flow-derived intrinsic-value process, which considers growth long into the future (well beyond this year or next). Were it not for its unattractive relative valuation versus peers, Facebook would register a 9 or 10 on the Valuentum Buying Index -- one of the highest ratings.

Our Report on Facebook

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. We expect the firm's return on invested capital (excluding goodwill) to expand to 79.9% from 62.7% during the next two 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 (NYSE:AOL) was the biggest name industry. With such low barriers to entry, the landscape could be completely different in five to ten years, posing both risks and opportunities.

• Fundamental risks aside, the likelihood of a singlestock bubble in Facebook is considerable. If the talk of Facebook possibly changing the landscape of the Internet starts to expand across social media, the trajectory of its share price rise will be meteoric (whether it comes true or not). Speculators should take note.

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 43.3%, which is above the estimate of its cost of capital of 10.8%. 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 31.7% 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 79% from levels registered two years ago, while capital expenditures fell about 0% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Facebook's shares are worth between $76.00 - $118.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $97 per share represents a price-to-earnings (P/E) ratio of about 163.7 times last year's earnings and an implied EV/EBITDA multiple of about 61.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 31.1% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 28.5%. Our model reflects a 5-year projected average operating margin of 44.4%, which is above Facebook's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 13.5% 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.

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 $97 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 $76 per share (the green line), but quite expensive above $118 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 $97 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 $132 per share in Year 3 represents our existing fair value per share of $97 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

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.

Additional disclosure: Several firms included in this article are included in the newsletter portfolios.

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