Facebook Has A Negative Margin Of Safety

| About: Facebook (FB)
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Facebook currently has a P/E ratio of 75, which is fertile soil for significant P/E compression over the long term.

The company increasingly relies on mobile revenue, which is harder to monetize.

A realistic worst-case scenario where Facebook grows at 10% annually, but sees its P/E ratio dip below 20 would lead to a 35% investment loss over ten years.

To get an idea of where a stock will be ten years from now, I try to project not only a company's likely future growth prospects, but the P/E ratio the stock will trade at upon reaching its full maturation. I do this for an important reason: There are too many times in corporate history where a business delivered 10%, 15% or 20% annual earnings per share growth only to produce actual total returns that fall significantly below that because there is a tendency for most mega-cap stocks to eventually end up with a P/E ratio somewhere in the 20s as the period of exemplary growth moderates.

In the case of Facebook (NASDAQ:FB), the social media company generates $3 billion per year in profits. The company has no dividend or buyback program (in fact, the share count has diluted from 2.3 billion shares outstanding in 2012 to 2.65 billion shares now) so it will have to currently rely on EPS growth to generate total returns for shareholders.

If you assume Facebook grows at a rate of 15% annually for the next ten years, those $3 billion in profits today will grow into $14 billion in annual profit by 2024. What happens if, at that moment in time, the P/E ratio comes down from the current 75x earnings valuation and trades at a valuation of 25x earnings? In that case, the market cap of the stock would be $350 billion, for a gain of 46% on your investment over the coming decade. Think about what a bum deal that is: Even under optimistic projections for the next ten years, you would only grow a $10,000 investment into $14,600.

I've never seen anyone run a realistic worst-case scenario on FB prior to making their investment. What happens if FB trades at a valuation ten years from now in line with Apple (NASDAQ:AAPL) at 17x earnings or Microsoft (NASDAQ:MSFT) at 18x earnings? That would most likely be the result of Facebook growing profits at a rate below expectations, such as 10% annually. Here is how that scenario would play out: If Facebook grows profits at 10% annually for the next ten years, it will make a little over $8 billion in annual profits ten years from now. If it trades at 18x profits at that point, it will have a market cap of $144 billion. It pays no dividend and has no buyback so you would be looking at a 35% loss on your investment even if profits grew 10% annually over that time frame.

I have no interest in investing in companies that could grow profits by 10% annually for a decade and still deliver a substantial loss if the P/E ratio compresses to something resembling its peers. Furthermore, the road to that growth may be harder to achieve than analysts currently project, as the real growth in Facebook is through its mobile use rather than desktop (mobile use of Facebook is growing at 30%, whereas desktop use is growing at half that rate). Mobile advertising now constitutes two-thirds of Facebook's ad revenue. And because mobile ads tend to pay less than desktop ads, it is also possible that profit growth will trail user growth once the adjustment toward mobile advertising revenue becomes more prevalent.

Most of the commentary on Facebook stock has a tendency to focus on Facebook's future earnings growth, with many people throwing out numbers well above 10%. Those predictions have a fair chance of coming true, but are incomplete because they do not take into account the likelihood that FB's P/E ratio will come down substantially in the coming years.

I often refer to this as the negative margin of safety because it indicates a high likelihood that total returns will trail the growth rate of the company itself (for my thesis to be wrong, Facebook would have to maintain a long-term P/E ratio at 75 or above). What scares me off from buying Facebook stock is that even predictions of sustained earnings per share growth in the range of 15% annually can still lead to meager returns if the P/E ratio comes down to 25. There is even an outside possibility of losing a third of your investment if Facebook grows at 10% annually and sees its P/E ratio fall below 20 under a realistic bad-case scenario.

If you are contemplating an investment in Facebook, I ask that you not only calculate the growth in earnings per share you expect, but tie it to an eventual P/E ratio you expect Facebook to trade at in the future. Any analysis that doesn't account for the possibility of significant P/E compression is incomplete and leads to unnecessary portfolio risk.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.