Performance and Valuation Prime™ Chart
The PVP chart above reflects the real, economic performance and valuation measures of Facebook, Inc. (NASDAQ:FB) after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.
The four panels above explain the company's historical corporate performance and valuation levels plus consensus estimates for forecast years as well as what the market is currently pricing in, in terms of expectations for profitability and growth.
This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.
The problem with Generally Accepted Accounting Principles (GAAP) is that they create inconsistencies when comparing one company to another, and when comparing a company to itself from year to year. By utilizing UAFRS, we aim to remove the financial statement distortions and miscategorizations of GAAP. Some of these can be automated through consistently applied formulas; however, many must be made manually. Manual adjustments that cannot be automated include mergers and acquisitions accounting, special charges, business impairments, and others. The practice of creating consistent, apples-to-apples comparable measures of financial performance is often considered either tedious or overly complex by even seasoned financial analysts.
For Facebook, there are many failures of GAAP that lead to a low-quality earnings number and an unreliable balance sheet. One major issue is the failure to consistently require capitalization of research and development expenses, which tech companies usually have in abundance. The natural "lumpiness" of the roughly $2.67bn expenditure in R&D results in earnings, margins, cash flow from operations, and return on assets that can fluctuate up and down materially from year to year, unlike economic reality.
GAAP requires R&D costs to be either expensed or capitalized from acquisitions as in-process, or written off later. The goodwill and intangibles from acquisitions compound the issues when research and development expenditures are involved. For Facebook, goodwill in the $18bn-$19bn range also creates material inconsistencies.
These create inconsistencies when comparing one company to another, and when comparing a company to itself from year to year. It's worth noting that the handling of R&D under IFRS is even more of a problem than under GAAP as it can allow even more wiggle room for judgment by management from year to year as to what is capitalized and what is expensed.
As it stands, even the venerable Statement of Cash Flows is full of distortions and the expensing of R&D is just one of the many issues. When SFAS 95 implemented the Statement of Cash Flows in the late 1980s, three of the seven FASB members voted against it. It's almost unbelievable, and yet it's written into the actual Statement of Financial Accounting Standard. One would think that, for such a major change in financial statement reporting and disclosures, you'd require a unanimous vote or at least a super-majority.
Analysis shows that FB's GAAP net income was $2.94bn for 2014 when, in economic reality, FB's UAFRS-based Earnings were twice that at $5.81bn. The profitability of FB is therefore not as traditional metrics suggest.
Adjusted Return on Assets - ROA'
The top panel of the chart shows the firm's Adjusted ROA. This measure is comparable from year to year and across peers as it is based on UAFRS in order to remove the aforementioned GAAP accounting issues and provide consistent analysis. Two forecasted years are shown after the last full fiscal year, both marked with an "E" to indicate that they are estimates. The calculations are based on publicly-available consensus analyst forecasts of firm sales, net income, capital expenditures, and other information.
Facebook's UAFRS-based Return on Assets is forecasted to fall to 25% from 2014 levels of 33%. While their adjusted ROA is projected to fall in the near term, the forecasted figures are still significantly higher than the 11% GAAP ROA reported by most financial databases. In addition, the expected fall in Adjusted ROA in 2015 is due to the disproportionate rise in Adjusted Net Assets (43%) and Adjusted Earnings (10%). Furthermore, the company has spent significantly on acquisitions, leading to a large discrepancy between UAFRS-based ROA and FB's as-reported ROA, as the GAAP method artificially punishes the company for goodwill and other intangibles. FB's Adjusted ROA is 5x cost-of-capital levels and is approximately 3x the U.S. corporate average of 9% and the firm's traditionally-calculated 11% ROA. These are all real, not nominal, numbers, undistorted by varying levels of inflation from year to year or country to country.
Facebook's Adjusted ROA has been fluctuating since its IPO, peaking at 39% levels in 2011 before falling to 28% in 2012. Adjusted ROA then began rising to a recent peak of 33% in 2014 and is expected to fall to 25% levels in 2015. While a falling Adjusted ROA may indicate that FB's profitability is fading, this is only a natural result of the firm's aggressive investment. In reality, Facebook is a massive cash flow generator that has been heavily investing in itself. That is a major difference in context and concept for evaluating Facebook's situation.
Growth in Business Assets - A'
The second panel of the chart shows the firm's real annual UAFRS-based Asset growth rate (Adjusted Assets growth or Assets' growth). This metric shows the management team's propensity to reinvest or divest over time. When viewed in context of Adjusted ROA, the growth rate explains a lot about management's intended strategies and even performance incentives.
Facebook has shown a history of significantly investing in the firm, which is the right thing to do when Adjusted ROAs are well above and expected to remain above the opportunity cost of capital. Adjusted Asset growth rates ranged from 16% to much higher levels in the last decade, and peaked at 131% in 2012. This is significantly above GDP growth rates as well as U.S. corporate average growth of 3% to 9% over the last ten years. By reinvesting in such high Adjusted ROAs, the firm is compounding its returns. Valuations reflect that positive performance.
Valuation Relative to Adjusted Assets V/A'
The third panel shows the Adjusted Value to Assets ratio (V/A'), a UAFRS Price-to-Book metric that compares the UAFRS-based Enterprise Value (Adjusted Enterprise Value or V') of the company to its UAFRS-based Asset level (Adjusted Assets or A'). The Adjusted Enterprise Value is the market capitalization of the company, plus the total debt of the company, including off-balance sheet debt, and less excess cash (or non-operating cash balances). Meanwhile, the Adjusted Asset level reflects the total operating assets of the firm, necessarily adjusted using UAFRS for problematic accounting standards for reporting of the balance sheet. The Adjusted Asset level is the same as the denominator of the Adjusted Return on Assets calculation and the Adjusted Asset growth panel.
Throughout the 50+ years of history and across industries and countries, there has been and continues to be a tremendously strong relationship between Adjusted ROA levels and Adjusted Value to Assets. In other words, firms that generate higher cash flows relative to their investment base experience higher market valuations relative to their investment base.
The historically strong relationship between valuation levels and firm "quality" - between Adjusted Value to Assets and Adjusted ROA - creates an opportunity for evaluating valuation levels very quickly. The empirical, observed relationship between quality and valuation when measured this way is amazingly intuitive and logical.
The market tends to value firms at 1.0x Adjusted Asset levels when the firm generates an Adjusted ROA at the cost of capital. In other words, firms trade near their "book value" when their returns are merely at their cost of capital. When the firm's cash flow returns sustain double the cost of capital, the valuations tend to be double the book value, and so on. Again, the observation is extremely intuitive and even somewhat serves as a proof of the necessity for using Uniform Adjusted Financial Reporting Standards. Relationships between traditional Price-to-Book metrics and other return metrics are seldom so logical.
As Facebook's returns fall, we also see the asset multiple (V/A') fall. The firm's 33% Adjusted ROA, when the as-reported ROA is 11%, may indicate that a V/A' of 10.5x may be too high. However, FB's continued investment growth ought to justify this multiple.
Valuation Relative to Adjusted Earnings V/E'
In the fourth panel, we have another perspective of valuation to help triangulate the market's embedded expectations for company performance. We always want to know what is "priced in" to the stock price. In this case, Valens evaluates the Adjusted Value to Earnings ratio (V/E'), a UAFRS Price-to-Earnings metric that compares the UAFRS-based Enterprise Value (Adjusted Enterprise Value or V') of the firm relative to their expected UAFRS-based Earnings (Adjusted Earnings or E') for the next year. Adjusted Earnings are earnings resulting from the company's core business operations, regardless of how it is financed, and adjusted to its current dollar value. This is adjusted with UAFRS to eliminate accounting distortions and shenanigans, and to enhance comparability across different companies, industries and geographies, to determine potential mispricings.
Facebook's as-reported P/E is at 36.7x, indicating that the firm may currently be overvalued. Our analysis finds that FB has a UAFRS-based P/E of 38.0x that supports the suggestion that FB equity has an overly high valuation given long-term P/E averages of 15x to 17x, unless of course, FB can continue to grow aggressively, which they've shown the ability to do, while maintaining superior adjusted ROA levels.
As-reported financial statement information and financial ratios, which make up most of the publicly available financial databases, do not consider the extent to which distortions, mis-categorizations and misclassifications cause as-reported financial statements to depart from economic reality. Even the venerable "statement of cash flaws" - pun intended - is horribly distorted, as many items in the statement of cash flows are actually non-cash related. What is deemed cash flow from operations, investing and financing activities are inconsistently booked from company to company and even just from year-to-year at an individual company. The distortions are material and directionally changing, and the mis-measurements that result are decision-changing issues.
A far better picture of the economic reality of Facebook can be seen once those distortions are removed by using Uniform Adjusted Financial Reporting Standards (UAFRS). The firm is generating returns at five times cost of capital and is successfully reinvesting in itself at levels far above the anemic GDP growth rates seen around the world. With that context of corporate performance and market valuation, we have a far better means for evaluating FB's prospects for the future of its stock.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Caroline Cervillon. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
Disclosures: Officers of Valens Securities and Valens Equities are engaged and have positions in securities of Facebook, Inc., FB, as of the date of this report.
Officers of Valens Securities and Valens Equities are engaged and have beneficial interest in an investment management company, Kennebec River Capital, which has positions in Facebook, Inc., FB, as of the date of this report.
Disclosure: I am/we are long FB.
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: Officers of Valens Securities and Valens Equities are engaged and have positions in securities of Facebook, Inc., FB, as of the date of this report. Officers of Valens Securities and Valens Equities are engaged and have a beneficial interest in an investment management company, Kennebec River Capital, which has positions in Facebook, Inc., FB, as of the date of this report.