Facebook (NASDAQ:FB) is with no doubt the strongest company among social media networks. It has 1.7 billion MAU (not accounting for WhatsApp, Oculus, and Instagram). Accompanied with a 5-star rated financial statements, and an outstanding culture. But what about valuation? Valued at $370 billion, its market cap is slightly less than that of the retail giant, Amazon (NASDAQ:AMZN). Is it logical for Facebook to have a market cap close to that of a company which has a "Gross Profit" 3 times bigger and has similar growth opportunities? This is summarized in one world, ridiculous.
In my article, I will value Facebook by valuing each of Facebook's segments as a standalone company.
Facebook (The platform) contains data of ~23% of the world's population. It's without doubt a gold mine. But what about growth? Does this platform have growth opportunities? Let's do the math. To make things simpler, my calculations are summarized in the table below.
The world population is standing at 7.4 billion people. 27% of those people are in places where Facebook is banned from operating. That leaves us with 5.4 billion people.
With a 46% internet penetration rate and 20.9% of the population are either less than 10 years or above 65 years old, Facebook's users limit is at 1.95 billion people. With current MAU of 1.7 billion, only ~300 million people are left to sign up for FB.
Taking historic Facebook user growth of 14%, reaching the current market limit will happen at the end of 2017. After that, Facebook's growth should depend on the internet penetration rate. That's why you see companies like Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook trying to invent ways to connect people, mainly in Africa and Indonesia, to the web.
Facebook is depending on Africa, Indonesia, India and Brazil for future growth. But the problem is that a huge percentage of the population in these countries earns less than $2/day (as seen below).
That leaves us with Brazil, the country with the most moderate income per capita among the countries mentioned. But even Brazil has its own problems. Only 23% of the population use their phones to access the internet. And 60% of Brazilian residents lack internet access. In addition, 38% of Brazilians are aged at less than 12 or above 50. It is hard to convince a 50-year-old Brazilian to sign up for Facebook right?
The problem is, these countries (Indonesia, India, Brazil, and Africa) have low education levels. India for example has a literacy rate of only 75%. People there barely know the basics of the internet, and it takes time to educate them on how to use it.
Using the internet penetration rate increase in the last couple of years, I will assume only a 7% MAU growth after 2017. The assumptions I used to calculate the present value of Facebook's net income are listed below.
1) Average Revenue per User (ARPU) will stay at $8 with a 30% net profit margin for the two coming years (ARPU is $10 for Facebook Corp., $2 are from Instagram).
2) 7% MAU growth rate will stay constant for 10 years. After that I will assume Facebook to witness a decreasing growth rate, due to users' natural shift towards new platform.
3) ARPU will decrease till $6.5 in the first 10 years then it will stay constant. That's because new user growth will depend on low margin markets. The current ARPU outside the US & Canada (where future growth lies) is less than $3.5.
Calculating the Net Present Value of these cash flows at a 4.8% WACC, the NPV is $101.471 billion.
Facebook's declining rate in my model is due to natural factors. The world is changing day by day. Every generation needs something new to use for its own. It needs something special which the earlier generation can't understand. Facebook is having its time as a social media frenzy, but this time will come to an end. The challenge is, can Facebook take advantage of its current supremacy and buy or invent the new Facebook?
Although it did that with Instagram, it couldn't with Snap (NYSE:SNAP). There will come a time when a new feature will shock the industry and Facebook cannot take advantage of it. If that happens, the actual declining rate of Facebook's MAU will be more severe than stated in my model and the company will face many hardships in maintaining its leading position.
Concentration of Risk in Facebook's Portfolio
Facebook has a huge reliance on ads to generate revenue. Four fifths of Facebook's revenue is from mobile, and all of its revenue is generated from ads. This is a huge risk for Facebook; you can't put all your eggs in one basket. The feature of Ad Blocks can't be underestimated; it costs Facebook and Google 10% of their annual revenues. Think of a scenario where Apple (NASDAQ:AAPL), the only major company that can fight ads since it does not rely on any, lets its users use Ad Blocks in its iPhones.
This will have unimaginable effects on companies like Facebook and Google since most iPhone users will use it; no one loves seeing ads. With 15% iPhone market share, the Ad Blocks feature will have a $2.6 billion decrease in Facebook's revenue. At 16 Price/Revenue, it's a decrease of 11.6% from its current market cap.
Ads Revenue Might See a Huge Decline.
As seen in my model above, Facebook is forced to shift its focus towards other countries like Brazil and Indonesia. In 3rd world countries, Facebook has the advantage over startups there, due to its financial power and strong brand name. But the problem lies in the US where its ARPU is 4 times higher than in 3rd world countries.
The market in the US is different. There is a strong financial system that can support startups and enable them to reach hundreds of millions of users in a couple of years. Look at Snapchat. No wonder Facebook is trying to copy Snapchat through Instagram by any means. Facebook is afraid of losing user engagement to other competitors, and Snapchat is doing a good job in that.
This unpredictable market can shift users' attention to other social media companies which means spending less time on Facebook. This translates to lower ARPU. Increasing the number of users is not enough for Facebook, it needs to maintain its current user engagement in the US and Canada to not lose a huge part of its revenue.
Hardships in Monetizing Future User Growth
With high percentage of the population living under $2/day in countries where the future growth of Facebook lies (Indonesia, Africa, and India), monetizing the user base is a difficult task. Even though signing up for Facebook is free, it has hidden costs. Costs such as smartphone price, internet subscription fees, and even time cost. Those who get paid $2/day are people who work in manual jobs which require hard physical work.
Farming, manufacturing, cleaning, driving, etc., these kinds of jobs make it difficult for workers to have enough time to check their Facebook accounts (relative to people in the US and Canada) or even if they do, it's hard to extract revenue from these users. People living under $2/day consume cheap products with producers having low margins, which make it unprofitable for them to use Facebook ads to attract customers.
To make things simpler, I will show this example. In the US, the average wage/hour is now at ~$22, while in India it is $0.4/hour. With an ARPU of $14.34 in the US, Facebook was able to take 65% of a one-hour work annually. Assuming FB engagement in India is the same as in the US, applying 65% of $0.4 will give Facebook a $0.26 ARPU in India. So Facebook needs 55 new users in India to replace the loss of only one user in the US. That's why Facebook's revenue will witness a huge decline once it loses users in the US or Canada.
What About Monetizing Current Users?
I think Facebook's strong point is its ability to monetize efficiently its users. As long as it doesn't lose users, it will still be able to extract the same ARPU, especially in the US. Its recent "Instant Articles" launch is an example of how creative the company is in pushing users to spend more time on the platform. But the problem for Facebook is not maintaining current user ARPU, it's growing that number. With so many ads in the platform and flat US MAU, even Instant Articles now contains videos ads; Facebook might not witness any growth in its ARPU.
Last year Instagram surpassed Twitter (NYSE:TWTR) in the number of MAU. It has 500 million MAU, up from 400 million in late 2015. But since Instagram is a subsidiary of Facebook and has no known metrics like profit margin or historic user growth, I'm using its closest comparable Snapchat to value the company. Instagram and Snapchat are similar in terms of platform usage (Stories and photo apps) and share the same market; that's why in my analysis I'm assuming they are valued the same by investors.
If the WSJ report that came out one week ago is true, then Snapchat will be valued at $25 billion. Snapchat has 150 million MAU which means it's valued at ~$166/user. Applying this metric to Instagram, this will value the platform at ~$84 billion. But we know Snapchat is overvalued at $25 billion right? Two years ago, Facebook valued it at $3 billion.
Although WhatsApp has more than 1 billion users, it's still unclear how the platform can monetize these users. Since there is nothing special in WhatsApp except its design and simplicity, users might run away from the platform as soon as ads pop out. This leaves us with the only way for WhatsApp to make money, charge users annually. In the US, it isn't a problem, but worldwide where most of the user growth and current number of users are, it is. Why?
Since a huge number of users worldwide don't have the needed infrastructure to pay using credit/debit cards, they prefer going to free alternatives such as Viber, Facebook Messenger, Wechat, Snapchat, and even Twitter. Since we don't know the exact information of the geographical distribution of WhatsApp users, we can't know where the company can charge them without risking them leaving the app. That's why I will take the acquisition of WhatsApp in 2014 as a basis for my valuation.
At that time, FB paid $55/user for WhatsApp valuing the company at $22 billion. In 2016, WhatsApp is estimated to have more than 1 billion users, which will value WhatsApp at ~$61 billion if we assume there are 1.1 billion users.
Now adding the parts, Facebook, Instagram, and WhatsApp, we get a valuation of $246 billion. Subtract that from the current market cap of Facebook and we get $124 billion left for Oculus. Oh really? Sony (NYSE:SNE) has a VR segment and the "whole company" is valued at $41 billion.
Oculus is extremely hard to value since its valuation lies in the sales of its products which are not yet explained. In addition, there are no public comparable companies to Oculus; most of VR firms are private startups with no products offered yet. But I can take a shot.
Oculus devices, the Rift and Touch, are sold for $800. According to an analyst, Oculus will be able to sell 300,000-500,000 devices in 2017. Taking the high end of this estimate, Oculus revenue would be $400 million. Facebook is currently valued at Price/Revenue of 16. Giving that to Oculus, its valuation would be ~$6.5 billion.
Why Facebook Can Move Even Higher
Since Facebook is a powerful company, in terms of market cap and brand name, it is hard to predict its future. Facebook can keep buying young startups which can be the next Facebook. And Mark Zuckerberg had proven himself to be the entrepreneur with long-term vision. He bought WhatsApp, Instagram, Oculus, and maybe Twitter, and all are considered genius acquisitions.
Facebook is even connecting continents through building the fastest trans-pacific cable yet. FB can keep this acquisition and spending spree forever why not? They have the lowest cost of capital in the industry and a genius founder. But the risk lies in Facebook not being able to buy the next Facebook, not for financial reasons, such as Google or Apple buying it or even a private equity firm refusing to sell the new bazooka. In this case, my short position will pay off.
Facebook is a great company which proved its ability to grow faster than anyone can expect. But at these levels, with 1.7 billion users, I don't think there is huge room to grow, especially on the revenue side where most of the coming growth of users is from the 3rd world. Adding all parts mentioned before, I came up with a valuation of $253 billion or $91/share, 30% lower than current market valuation.
Since the upside is limited due to the reasons mentioned above, I recommend readers to buy out of the money put options with a long maturity date. However, if Facebook succeeded in hunting investment opportunities and was able to predict the coming frenzy (Read: The 5 Ingredients of Zara's Success), it will be able to dominate its current market position in the industry. That will be a huge risk to my recommended position but until Facebook finds the new bazooka, I am short Facebook.
Disclosure: I am/we are short 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.