Facebook Is Planning For The Future, And Will Reward Investors Long-Term
Summary
- Facebook's recent actions have unsettled the stock at times.
- But I see those actions as a long-term positive for the company that will strengthen its image and its future, even if short-term profits and usage decline.
- I like Facebook and have a target price for it of ~ $204/share.
Despite Facebook's (FB) choppy recent performance, I like the company and the stock. Facebook has faced challenges recently, in the form of Russian election interference and the subsequent changes Facebook has made leading to a decline in U.S. and Canadian users.
Facebook is focused on the long term and is not just trying to maximize short-term profits or short-term usage. Hiring additional security to limit problems like Russian interference will cost money in the short-term but will increase the reputation and image of the Facebook platform in the long term. Similarly, Facebook's focus on having the Facebook feed positively impact its users' lives will lead to higher user satisfaction, and lower rates of people disconnecting their Facebook account. Both changes will promote the platform and the company long term.
Since my previous article on Facebook in October, Facebook's performance has been choppy. Some of this performance can be attributed to the underlying market - Facebook's slide during the first week of February was in line with the rest of the market, rather than based on Facebook-specific events. But Facebook has also fallen due to company-specific news.
Russian meddling in American elections has been a point of concern for Facebook. Last week, 13 Russian nationals were indicted over 2016 election interference. Much of this interference occurred on Facebook and on Facebook-owned platforms, such as Instagram:
The indictment says that the [Russian Internet Research Agency (IRA)] controlled an Instagram account called "Woke Blacks".
"A particular hype and hatred for Trump is misleading the people and forcing Blacks to vote Killary," one message, posted by the account in October 2017, declared.
"We cannot resort to the lesser of two devils. Then we'd surely be better off without voting AT ALL."
The IRA is hardly new. A 2015 expose from the New York Times magazine describes various hoaxes from the IRA. The group spread false information about an ISIS-caused explosion in Louisiana (which never happened) and news about Ebola in Atlanta (which also never happened). Much of this disinformation is spread through Facebook and its platforms, although with other sites like Twitter (TWTR).
Facebook has responded extremely well to the Russian interference. In the wake of the Russian interference, Facebook is doubling their security staff from 10,000 people to 20,000 people. This move will increase costs in the short-term but will also allow the company to more effectively sort real information from "fake news." This is the right move for the long-term growth of Facebook - increasing the signal/noise ratio on the site will increase user trust in both the news feed and advertisements and will improve long-term user retention.
Building For The Long Term
Facebook has consistently acted in ways that will help their platforms succeed long-term.
Back in December, Facebook's blog posted, "Hard Questions: Is Spending Time on Social Media Bad for Us?" In that post, Facebook discusses how their research team review scientific/academic research on the interactions of social media and user happiness. The overall message is that spending time passively consuming content makes users feel worse. Meanwhile, actively interacting with people - sharing messages, posts, and comments - improves users' well-being. (Take that as an invitation to comment on this post - perhaps you'll feel better?)
As a shareholder, I am thrilled that Facebook is looking at this type of information and willing to write about it on a public forum. We all remember past stories of how the NFL hid concussion research, or how big tobacco hid cancer research. I am not equating Facebook's potential impact on user happiness to either of those conditions, but I am encouraged that Facebook is willing to come forward with information about the impact of their product - good or bad - and work on ways to improve that impact.
Source: News Feed FYI: Bringing People Closer Together.
To that end, Facebook has made changes to their news feed intended to improve user experience. These news feed changes decrease the frequency that users see posts from brands and businesses and increase the frequency of posts from friends and family. Zuckerberg is changing Facebook's goal itself:
The research shows that when we use social media to connect with people we care about, it can be good for our well-being. We can feel more connected and less lonely, and that correlates with long term measures of happiness and health. On the other hand, passively reading articles or watching videos -- even if they're entertaining or informative -- may not be as good.
Based on this, we're making a major change to how we build Facebook. I'm changing the goal I give our product teams from focusing on helping you find relevant content to helping you have more meaningful social interactions."
Switching Facebook from a move passive experience to a more active experience will help users' mindsets and will improve the long-term future of the brand. These changes are not necessarily good short-term. Facebook's US & Canadian user numbers declined in the most recent quarter. This decline was due to the changes in the news feed, including the reduction of viral video content. It is expected to be a one-time decline.
I fully support these changes as a shareholder with a long-term view. Facebook's research team is focused on ensuring that Facebook is a positive part of their users' lives and that they improve their users' well-being. If they do their job correctly, this means that users visiting Facebook will leave the site happier than when they came. On a long enough timeline, this will stem the flow of users away from Facebook and will support the platform's growth and stability.
I have seen many friends and family members walk away from Facebook, for a time or permanently. People will deactivate - or delete - their accounts based on social media fatigue. In my view, users get tired of social media and Facebook because when they visit, they don't feel better. Instead, they feel worse. After enough time, we notice which hobbies we have improve our lives and which make our lives worse. And we actively seek to cut out aspects of our lives that consistently make us feel worse (or at least we should).
Facebook is actively taking steps to ensure that it is a positive part of its users' lives. That means that users - like you and me - will leave Facebook's site feeling better than when we came. If we feel better after we visit Facebook than before, we are not going to deactivate our account or stop visiting the site. Instead, these changes will foster the long-term growth of the platform in a way that is beneficial to society and beneficial to investors.
Valuation - Revenue
| (In millions) | 2016a | 2017a | 2018e | 2019e | 2020e | 2021e |
| Facebook Revenue | $27,638 | $40,653 | $56,945 | $75,771 | $95,506 | $105,004 |
| Total Digital Ad Spending | $191,870 | $228,440 | $266,040 | $306,590 | $341,810 | $375,800 |
| FB Share | 14% | 18% | 21% | 25% | 28% | 28% |
| Ad Spend y/y | 18.6% | 19.1% | 16.5% | 15.2% | 11.5% | 9.9% |
To value Facebook, my preferred tool is a discounted cash flow. I believe that it is a good model for Facebook, given Facebook's reasonably well-developed business. In my view, two key factors are driving Facebook growth: the growth of the online advertising market, and the growth of Facebook's market share within online advertising.
I estimate future online advertising growth based on data from eMarketer. For years after 2021, I assume that annual advertising spend will decline linearly over the next five years until it reaches my terminal growth rate (2.94%). I believe that this estimate is conservative: online advertising is likely to continue to take over from previous forms of advertising past 2021. Because of money moving away from other advertising and into online advertising, online advertising growth is likely to continue to outpace the long-term growth of the economy for the foreseeable future. Growth from developing nations is also likely to outpace my terminal growth rate.
Facebook's share of the online advertising budget has also been increasing rapidly as Facebook has grown. From 2015 to 2017, Facebook's share of the digital advertising market rose from 11% to 18%. Going further back, the 2010 online advertising market was ~ $68.4 billion, and Facebook's revenue was less than 3% of that total at $1.97 billion. Based on this market share growth, I project that Facebook can increase their market share another ~ 10%, up to 28% of the online advertising market, and then continue to grow alongside the online advertising market in the future.
This growth will be driven by the continued strength of the Facebook platforms, and its continued growth in overseas markets. During the past year, Facebook saw daily active users grow 14% to 1.4 billion, and monthly active users grow 14% to 2.1 billion. I would expect this growth to slow after a time, as Facebook reaches near-saturation levels in more markets. As a result, I expect their market share of advertising spending to eventually peak and reach a relatively stable level, which I estimate at ~ 28%.
My revenue estimates for 2019 are a bit more aggressive than analysts on Yahoo, who expect ~ $70b revenue (from $59b to $75b). My revenue estimate for 2018 is approximately in line with analysts' expectations of $55b (from $52b to $57b).
Valuation - Operating Margins
FB Operating Margin (TTM) data by YCharts
During the past twelve months, Facebook's operating margins were ~ 50%. These margins have steadily increased over the past several years. Like many software/service companies, Facebook benefits from economies of scale. Revenue from Facebook's platforms scales linearly with user growth, for the most part, while costs to design and develop those platforms does not scale linearly with growth.
In my model, I expect Facebook to continue to maintain 50% operating margins. I see this as a conservative estimate, given Facebook's projected revenue growth. Operating margins will be pressed a bit by increasing security, but would naturally expand due to economies of scale. I'll call it a wash, although I would not be surprised to see Facebook's margins increase further over the coming years.
Valuation - Unlevered Free Cash Flow
| (In millions) | 2017a | 2018e | 2019e | 2020e | 2021e | 2022e |
| Revenue | $40,653 | $56,945 | $75,771 | $95,506 | $105,004 | $114,181 |
| Revenue Growth | 47% | 40% | 33% | 26% | 10% | 9% |
| Operating Income | $20,202 | $28,342 | $37,770 | $47,680 | $52,502 | $57,091 |
| Tax Rate | 23% | 26% | 26% | 26% | 26% | 26% |
| NOPAT | $15,609 | $20,973 | $27,950 | $35,283 | $38,851 | $42,247 |
| Net Reinvestment | $4,723 | $6,433 | $8,343 | $10,212 | $10,300 | $11,113 |
| Unlevered FCF | $10,886 | $14,540 | $19,606 | $25,071 | $28,552 | $31,134 |
Above are my expectations for Facebook's free cash flow over the next five years. Revenue and operating income are as described above. For a tax rate, I am assuming a simple 26% tax rate in the future, based on the recent tax changes.
Net reinvestment is based on Facebook's past reinvestment rates. In 2017, net capital expenditures were ~ 9% of revenue, so I have used that rate in the future. Non-cash working capital was ~ 8% of Facebook's revenue at the end of 2017. Net reinvestment is based on the combination of the increase in Facebook's working capital as its revenue grows and in similar increased to Facebook's net capital expenditures.
Note that the above chart only shows up to 2022. My full model extends to 2027, as I am anticipating a linear decline in online advertising growth from ~ 10%/year in 2021 to 2.94%/year by 2027. Facebook's revenues are projected to track the growth in online advertising spending, keeping their "market share" at 28%.
Valuation - Discount Rate
| Discount Rate Calculation | |
| Risk-Free Rate | 2.94% |
| Equity Risk Premium | 5.63% |
| Unlevered Beta | 1.05 |
| Discount Rate | 8.8% |
I use a discount rate (cost of capital) of 8.8% for Facebook. This rate is based on the CAPM, using a risk-free rate of 2.94% - the current 10-year treasury constant maturity rate.
Source: 2017 Facebook 10-K.
My equity risk premium of 5.64% is based on Facebook's current geographic mix of revenue. This is a premium that investors demand - over and above the risk-free rate - for taking on the risk of investing in an equity rather than the assurance of a bond.
I am using an equity risk premium of 4.78% for the United States, based on the current cash yields of the S&P 500. International risk premiums are adjusted upwards based on the increased risk of those countries, and then I use a weighted average (weighted by Facebook's regional revenue) to arrive at 5.63%.
FB Beta (1Y) data by YCharts
I use a beta of 1.05 for Facebook, based on a bottom-up beta using Facebook's peers. This beta reflects how Facebook's share prices are likely to move with the market. This measure is important since investors can diversify away company-specific risk but cannot diversify away market risks.
This beta is higher than many might use - Facebook has a five-year monthly beta of 0.71 and a three-year monthly beta of 1.07, according to Intrinio. Yahoo Finance lists a beta of 0.54, while Ycharts gives a one-, three-, and five-year betas between 0.48 and 0.59. Using those lower betas would result in a discount rate of ~ 6%. In my opinion, that discount rate is inappropriate for Facebook - investors should expect a higher level of return than that for a technology company dependent on advertising.
Conclusion
| Discount Rate | 6% | 7% | 8% | 8.5% | 9% | 10% | 11% | 8.8% |
| Target Price | $377 | $288 | $235 | $215 | $199 | $173 | $154 | $204 |
Based on the above, I set a target price for Facebook of $204, for one year from now. This price is based on my expected value of Facebook in a year, based on a discounted cash flow. I have also included prices for other discount rates, since many might prefer to use a different discount rate.
I do not believe that Facebook is underpriced, based on this analysis. Instead, I believe that Facebook is priced fairly. But Facebook offers growth at a reasonable price - the company trades at a forward multiple of 25x, and a one-year forward multiple of 21x. For that price, Facebook offer huge growth - revenues grew 47% y/y in 2017.
I really like the changes that Facebook has made to its platform, and Zuckerberg's focus on user experience. Those changes are not geared towards maximizing profits today, but instead reflect a long-term focus on making Facebook a beneficial part of its users' lives. Facebook shareholders - invested for the long haul - will benefit from this long-term focus.
I own shares of Facebook in an IRA that I do not plan to touch for decades (I am 34 years old). I expect that Facebook will continue to grow and thrive for years or decades. Certain changes the company makes will cause short-term headwinds - hiring security hurts margins, declining ICO advertising hurts revenue, and cutting viral videos decreased screen time - but all these changes will help the long-term value of Facebook and its various platforms.
As a shareholder, I approve.
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Analyst’s 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.
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Comments (35)
however, I disagree with your price target. FB is one of the cheapest tech / big cap stocks out there today and should have a Price Target
of $250 +...imo.
FB is FAR from monetizing their total portfolio.
