Facebook Looks Undervalued On Several Metrics

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About: Facebook (FB)
by: Mike Berner
Summary

Investor enthusiasm for Facebook has waned amid slowing growth and numerous public relations fiascos.

Fundamentally, though, the company is stronger than ever before.

Revenue divided by aggregate user hours shows that advertisers are paying more for Facebook compared to five years ago.

The company is selling for a below average earnings multiple, even though Facebook is clearly an above-average business.

In just four months, Mr. Market has erased nearly two years of Facebook (FB) stock gains. Between the company's slowing growth, an ongoing public relations crisis, and a broader selloff in technology stocks, investor enthusiasm for the social media giant has waned considerably.

One year ago, commentators touted Facebook - the 'F' in the trendy FANG basket of tech stocks - as being worth growth at any price. I disagreed and wrote at the time that Facebook was overvalued at 39 times earnings. Despite a good run throughout 2017, the stock price is now 10 percent below the point where I first criticized the valuation.

Now the stock looks cheap.

Fundamentally, the company is objectively stronger now than at any other point in its history. With control of social media largely solidified, Facebook's 'moat' looks secure for at least another generation. Advertisers are paying far more per hour of user time than in five years ago.

Yet, the P/E ratio of 21 remains below S&P 500's earnings multiple. Here we have an excellent company being valued at an earnings multiple that is smaller than a merely average company. Clearly, something is amiss.

User Engagement and Valuation: An Overview

Analysts often point to 'user engagement' as the underlying driver of many technology platform companies, but the term remains somewhat amorphous. What exactly is user engagement?

In the case of Facebook, Wall Street has always scrutinized growth in the number of users. With 2.27 billion monthly active users as of the latest quarter, the core Facebook brand seems to be plateauing.

At the same time, though, time spent on the site rocketed from an average of 18 minutes a day in 2013 to more than 50 minutes a day in 2018. That is why looking at user hours in the aggregate is the best way of measuring Facebook's output.

In 2013, Facebook counted 845,000 daily viewers who spent an average of 18 minutes on the site, for a total of 92.5 million hours annually. That year, Facebook brought in $5 billion in advertising revenue. The company had also just completed the acquisition of Instagram for $1 billion in 2012. Although Wall Street derided Zuckerberg for the purchase, the price tag proved an incredible bargain considering that the photo-sharing service was recently valued at $100 billion.

Instagram is still growing rapidly. The site's active user count recently surpassed 1 billion for the first time, surging past the 800 million mark hit in September 2017.

Including Instagram's user base, Facebook now counts 2.5 billion average daily viewers who spend more than 50 minutes on the company's sites - a yearly total of 760 million hours in aggregate. The company currently rakes in $52 billion in sales.

Madison Avenue Vs. Wall Street

Although investors on Wall Street are less enamored of Facebook lately, their opinion matters less than ad buyers and brands that continue to spend large sums on social media marketing campaigns.

As noted, Facebook's revenue currently exceeds $52 billion. With 760 million hours spent on the site annually, advertisers now spend $0.068 per user hour. This represents a substantial rise over 2013 when user hours were 'sold' for $0.054. The rise in spending on a per hour basis shows that marketers view Facebook as a more valuable advertising medium.

Facebook's virtual monopoly on social media allows the company substantial pricing power, and the company's services have proven sticky with users and advertisers. The recent data privacy scandal did not faze Madison Avenue in the slightest; a recent survey of 1,000 brands showed Facebook enjoyed a 62 percent year-over-year increase in ad spend during Q1 of 2018.

Source: author's calculations

Below Average Multiple, Above Average Company

I was not a big fan of Facebook at 39 times earnings. As some observers pointed out, extrapolating historic growth rates would mean that Facebook and Google (GOOG) sales would exceed the size of the entire advertising industry within several years. Clearly, Facebook's growth rate must slow, and the new multiple on the stock reflects that reality.

Yet, I find it surprising that Facebook would sport an earnings multiple below that of a merely average business because it is objectively a much better bet than most companies in the S&P 500. As of this writing, the S&P 500 trades for 22 times earnings, while Facebook trades for a P/E of 21.

The company's portfolio of services dominates social media both domestically and globally. The core Facebook brand counts 2 billion monthly active users, with its WhatsApp and Messenger services drawing in 1.3 billion and 1.2 billion users, respectively. Fast-growing Instagram follows with 800 million, meaning that four of the top five social media brands globally are owned by Facebook.

Network effects make it increasingly difficult for upstarts to dislodge Facebook. Although the site faced a slew of competitors during the early days, most are now defunct. Snapchat (SNAP) was once thought to pose a threat, but the photo-messaging app still lags far behind Facebook's user base.

The balance sheet is an investor's dream, with little debt and over $40 billion in cash. Facebook requires little capital to produce its services, so free cash flow is enormous. To quote Warren Buffett in 2017:

I believe that probably the five largest American companies by market cap - they have a market value of over two-and-a-half trillion dollars - and if you take those five companies, essentially you could run them with no equity capital at all. None.

Buffett, whose Berkshire Hathaway (BRK.A) (NYSE:BRK.B) now holds an enormous stake in Apple (AAPL) after avoiding the technology sector for years, doubled down on his about-face during this year's annual meeting in Omaha.

The four largest companies today by market value do not need any net tangible assets. They are not like AT&T, GM, or Exxon Mobil, requiring lots of capital to produce earnings. We have become an asset-light economy.

Buy This Dip

Facebook still has lots of growth ahead, even if the growth rate will not be as meteoric. Internet advertising has grown rapidly due to high return on investment for advertisers and that does look like it will go away any time soon. By some estimates, the global ad market could reach $900 billion within five years, with the lion's share of the growth accruing to internet companies - led by Facebook and Google. A 20 percent annual growth rate for Facebook sales still looks feasible.

I like Facebook at 21 times earnings. It is not a dirt cheap valuation, but clearly, the stock is not in bubble territory, either. The stock is falling even as brands and advertisers bid up the value of user time. Moreover, the valuation on Facebook shares remains below the market average, despite that the company is obviously much better than average.

When the ongoing public relations malaise and broader technology selloff dissipates, it will become clear that $140 was a good bargain.

Disclosure: I/we 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.