By Brian Nelson, CFA
I really can't believe how many people have an ax to grind with Facebook (FB). My experience with the platform hasn't been the best, but that's probably my fault. I'm generally not very good with social media. I've never been the popular type of person. I have a strong tendency to say what's on my mind as I see it, not necessarily what people want to hear. If we think about Facebook, however, to a large extent, Facebook is a reflection upon us, our society. While I'll avoid getting into the philosophical too much, maybe that's what some "haters" of Facebook don't like, not Facebook, itself. It's interesting because the people create the content on Facebook, and it's hard for me to blame Facebook for any news bias, at the same time that some of the largest newspapers seem to have some political tilt to them, too, and this may be an understatement (depending on who you ask).
Though I am a student of history, I just get the sense that the political environment in the US hasn't been this charged in a long time. The mudslinging is incredible. What about you? Has the political environment been worse in your lifetime? This is getting out of hand, and I've turned off the shouting matches on television. It seems like the left and right have never been further apart, too, and frankly, it is a little concerning. It's hard to know exactly how all of this will play out in the 2020 election, and how the media and advertising markets will shape up, but it seems like politics has never been "uglier." The one thing that I thank my parents greatly for is my childhood, where perhaps the only politician I knew of was the President of the United States and the local mayor, and that was that. It was a glorious time in my life, perhaps as it was in yours.
Let's speak the obvious and get it out of the way. Facebook is not a perfect company, but I don't know any company that is perfect. Whether it be Boeing (BA) and the tragic situation with respect to the 737 MAX 8 or Johnson & Johnson (JNJ) as it relates to children's Tylenol or situations ongoing with talc powder, companies sometimes make mistakes, or if they are only alleged mistakes, can face severe media scrutiny. What we hope, however, is that the company, as a whole, acts in the benefit of society in providing a good that we all demand - the good outweighs the bad, so to speak. Though Facebook seems to have dropped the ball with the Cambridge Analytica scandal, the company is working hard to make things right. Look at how much it is investing in ensuring privacy and security, and monitoring its content.
But then, now, fast forward to March 2019 and it seems now that the actions Facebook is taking to protect its readers are now being viewed as over-stepping the bounds on the other side of the spectrum, perhaps in taking away free speech or expression. For example, 2020 Presidential candidate Elizabeth Warren noted that Facebook took down her advertisements calling for a breakup of the company. Also, one of the news publishers in finance, Zero Hedge, seems to be facing some opposition with respect to users being allowed to share links to Zero Hedge content on the platform. Is it a case now where Facebook is darned if it does and darned if it doesn't? In a society that seemingly wants to blame everyone else, can Facebook win?
I think sometimes we forget that Facebook has made so many things in our lives easier and that it is a publicly-held business with shareholders that rely on it to make critical decisions about its long-term profitability and cash flow. There are other content providers out there that may refuse to publish content or remove links from works, too. Is this right or wrong? Who gets to decide this? It would seem that the publisher would have the right to do so. But if politicians are sounding the alarm bells and some users are being banned, it's hard to know who is right or who is wrong. At the end of the day, the people will decide. In the meantime, Facebook continues to generate boatloads of free cash flow as it holds one of the best balance sheets around.
Some More Background
Those that have read my new book, Value Trap: Theory of Universal Valuation, know that our team spends tons of time on enterprise valuation. Enterprise valuation is called the free-cash-flow-to-the-firm process, or FCFF, for those well-versed in corporate finance. To me, it is a vital way to analyze stocks and forms a critical part of our Valuentum Buying Index (VBI) rating system. For example, enterprise valuation helps answer the question: what is a company worth? It distills down everything about the company into estimates of future enterprise free cash flows, discounts those back to today, and adds a company's net cash or subtracts its net debt position to arrive at equity value. To me, that's what investing is about: answering the question of what a company is worth and then comparing that to the share price.
It has become clear that the market overreacted during the summer of 2018 when it sent shares of Facebook tumbling. You knew my opinion about this all along. In April and June 2018, shares of Facebook registered a 10 on the Valuentum Buying Index (10=best, 1=worst) at $174 and $193, respectively, and the equity promptly rallied to ~$220 in short order. Then came the swoon and shares again registered a 10 on the Valuentum Buying Index in January 2019 at $143, before now promptly rallying to $170+ (see chart at top of article). This is what the VBI should do. On December 14, 2018, I penned the following on Facebook, "Why Don't I Feel Wrong About Facebook." Shares have rocketed since.
The Valuentum Buying Index is a timing overlay to the enterprise valuation process. We don't use the VBI or enterprise valuation, by itself. If we think shares of a company are undervalued but their technicals and momentum indicators are terrible, we won't come close to it - think General Electric (GE) in the high $20s. If we think shares are overvalued but its technical and momentum indicators are still running, we won't ditch it - think Chipotle (CMG) at the moment. The Valuentum process has come in mighty handy through this 10-year bull market as prices would stretch for some time, only for valuations to eventually follow higher.
In what many believe may be our worst call (given the timing of a few of our emails last summer), our "cost basis" in the Best Ideas Newsletter portfolio for Facebook is in the mid-$130s, so the company's rally has put this one in the winner's column in a meaningful way... again. What we are effectively after as Valuentum investors are the stocks that the in-depth value and income-oriented investors already might own anyway but ones that have added conviction as measured by technical/momentum indicators. We simply like stocks that are undervalued on an enterprise valuation basis (and on a behavioral valuation basis, as in the forward-looking PE or PEG ratio) and are exhibiting strong technical and momentum indicators.
Why I Still Like Facebook
Image shown: How our team arrives at our estimate of Facebook's fair value.
The answer to the question of why I still like Facebook is quite simple. Despite the increasing political and regulatory risks, which may indirectly only widen its economic moat (a term meaning competitive advantages), Facebook's cash-based sources of intrinsic value, as in the net cash on its books and its capacity to generate considerable free cash flow, are phenomenal. This, despite the added expected costs related to some of the privacy initiatives it has put into place. From where I stand, Facebook is worth $226 per share, and our discount rate of ~9% means we estimate this intrinsic value to advance this pace on an annual basis going forward. But just how realistic are our forecasts?
Image source: Facebook Q4 slide deck
Image source: Facebook Q4 slide deck
Well, quite realistic. Facebook generated 30%+ top-line expansion in its most recent quarter on an operating (EBIT) margin of 46%, both of these items well above what we're forecasting over our discrete five-year period. Our estimated cash tax rate of 15% seems to be on the mark, with the measure coming in the low-teens the past few quarters. We're also "only" looking at earnings per share expansion in the mid-teens range in the coming years and enterprise free cash flow (free cash flow to the firm) to grow modestly (just at a 7% CAGR), mostly pressured by increased capital spending. Our discount rate of ~9% is also quite punitive in an interest-rate environment where the 10-year is having trouble staying above 3%. Facebook ended 2018 with $41+ billion in cash and cash equivalents and no debt.
You'll notice my write-up didn't talk about daily average users (DAU) or monthly average users (MAU). Well, that's because once you've got the scale that Facebook has, well, advertisers are still going to spend for it. Even so, DAU and MAU are still on an upward march at Facebook.
Given all of this and even considering some haircut due to increased regulatory costs, I'd go so far to say that our fair value estimate of Facebook, which implies significant upside, by itself, may be conservative. The 9% discount rate is rather high for a company that generates so much free cash flow and has such a healthy balance sheet. In some ways, the high discount rate may implicitly capture the inherent "break-up" risks from political candidates such as Senator Elizabeth Warren and/or fines from privacy mistakes.
Facebook is super cheap, growing like a weed, its chart is looking up, the company generates gobs of free cash flow, has a boatload of net cash on the books, and has one of the strongest competitive advantages out there: the network effect. The market is not giving Facebook its due credit at all. I'd be in favor of the company launching a massive buyback program and taking on a little debt to do it (with intentions of paying it back very soon, of course). I think the best days are still ahead at Facebook.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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.
Additional disclosure: FB is included in Valuentum's simulated Best Ideas Newsletter portfolio.