- 2 out of 5 of Facebook's most important competitive advantages show signs of erosion and weakening fundamentals.
- Facebook faces an increasingly challenging competitive environment, especially in light of its recent announcements in FY Q2 2021.
- The valuation offers hope in terms of a buffer/margin of safety.
- Continued insider selling and a weak technical setup may indicate a continued correction in the share price.
This article presents contrarian research for any investor considering the dedication of their hard-earned money to the shares of Facebook (FB). The article examines, each in turn:
- Facebook's weakening competitive advantages
- The increasingly challenging competitive environment for Facebook
- Valuation, as assessed by comparative metrics, DCF, and EPS models
Source: Seeking Alpha
An examination of Facebook's competitive advantages reveals a company, which beneath the impressive financial metrics, belies a deterioration of fundamentals. The below order represents the relative strength of one competitive advantage over another and the advantages are ranked from 1 (very weak) to 10 (very strong). Early Warning indicators are defined to help investors monitor any further deterioration of the competitive advantages year over year and thus to formulate an early exit strategy, if needed.
1. Dedicated Management and Employees (Strong Moat - 9/10)
Investors may be surprised to learn that Facebook's strongest competitive advantage is its people. The CEO, CFO, and COO, in addition to many senior managers and directors, are dedicated to the welfare, profitability, and success of the company.
I personally reviewed ~180 Glassdoor reviews and I strongly encourage any biased detractor of Facebook to do the same. While Facebook may have many questionable business practices and policies that are outward-facing, employee reviews of the company demonstrate exceptional internal unity, collaboration, agility, perseverance, a diligent work ethic, ingenuity, high emotional intelligence, outstanding compensation and benefits, and the type of work environment that fosters innovation and diversity of ideas, rather than inhibition and infighting.
The only real downside for employees (not for investors!) is work-life balance (high workload), the prevalence of occasional internal politics, and exhaustion from Zoom meetings (lack of face-to-face meetings due to COVID).
The culture appears to show signs of a "start-up" feeling, with some evidence of disorganization and lack of formal processes, while promoting openness (lack of siloes), autonomy (trust of employees), and targeted metric-driven results (very goal-oriented in terms of performance targets). This culture and environment might in turn explain why Facebook has run into some of the ethical, social, and public quandaries it has faced in the past decade - because the industry it exists in is lightly regulated and processes can still be eschewed in the pursuit of growth and profits.
There is very limited mention of ethical concerns by employees (even when one reviews the lowest-ranked reviews, which are usually case-by-case specific grievances and do not present any unified theme).
Early Warning(s) to watch: sudden or increasing YoY turnover in senior management, worsening YoY employee Glassdoor reviews, public lawsuits by employees against the company
2. Network Effect (Strong Moat - 8/10)
As one of the leading social networking service companies, Facebook has taken pains to grow both organically and via acquisitions its network effect competitive advantage. The platforms owned by Facebook clearly demonstrate both the appeal and popularity of social networks for consumers, businesses, and advertisers alike:
- Facebook - Approximately 2.89 billion monthly active users as of Q2 2021. Active users are those who have logged into Facebook during the past 30 days. Facebook is the largest social media platform globally. For context, this is ~37% of the world population (estimated at 7.9 billion as of September 2021).
- WhatsApp - Approximately 2.0 billion monthly active users as of July 2021, outranking Facebook Messenger at 1.3 billion and WeChat at 1.2 billion users. Following Facebook and YouTube, it is the third most popular social network worldwide.
- Instagram - Approximately 1.0 billion monthly active users as of Q2 2021. At ~1.4 billion (in terms of potential ad reach) Instagram is ranked as the 4th most popular social network by number of users. Instagram is most popular in India, with 180 million users, followed by the United States (170 million), Brazil (110 million), Indonesia (93 million), and Russia (61 million).
- Messenger - Approximately 1.3 billion monthly active users globally as of Q2 2021. 64% of people who use Facebook are also using the messenger platform. 90 million small businesses are actively using Facebook one way or another. Facebook Messenger statistics reveal that 20 billion messages are exchanged every month between businesses and customers.
As Facebook derives a stunning 98% of its revenue from Advertising, this competitive advantage serves as the lifeblood of the company. Without it, immediate growth prospects, profitability, financial leverage, and Facebook's negotiating leverage within the business world would vanish.
Unfortunately, this competitive advantage is being eroded by Facebook's blunders, executional errors, competition, and by managerial tendency to overstate or embellish both metrics and future R&D prospects. Furthermore, the Network Effect competitive advantage for Facebook is heavily dependent on and correlated with the Brand and Vision competitive advantage, which is dragging down the company's profitability and weakening what should be an otherwise unblemished and glorious competitive position.
With respect to metrics, Facebook has historically presented Facebook Daily Active Users (DAU) and Facebook Monthly Active Users (MAU), with DAUs / MAUs usually sitting at a ~66% ratio to one another. Within the more recent fiscal quarters, Facebook now has adopted Family Daily Active People (DAP) and Family Monthly Active People (MAP), with the DAP / MAP ratio sitting at ~79%.
Facebook has implemented these measures to entice the investment community in re-evaluating the business prospects by focusing not only on the Facebook social media advertising platform, yet on the entire family of products (Facebook, WhatsApp, Instagram, and Messenger). Reminiscent of the efforts of Apple (AAPL), Microsoft (MSFT), and Adobe (ADBE), Facebook hopes to cultivate an "ecosystem" for its product offerings and platforms.
While seemingly impressive at first look, the issue with the metrics - as with many S&P 500 companies' claims made publicly to investors - is in the footnotes/disclaimers/appendix. In the FY Q2 2021 Earnings Call Presentation, the Appendix houses a section dubbed "Limitations of Key Metrics and Other Data." In it, Facebook admits that the metrics they present to investors may be inaccurate, may fluctuate with time, and may be inherently challenging to measure - in particular the newly adopted DAP and MAP metrics.
What is striking is the distinction in the perceived error between the old set of metrics (DAUs, MAUs) and the new set of metrics (DAPs, MAPs).
Despite readily admitting that the Family Metrics are much more challenging to calculate due to the use of "complex techniques, algorithms and machine learning models," Facebook claims only ~3% of worldwide MAP consisted solely of violating accounts while claiming that duplicate accounts for the Facebook metrics (MAUs, DAUs) sat at ~11% worldwide for duplicate accounts and ~5% worldwide for false accounts.
Even if WhatsApp, Instagram, and Messenger platforms had much lower rates of abuse (duplicate, false, or violating accounts) - and there is no reason to immediately suspect so when one considers the opportunities to be gained by abusing these social platforms - it is difficult to understand why the Family Metrics would have such a drastically low ~3% of violating accounts worldwide considering that:
- The Facebook platform itself, and the traditional MAUs / DAUs, constitute the largest chunk of those accounts at ~2.89 billion active monthly users.
- The new MAP / DAP metrics are by Facebook's own admission far more difficult to calculate accurately and thus one should err on the side of caution in reference to violating accounts instead of understating them.
Even further evidence of Facebook's misleading approach to metrics can be substantiated by the choice to use both monthly (instead of weekly) and daily active users to gauge the importance and success of a social platform. If one looks at daily active users instead of monthly active users, the stalwart network effect competitive advantage for each platform becomes much less apparent:
- Facebook - ~1.9 billion daily active users or ~24% of the world population (66% of the monthly active users).
- WhatsApp - ~1.0 billion daily active users (half of the monthly active users).
- Instagram - ~500 million daily active users, (again, half of the monthly active users).
- Messenger - while global statistics could not be readily located, research suggests at least 50% of US teenagers used the platform daily, and extrapolating this globally would yield ~750 million daily active users (half of the monthly active users).
The significance to investors is that depending on what set of metrics they choose to believe and to use, the underlying strength of the business and of Facebook's social platforms may be both misleading and overstated. As will be discussed in a later section, Facebook does face more competition than investors may be realizing, and this, in turn, means that a conservative approach to metrics in the evaluation of the business - rather than a sanguine one - is warranted.
Early Warning(s) to watch: any YoY loss of 5% or greater in # of DAUs, MAUs, MAPs, or DAPs in US & Canada and/or Europe, any YoY loss of 5% or greater in Facebook Average Revenue Per User in any geography, the introduction of any new metrics to gauge the success of the social platforms [which may obfuscate underlying actual business strength and results]
3. Research and Development (Strong Moat - 7/10)
Facebook spends an inordinate amount of money on R&D. For reference, at 18% in 2018, 19% in 2019, and 21% in 2020, Facebook is out-spending most of the medical device industry in terms of % of R&D compared to revenue. Allow that to sink in.
Source: Facebook FY 2020 10-K
On the one hand, this speaks to the company's focus on the future and the never-ceasing focus on innovation. On the other, one ponders the need for such high R&D spend as a % of net revenue, and given what we learned about the company's culture from Competitive Advantage #1 - Dedicated Management and Employees, one might suspect some operational inefficiencies. Nonetheless, this may be a minor and temporary issue and will present a compelling cost savings opportunity in the future as any additional product launches (if successful) reduce the need for such high levels of R&D spend as a % of revenues.
Certainly, compared to many competitors such as Twitter, Snapchat, TikTok, Reddit, Pinterest, and WeChat - YouTube and LinkedIn being the exceptions - the R&D spend presents a concrete benefit and competitive advantage for Facebook, and not one that is easily or quickly replicated.
Particularly strong is Facebook's continued focus on virtual reality (in anticipation of the Metaverse), which is buttressed by the existence of Facebook Reality Labs. That said, investors should definitely not expect any immediate results in this arena - as previously mentioned, the vast majority of Facebook's revenue comes from advertisements on its social media platforms, not from Virtual or Augmented Reality headsets or any such similar products.
Investing in a company still in the nascent stages of revenue generation and profitability for a group of products representing merely 2% to 3% of total revenues based solely on excitement or sanguine expectations for these products - and in an industry projected to have swarming competition - would be a foolish and careless mistake.
Of further concern in relation to Virtual and Augmented Reality is the way Facebook likes to generate hype about products not yet in existence (note the constant use of not actual product images. Images are strictly for illustrative purposes only):
Personally, I do not understand the purpose of hyping products not yet in existence unless to attract additional investors, and such marketing appears somewhat disingenuous and yet another blunder on Facebook's behalf.
Early Warning(s) to watch: ~3 to 6% YoY sudden decrease or increase in R&D spend without a corresponding increase in revenue, decrease in # of filed or in force patents, acquisitions, diversification or investment into areas drastically outside of Facebook's expertise or into sectors or industries with poor CAGRs or margins
4. Filing of Patents (Moderate Moat - 6/10)
In 2019, Facebook was awarded 989 patents. Most of Facebook's patents were in fields like data processing and digital transmission, but 169 patents were in the Optical Elements category. That would be related to virtual reality headsets. Facebook total in force patents numbered ~3,801 in 2019, and the company continues to vigorously protect its intellectual property.
According to research conducted on JUSTIA Patents, Facebook has applied for ~7,350 patents in its existence (50 patents per page).
Source: Justia Patents
While patents are an excellent way to protect one's intellectual property, in the case of social media use cases and the software applications Facebook must employ, it is difficult to see patents preventing competitors from outright replication of features by enabling similar or copy-cat algorithms, as this can be commonplace and widely seen across digital e-commerce, website design, advertisements, marketing, workflow design, and social platforms and ecosystems.
The company's primary advantage lies in the more difficult to replicate patents granted for virtual reality, augmented reality, and optical elements, which will hopefully give Facebook the necessary head start and advantage to establish itself as one of the leaders in the blossoming and futuristic industry and thus to mitigate any existing challenges or headwinds in its traditional social platform and advertising businesses.
Early Warning(s) to watch: decreasing # of patents filed year over year, losses of lawsuits in relation to intellectual property copyrights
5. Brand and Vision (Moderate Moat - 4/10)
Prior to February 2017, Facebook's mission statement read as: "To give people the power to share and make the world more open and connected." In 2017, the CEO acknowledged the severe shortcomings and blind spots that his company's mission created and established a new one:
Notwithstanding the oft heated debates and arguments present on social media platforms, it would be remiss of any individual to argue that social media fails to bring the world closer together or that it fails in providing an opportunity (power) to build a community. As many will aptly point out, social media at times brings out both the best and the worst in human nature, when the unabashed personalities are revealed in a virtual environment.
The issues, unfortunately, are present with Facebook's notorious brand:
- Use of the platforms for political polarization, misinformation, sensationalism, fear-mongering, and outright violence
- Claims of social platforms being addictive and toxic to mental well-being
- Claims of the social platforms leading to stigmas, low self-esteem, self-harm, and an overall negative impact on children
- Federal agencies accusing Facebook of withholding key data
- Improper use of user data as a bargaining chip over competitors
- Illegal harvesting of personal user data of up to 87 million Facebook users, sold to Cambridge Analytica (FB fined $5B by the FTC to settle)
- Solemn concerns over Facebook's continued use of private user data and lack of public transparency regarding how FB uses the data
- Antitrust lawsuits and concerns, which a federal judge threw out six months after the lawsuit was filed, saying the FTC did not provide enough evidence for the claim that Facebook is a monopoly and that it waited too long to present the case. While the UK has cleared Facebook's proposed and recent takeover of Kustomer, it remains to be seen how the USA and global regulatory agencies respond.
- Controversy regarding Facebook's policies (or weakness thereof) aimed at curbing hate speech
- Even more importantly for investors, Facebook does not have the trust of many "creators" due to purported stealing and re-posting of content (a ~5 minute informative video)
- Even seemingly positive attempts by Facebook to reconcile with the public and governments, such as the removal of a series of accounts that worked together to spread COVID-19 misinformation and encourage violent responses to COVID restrictions prior to the German Federal elections, are vilified.
The above are only a subset of the many issues Facebook's business and brand have faced over the past decade and since inception. The implications are profound.
Brand and Vision, as a competitive advantage, usually strengthens and drives other competitive advantages such as Network Effect, Ecosystem, or Consumer Loyalty. Yet in Facebook's case, the absolutely amazing year over year blunders by the management and the company have created a self-fulfilling prophecy: as more users learn about Facebook scandals, a growing number of businesses, users, and advertisers are beginning to hate the brand, the company, and what it represents.
Hate is a powerful word, isn't it? Yet that is exactly the types of frequent articles, opinions or comments you encounter about Facebook:
- Reasons for not deleting Facebook accounts despite hating FB / not enjoying the platform; not remembering dates for life milestones, needing Facebook to log into other platforms, wanting to use another Facebook owned app, not wanting to cut community ties, wanting to keep a digital time capsule, and needing FB for school or work - importantly, these reasons do not present major "switching costs" for users
- Explanation of why some entrepreneurs or business owners feel Facebook is no longer "worth the money" for growing their brands and companies
- Claims of Facebook losing advertisers due to the latest iOS "privacy" changes
- Abysmal net promoter scores of -47 according to a Medium survey and -21 according to Customer Guru (this means users/consumers of Facebook are detractors of the products/platforms and actively encourage others not to use the products)
One would think that the company would realize the destructive tendencies and poor prognosis for its business due to the heightened degree of enmity expressed, yet in the recent Q2 2021 Earnings Call Transcript and Q&A, it appears the CEO continues to imply that Facebook's business practices - in the latest ventures of AR, VR, and the Metaverse - will not change:
And on the metaverse points, we're primarily focused on here. Before I get into the business model, our basic playbook as a company is build products that you get to scale, especially social products. It's important that the people you want to interact with are there. So we are going to focus on having hundreds of millions of people use the metaverse and the new platforms that we're building before we really turn this into what I expect to be a very important and big part of the business. But overall, and I think that there is -- as we embark on this next chapter, ads are going to continue being an important part of the strategy across the social media parts of what we do and it will probably be a meaningful part of the metaverse too. I think commerce is going to be increasingly important, which is why we're -- one of the reasons why we're focused on this across our current apps and the current economy. But I think digital goods and creators are just going to be huge, right, in terms of people expressing themselves through their avatars, through digital clothing, through digital goods, the apps that they have, that they bring with them from place to place, a lot of the metaverse experience is going to be around being able to teleport from one experience to another. So being able to basically have your digital goods and your inventory and bring them from place to place and that's going to be a big investment that people make.
That is a lot of gaming references. If I read between-the-lines correctly, the CEO is proposing to monetize digital goods or "inventory," which any gamer will immediately tell you has no inherent or real value in the world outside of aesthetic or emotional pleasures (music, art, entertainment, paintings/pictures, video, avatars, etc.) Ethical and social considerations aside, it is difficult to envisage an overwhelming majority of people acceding to using sleek augmented reality glasses (once developed and released) while being overwhelmed with advertisements at inopportune moments and influenced to spend money on virtual/digital goods that cannot readily aid you in reality.
The only remaining and major benefit of Facebook's brand is that it is popular (or notorious) and this, in turn, draws continued usage and adoption in developing countries or areas where Facebook's social media penetration (and associated business practices) may not be as widely known. Note the growth in Rest of World and Asia-Pacific while Europe and US & Canada stagnate:
Early Warning(s) to watch: any new lawsuits by consumers or regulators against the company, passage of any laws forcing interoperability and ease of data transfer from Facebook's platforms to competitive offerings, worsening YoY NPS scores
In summation, Facebook's Competitive Advantage #2 and #5 - Network Effect and Brand and Vision - face deterioration and increasingly alarming prospects, in particular for the company's brand. Investors should not ignore the disdain Facebook faces by the public - despite wonderful internal unity - as ultimately the company is dependent on future business partnerships (Metaverse) and public trust to continue making money.
If over the next 5 to 10 years the company fails to drastically amend its policies and to begin regaining regulatory and public trust, even the most amazing Virtual Reality / Augmented Reality products may falter to gain widespread adoption because of outright distrust of Facebook's privacy, policies, and actions, especially in light of possible competitive offerings.
The part that was most startling to me in my research of Facebook is the perception by many highly intelligent investors that Facebook somehow occupies an indomitable and impregnable leadership position both in social media and the very, very young virtual/augmented reality industry. Occasionally, major risks from the growth of competitors seemed to be outright ignored or swept under the rug.
Social Media Platforms
In Facebook's traditional social media platforms (Facebook, WhatsApp, Instagram, and Messenger), there is burgeoning competition in the USA:
- YouTube - 2 billion monthly users, $19.8B in revenue
- TikTok - 689 million monthly users, $1.9B in revenue
- SnapChat - 433 million monthly users, $911M in revenue
- Reddit - 416 million monthly users, $212.5M in revenue
- Pinterest - 416 million monthly users, $1.7M in revenue
- Twitter - 353 million monthly users, $3.72B in revenue
- LinkedIn - 310 million monthly users, $8.05B in revenue
...and then below are the 15 largest global social media platforms.
Respectfully, as many Facebook investors can probably grumpily attest, many of these global social platforms (growing at some very swift rates) do not have Facebook's scourge of a notorious brand and thus remain very real alternatives to consumers and users.
Conduct a simple thought exercise:
- If a consumer/user was offered all of the features of Facebook (the most dominant social platform because of the community, captured life milestones, etc.) at $10 per month on a platform that promised to a) fully protect user privacy, b) minimize unnecessary or unwanted advertising, c) prevent hate speech, misinformation, and fraud, d) promote ethical standing and goodwill with society, e) avoid especially sensitive topics (e.g. moderation on politics/religion/extremism) f) promote a true sense of community, discovery, and friendship (inasmuch as this is possible on such platforms) - how many would take that offer?
Advertising Platforms (Alternatives to Facebook)
To demonstrate how frail and worrisome Facebook's dependence at 98% on Advertising revenues is, consider the following (useful chart in the article link):
- In the United States, prior to 2015, the digital ad space was a duopoly consisting of just Facebook and Google. At the time, Amazon (AMZN) ad revenues were relatively minuscule, totaling under $1 billion.
- Typically known for their ecommerce business, Amazon now also makes over $16 billion in ad revenue each year (2020).
- The vast majority of US advertising revenue in 2020 came from "Other" sources at 50%.
- Google continues to grow its advertising business, and the industry (in the US) for digital advertising is now dubbed a "triopoly," which is a misleading misnomer considering the three largest players (Google, Amazon, and Facebook) account for only 50% of the market. Where is the rest of the spend going? Well, everywhere and to at least 10 Large Online Advertising Agencies and Networks that many may be ignoring.
This isn't an industry that's especially difficult to enter. Any company with a large enough network of users and a solid brand and reputation for privacy can host your business with advertisements.
Globally, Alibaba, Amazon, and Tencent continue vying for power with Google and Facebook. It is a surprising and remarkable testament to Facebook that it has continued to gain market-share to date despite the issues with the brand.
Source: Insider Intelligence
However - what happens if users and/or advertisers begin to abandon Facebook's platforms for competitive offerings or alternatives? Why is this considered an implausible scenario especially in light of the blunders by Facebook management and poor public relations?
Many alternatives do exist for both social platforms and for advertising platforms, and Facebook's recent new diversification to additional areas to build an ecosystem sounds - to me, personally - like a retroactive and reactive move. Consider what the CEO announced on the FY Q2 2021 Earnings Call:
I want to start today by discussing some of the themes that we're seeing and our major efforts around creators, commerce and the next computing platform. Each of these areas is important and it's going to unlock a lot of value on its own, but we're also building blocks for the future of the Internet and the future vision for our company...
So first, let's talk about creators. We want our platforms to be the best place for millions of creators to earn a living. And if we can do this within our services, we'll also have the best content across many different types of media, from text and photos to audio, gaming and video.
The second area that I want to talk about today is commerce. Our goal here is to create better experiences for people interacting with businesses and to help businesses grow even more on our platform. Our approach is to work our way down the stack and build world-class services at every layer of commerce, starting from discovery, at the top of the stack, all the way down to payments.
The third area I want to talk about is building the next computing platform. We're continuing to invest very heavily in building technology and product to deliver a full sense of presence.
But together, these efforts are also part of a much larger goal to help build the metaverse.
But it could take a lot of work and no one company is going to be able to build this all by themselves.
To put this in perspective, there are two ways to assess the CEO's promises:
- Facebook has very ambitious goals to develop an Ecosystem competitive advantage and to become a very relevant futuristic "internet" leader in the Metaverse by leveraging its existing social networks and incipient R&D investments
- Facebook is desperate, and in fact, it is startling it has taken the company's management so long to pivot to some of these areas (they are behind the curve here)
I strongly believe the latter, and here is why:
- There are dozens of companies catering to "creators." This is not a new concept. In addition to the various social platforms we noted, there is also Adobe (ADBE) - notably a much stronger contender to benefit "creators" and one without any sultry relationship with creators or alleged theft of content.
- There are dozens of companies catering to "e-commerce." Amazon, Adobe, Microsoft, Google, Apple, Walmart, Target, you name it... why would anyone choose Facebook over more renowned and privacy-focused brands?
- There are dozens of companies catering to "computing platforms." This involves established brands like Salesforce, Oracle, Snowflake, Palantir, IBM, Alteryx, Microsoft, Amazon, Google and again... countless others. Why would anyone choose Facebook over more renowned and technology apt leaders in this industry?
In essence, Facebook just both announced:
- Its expected entry into at least three different industries with heavy competition, thus making it so Facebook competes in at least six industries/markets (social platforms, advertising, "creators," "e-commerce," "computing/analytics," and virtual/augmented reality)
- Its desire to build a Metaverse and its need for massive cross-industry collaboration to build the Metaverse (despite its announcement of now competing with easily over 100 different companies, many of them in the S&P 500).
Perhaps other investors view this with incredulity similar to myself, and it is difficult to envision an eventual result that falls short of calamity unless the company retracts and amends its strategic goals to be more realistic and achievable. The new diversification appears to be a recipe for disaster - too much all at once.
Virtual and Augmented Reality
It would be remiss of me now to mention the competition in this area when so many hopes are pinned on it. As I mentioned under the Research and Development competitive advantage, Facebook's revenues from actual products sold under this emerging industry/market are miniscule. Facebook doesn't even break out these revenues separately in the 10K. It is dubbed "Other Revenue."
Competitors in this area include:
Source: Augmented Reality Companies
In fact, to demonstrate the swathe of competition, see this article listing the Top 100 AR & VR Development Companies. While not every single company might be in immediate direct competition with Facebook's own offerings (and those in development), it does demonstrate that Facebook's eventual domination and leadership in this industry is far from assured. Promising and auspicious - given their efforts to date - but not a guarantee.
The competitive landscape is precisely the reason the company is investing massive amounts into R&D to diversify the revenue streams. If and when the ads run out and revenue from advertising either stagnates - or even worse, dips - the impact to the company may be severe, especially in light of continued and growing public angst and pressure over Facebook's policies.
A peer comparison of P/E, EV/EBITDA, and EV/Sales are applied for a comparative analysis of FB financial valuation metrics to industry leaders and competitors.
Source: Seeking Alpha
Facebook tends to rank second behind Twitter, Google and Amazon in terms of comparative valuation metrics, yet ahead of Snap Inc. Snap is valued more generously based on EV / Sales, and its GAAP P/E indicates the company has not yet reached profitability.
To determine FB's intrinsic value, a discounted EPS valuation model and a DCF valuation model are applied. Since humans are terrible predictors of the future, a reverse EPS and reverse DCF are applied to assess FB's valuation.
A few disclaimers before you review the models:
- The models are directional only, they are not exact, and they rely on many assumptions, which can drastically alter valuation readings (thus why many investors opt to do a sensitivity analysis, yet I save time by instead using a Reverse EPS and Reverse DCF analysis).
- I am happy to re-run the models for you with your own desired inputs if you disagree with my projections; however, I was thoughtful in the selection of each parameter/assumption and can articulate why it was chosen.
For the discounted EPS valuation model, a 5 year weighted EPS is used with growth rate assumptions of 40% for the first five years and 30% for the last five years. A P/E ratio of 25 (virtually unchanged) is assumed. A discount rate of 9.0% is applied given FB's enterprise value.
Source: Author's Own Calculations
For the DCF valuation model, a 3 year weighted FCF is used with growth rate assumptions of 20% for the first five years and 15% for the last five years. A discount rate of 9.0% is applied given FB's enterprise value. The DCF model does run for a ten-year period. For purposes of ease of visibility, only the first five years are displayed.
Source: Author's Own Calculations
In order to improve upon the above approach and to account for human error in growth assumptions, reverse Dividend and DCF models are applied. In essence, the following questions are asked: how quickly do FB earnings need to grow over the next ten-year period for FB to be fairly valued today? Is the growth rate returned by the model achievable? How quickly does FB's FCF need to grow over the next ten-year period for FB to be fairly valued today? Is the growth rate returned by the model achievable?
Source: Author's Own Calculations
For the Reverse EPS Model, FB needs to grow earnings by ~15.6% for the next 10-year period to be fairly valued today. During the past 10 years, FB grew earnings per share by 63.3% per year. During the past 5 years, FB grew earnings per share by 42.8% per year. During the past 3 years, FB grew earnings per share by 23.2% per year, with EPS growth accelerating to 64.8% during the last twelve months.
Based on such comparisons, if you believe the company can sustain a growth rate of ~15.6% for EPS (very likely) for the next 10-year period, the business is currently undervalued and provides an attractive entry point.
Source: Author's Own Calculations
The Reverse DCF Model is even more revealing; note that it is easier for companies to manipulate EPS than it is to manipulate free cash flow. FB needs to grow FCF by ~17.25% for the next 10-year period to be fairly valued today. During the past 10 years, FB grew FCF by 50.8% per year. During the past 5 years, FB grew FCF by 22.9% per year. During the past 3 years, FB grew FCF by just 11.4% per year, with FCF growth accelerating to 70% during the last twelve months. Clearly, there is cyclicity to the free-cash-flow generation and the growth rates are slowing down.
Based on the Reverse DCF Model, one would conclude fair value for Facebook stock currently (or slight undervaluation, depending on how optimistic you are regarding FB's FCF generation abilities for the next decade and associated growth rates).
Based on a holistic valuation exercise, Facebook stock appears to be fairly valued (DCF, comparative metrics) to undervalued (EPS) at the current price. The question for investors becomes what margin or buffer of safety to seek in light of the eroding competitive advantages and a swarming competitive environment.
While Facebook's valuation may present a compelling opportunity, there are major concerns with the fundamentals of the business and its future prospects:
- The reliance on Advertising revenues, which can absolutely be disrupted by competitors (as evidenced by Amazon's rapid rise in digital advertising). Europe, US & Canada - the highest average revenue areas per user - are stagnating in growth.
- The hype perpetuated by the company itself in relation to Augmented Reality, Virtual Reality, and the Metaverse, especially in light of such products only representing ~3% of revenues to date.
- The deterioration of Competitive Advantages #2 and #5 - Network Effect and Brand and Vision. The damage to the latter is of particular significance and concern, as the CEO and the company continue to demonstrate the same principles in their business model vision for the Metaverse.
- The ambitious and late entry into additional industries, such as the "creator" economy, "e-commerce," and "computing" despite a plethora of well-imbedded leaders and competitors in each.
- On a shorter-term note - the insider selling and technical set-up appear poised for further breakdowns in the share price if the correction continues. For investors with high-conviction in Facebook and its future, this would present an excellent buying opportunity.
Investors are strongly encouraged to research the company further and to avoid rose-colored glasses when assessing Facebook's prospects. A healthy dose of skepticism has saved many money while jubilation has at times hurt us all.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
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