Saturday, August 4, 2012 4 comments ++[ CLICK TO COMMENT ]++

Facebook Hits Attractive Valuation... If You Believe In Its Core Business

Been busy with some important personal matters but I do keep tabs on the markets. It's hard to believe how the Facebook story has played out.



When I took a deep look at Facebook and social networks, I never imagined Facebook (FB) would fall so quickly without any major economic crisis or stock market crash. IPOs are often poor investments but large initial issues tend to be more efficiently priced so it's somewhat surprising to see investors bail—even before we hit the expiry of the lock-up period for insiders.

If you believe in Facebook's business model—that's a big 'if' for some—the stock appears to be entering attractive valuations. The following summary from Yahoo! Finance, whose numbers aren't always accurate, compares Facebook to Google.

Facebook Isn't That Expensive

I don't like doing relative valuation comparison (it can be misleading and I'm more of an absolute return investor) but I'm going to do it here and compare Facebook to Google.

I don't think Facebook and Google can be compared directly due to differing business models—for instance, Google is more vulnerable to Internet disruption by mobile devices, whereas Facebook has problems monetizing its users—but this is the best comparison I can come up with for now. Google is more mature and much larger so its growth will be more constrained than what Facebook faces.


Facebook has depressed earnings (partly because Facebook hasn't figured out how to monetize its users fully, and partly because the company is reinvesting heavily to expand its business) so a lot of its earnings-focused metrics cannot be relied upon. This is also one reason I suspect the Street has sold off the stock. If you just look at earnings, EBITDA, or FCF, the company looks wildly overvalued. Most of the buyers of the stock are likely growth investors, and such investors have historically bailed whenever earnings growth isn't obvious.

I think the best measure to look at is sales, which cleanly indicates how much money the company is able to earn from its customers. We don't have enough of a history but so far, sales have continuously increased, with trailing 12 month figure surpassing $4 billion. Facebook has around 800 million users (official number is a hundread million higher but some of the accounts aren't real accounts i.e. fake, duplicates, etc) so Facebook is generating around $5/user. A lot of the users are from poor, low-income, countries so Facebook is never going to earn as much as some developed-country-focused online businesses; but nevertheless, this figure should go up once Facebook convinces advertisers of the high-value proposition its platform offers.

Assuming Yahoo! Finance numbers are accurate, Facebook is trading at a Price-to-Sales value of around 8.7 whereas Google is at 4.8. Although some think Facebook is wildly overvalued, it isn't that overvalued on a sales basis compared to Google. If Facebook just doubles its revenue, which isn't that difficult for such a big company generating only $4 billion in sales, it will be at similar P/S valuation as Google. This isn't going to happen magically but I believe it is within reach.

On an enterprise value basis, Facebook is also not that expensive if you believe it can double its revenue in the near future. Enterprise-value/Revenue of Google is around 4 versus 6.5 for Facebook, or about 50% higher. I don't usually pay attention to enterprise value but it is important here because Facebook has sizeable cash (with no debt) on its balance sheet.

What May be a Reasonable P/S Metric?

One can never be sure what the future revenue will look like but what may be a reasonable P/S valuation?

Geoff Gannon (@GeoffGannon) had some thoughts on Facebook a while ago and his feeling was that Facebook may warrant a P/S of 5 (as usual, bolds in the quote are by me):
Let’s think about that $100 billion IPO price.

If Facebook ever had 5% of worldwide advertising spending it would justify the $100 billion IPO valuation.

As a no-growth business Facebook should trade around five times revenue.

Look at the company’s operating margins. In 2011, Facebook had revenue of $3.71 billion and operating income of $1.76 billion. That’s a 47% operating margin. At a 35% tax rate, that would put net margins around 30%. It’s pointless to talk about free cash flow right now because of Facebook’s rapid growth. But the owner earnings picture at Facebook is probably in line with something like Moody’s (MCO).

Basically every $1 of revenue turns into about 30 cents of after-tax cash. Divide that 30 cents of owner earnings by 5 and you get 6 cents. A free cash flow yield of 6% would not be odd for a big public company. Basically, that’s a P/E of 15. So that’s why I say Facebook would be worth five times revenue without adding any growth premium. (Of course an advertising supported media business with a wide moat should be able to manage 5% to 6% growth in nominal terms – basically it should match GDP over time.)

Every 1% of global advertising spending is $5 billion. So, with an enterprise value of five times revenue, a company with a 1% share of global advertising would be valued at $25 billion. This is only true if you have Facebook’s economics. Outside of local media (most of which is decaying), very few companies have anything like Facebook’s economics. Revenue is worth a lot less to them. I don’t want you to think five times revenue is the right value for all media companies – it’s not.

Facebook doesn’t really need working capital. And won’t use debt (media companies don’t need debt – they usually just use it when they buy each other up). So, that’s basically $25 billion in market cap per 1% share of the worldwide ad market you think Facebook will have.
For reference, the worldwide advertising market in 2010, according to GroupM is estimated to be around $490 billion (US market is around $143 billion out of that). Given how Facebook is truly a global business, I think it is reasonable to assume that it will get a piece of the global advertising market.

I agree with Gannon's estimates: 5x sales for a no growth business with high margins seems reasonable.

Final Word for Now

Facebook is trading at P/S of around 8.7 and EV/Revenue of around 6.5. I think it has hit attractive valuations. If it falls a bit more, it will definitely pique my interest. Beyond the valuation, investors need to believe in Facebook's core business. I understand how powerful the company's business is—the moat is truly massive—but I'm still thinking about how their business may evolve as mobile becomes more dominant.

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4 Response to Facebook Hits Attractive Valuation... If You Believe In Its Core Business

August 5, 2012 at 8:04 AM

I actually did a valuation of Facebook - last month (on July 8th) before it declined - and updated it recently on (on August 5th after the stock dropped a lot.

Anonymous
August 29, 2012 at 5:04 PM

I think there have been some recent comments to the effect that Yahoo Finance and other have understated the share count for Facebook and have not included the class of shares owned by the founder. If true, then the valuation metrics they provided are useless...

August 29, 2012 at 11:11 PM

Hi Anon,

Thanks for brining the potential share count problem into account. However, the initial count that was used in many valuations, including the ones I cited here, are correct AFAIK. Whatever is listed in the prospectus is the correct one as far as I'm concerned.

I think some of the confusion is due to the float, which has been increasing as insiders unload their shares onto the public market. But that shouldn't impact the total number of shares, assuming your initial number was correct.

February 6, 2013 at 1:35 AM

Facebook is a very overrated company. Its certainly not another google.

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