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Ted is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
Hot tech IPO, uncertain future, astronomical earnings multiple. These are not characteristics that are generally associated with ‘value investors’ — those whose strategy tends to be buy-and-hold rather than buy-and-pray. However, a fair number of self-described value investors, including Whitney Tilson and Mario Gabelli, have owned stakes in Facebook (NASDAQ: FB) at various points since its IPO.
While Tilson and Gabelli are not exactly strict disciples of either Ben Graham or Warren Buffett, both investors tend to invest in under-the-radar and out-of-favor companies, rather than stocks with lots of buzz.
But as Facebook’s stock price violently plunged just months after its IPO, value investors were right to have taken an interest. Despite its current characteristics, there is a price at which even Facebook promises safety of capital and a satisfactory return on investment. The purpose of this article is to determine at what price value investors should feel comfortable buying Facebook.
From an investment standpoint, Facebook is best viewed as an online media company that is supported by advertising revenue. The company has faced scrutiny from investors and advertisers alike for the lack of reliable metrics available to measure the success of advertising campaigns. While this represents a legitimate near-term concern, the problems should dissipate as the technology evolves.
Facebook’s most valuable asset is the vast amount of information it collects about its users. Advertisers are willing to pay more for targeted advertisements, so the greater the breadth of accurate information about users (and the ability to sort the users into meaningful groups), the higher price Facebook can charge advertisers.
In addition, Facebook may eventually leverage its database of user information to compete with Google (NASDAQ: GOOG) in search. Although its initial foray into search has been underwhelming, Facebook has a much better shot than Yahoo! and Microsoft at stealing share from the search giant.
Google is the king of search because it provides relevant search results and monetizes results with relevant advertisements. It also benefits from inertia; web surfers have always used Google, so why stop?
Google’s search engine is valuable because high traffic plus relevant ads yields lots of revenue. Google’s vast user-tracking abilities are key to its advertising profitability, and its database of user information is rivaled by no other company in the world…except Facebook.
Facebook has the data, it has the traffic, it just needs to put together a sensible search engine that gets users where they want to go.
Whatever potential gold-mines exist in Facebook’s future currently take back seat to near-term concerns. For long-term investors, the company’s reliance on Zynga(NASDAQ: ZNGA) should be a legitimate concern.
Zynga represents 15% of Facebook’s revenue. The social game developer has made a number of moves in an attempt to become less reliant on Facebook, but Facebook still accounts for the vast majority of its revenue. Therefore, the downside to Facebook is not that Zynga gains bargaining power; the real risk is that Zynga goes bankrupt.
Zynga is unprofitable, but it has a large cash position that should help it ride out near-term losses — assuming it does not blow it all on acquisitions.
However, there is a reason that Facebook is not in the game development business; it is highly competitive and each new game is highly speculative. Even though it retains solid revenue streams from previously-launched games, Zynga will have to pay high multiples for other hit games if it cannot continue to innovate on its own.
Facebook will be in much better shape once it reduces its exposure to Zynga.
Facebook is basically the same as Google; it just has a different platform for advertisers and has better information on its users. So far, Facebook has made better capital allocation decisions than Google; it has remained focused on growing the value of its core asset — the Facebook platform — while Google invests in all sorts of gadgets and science projects that provide lower returns on invested capital.
Normally, sane investors would want to look back at a long history of reliable business results and buy at a low multiple of past normalized earnings — assuming the prior results can be sustained into the future. Unfortunately, investors do not have that luxury when valuing Facebook.
Valuing fast-growing companies with uncertain futures is really hard to do. It is best to keep the valuation simple; the more complicated you make a valuation, the less useful it becomes.
A simple yet reasonable way to get a ballpark value for Facebook is as follows:
- Take Google’s average net margin from the last ten years: 22%
- Assume Facebook’s revenue grows to $10 billion in 2017 — a 14.4% annual growth rate
- Apply 22% margin to $10 billion in revenue to get 2017 earnings of $2.2 billion, or $0.93 per share assuming no additional dilution
- Apply a 20x multiple of 2017 earnings to get a future value of $18.60 per share
- Discount it back at 7% to get a present value of $13.26 per share
Of course, you can play with the assumptions all day and come up with wildly different answers. That is the problem with valuing a company like Facebook — it’s also why the stock probably will not trade in a range acceptable to most value investors. The more assumptions you have to make — and the less historical evidence you have to back up your assumptions — the less reliable your intrinsic value estimate will be.
Many investors will paint my assumptions as too conservative; that is likely a fair description. However, it is better to be too conservative than too aggressive when valuing any company — but especially a company with a future as uncertain as Facebook’s.
The analysis presented in this article was not intended for gung-ho tech investors who regularly invest in the hot tech stocks of the day. Instead, it was intended for investors who tend to avoid the tech sector due to its inherent unpredictability. The latter investors would be wise, however, to consider buying Facebook if it ever trades in the low teens; that is the range at which the stock offers safety of capital and satisfactory return on investment.