- Facebook trades at a reasonable valuation when compared to peers.
- Facebook’s revenue growth paired with falling incremental cost will continue to improve its profitability.
- Assuming Facebook can reverse the trend in share dilution through share buybacks, EPS growth will improve drastically.
Facebook (NASDAQ:FB) trades at a reasonable valuation multiple when compared to peers, and is set to grow earnings at a fairly exponential pace due to favorable cost tailwinds paired with continued growth in its core business. In future years, Facebook will eventually return cash to shareholder through share buybacks, which will reduce the negative impact share dilution has had.
Over the past five years, Facebook has increased in value quite significantly. And while the stock may be subject to market volatility, the forward P/E metrics are encouraging. Based on the below figure, Facebook’s forward PE ratio is 36.36 (using fiscal year 2015 estimates for earnings).
|FB Market Cap (intraday)||190.95B|
|Enterprise value (Aug 12, 2014)||176.33B|
|Trailing PE ratio (ttm, intraday)||95.25|
|Forward PE ratio (fye Dec 31, 2015)||36.36|
|PEG ratio (5 yr expected)||1.21|
|Price to sales ratio (ttm)||18.97|
|Price to book ratio (mrq)||10.22|
|Enterprise value/revenue (ttm)||17.61|
|Enterprise value/EBITDA (ttm)||32.5|
Source: Yahoo! Finance
The 5-year expected PEG ratio of 1.21 is solid, while it’s not below 1, between 1 to 2 is generally considered to be good. The 5-year PEG ratio divides the PE ratio by the projected five-year growth rate, and assuming the multiple is slightly above the growth rate, the stock is trading at a relatively reasonable value.
At 18.97 times sales, many would consider Facebook expensive. However Facebook’s high profitability when compared to low margin businesses in retail, basic materials, and manufacturing helps to justify the higher price to sales ratio.
PEG ratio (5 yr expected)1.213.872.95 Price to sales ratio (ttm)18.9726.3813.85
|Quarterly Revenue Growth (YoY)||0.61||1.24||0.47|
|Gross Margin (ttm)||0.81||0.63||0.87|
|Operating Margin (ttm)||0.44||-0.88||0.02|
|Net Income (ttm)||2.37B||-853.08M||-14.06M|
|PE ratio (ttm)||95.25||NA||NA|
Source: Yahoo! Finance
When I compare Facebook to other businesses in its space (Twitter and LinkedIn) Facebook, price to sales ratio sits in the middle with LinkedIn having the lowest PS ratio. However, LinkedIn doesn't generate any profit. Since LinkedIn doesn't earn any profit, the business itself is worth less intrinsically, and on a relative basis that translates into a lower P/S multiple when compared to peers.
Out of the three stocks in focus, Twitter is the most expensive, and it doesn’t generate earnings quite yet. However, the three companies are expected to boost their profitability as they scale their businesses over time. Furthermore, share related compensation will continue to weigh heavily on earnings at these three companies, which is why Twitter and LinkedIn often report a Non-GAAP EPS along with a GAAP EPS figure. The share related expenses helps to explain the negative earnings, and the difficulty in comparing Facebook relative to its peers.
Facebook Fundamental Trends
Since its IPO, Facebook has been able to improve its gross margin, operating margin, which resulted in exponential growth in terms of net income.
The gross margin improvement comes from falling server costs, which helps to reduce on upkeep. Also, the operating margin has continued to exhibit notable improvement as a result of favorable R&D, SG&A trends as indicated by the income statement below.
Looking at Facebook’s Q2 results, cost of revenue increased by 17%, R&D costs increased by 17%, marketing and sales increased by 33%, and general & administrative expenses increased by 13.8%. These cost categories grew at a significantly slower pace than revenue, as revenue grew by 60% year-over-year. Assuming costs trend at a slower rate than revenue growth, the net profit margin and net income will continue to improve exponentially. In Q2 net income grew by 137% year-over-year.
However, for EPS metrics to follow net income and improve significantly, share dilution from stock warrants will need to decrease in future fiscal years. Rather than share count increasing, you’d want Facebook to use its ever improving free cash flow to buy back shares to diminish the impact from stock expenses. Assuming this key trend reverses itself, on an EPS basis, Facebook will start to look more attractive.
The added dilution also comes from Facebook’s use of share issuances to buy-out companies. Since these types of deals may not be accretive, the added dilution can be a double-edged sword. On one hand, if the M&A activity results in incremental growth on top line and bottom line beyond what was invested, Facebook investors can absorb the negative impact from dilution through continued organic growth. However, if these deals fail to become accretive, Facebook investors have to factor in the negative impact from dilution into their financial models, and value the business accordingly.
Facebook is a fundamentally sound investment when comparing the value metrics to peers. However, ignoring valuations, the profitability is set to improve quite significantly if expenses and revenue continue to grow at such a wide differential. Assuming the company buys back shares in future fiscal years, the share outstanding figure will decline, and that will help support Facebook’s valuation in future accounting periods.