Facebook Stock Is Not As Overvalued As You Think

  • As videos gain traction, so will engagement levels. This will lead to even more revenue per user over time.
  • Instagram and WhatsApp will add billions to Facebook's top line.
  • I like the growth levels in all of Facebook's main fundamentals except gross margin levels. I expect these levels to surpass 90% soon.

Facebook (NASDAQ:FB) is expected to announce its fourth quarter earnings at the end of January and on the surface there doesn't seem to be many headwinds that have the potential to slow this company's growth curve. In the third quarter, Facebook beat analysts expectations on both the top and bottom line which made Facebook stock rally past $110 a share. I would caution Facebook bears not to take a big short position in Facebook stock despite its lofty valuation.

Facebook is now selling for around 107 times earnings, the stock price is currently around $107 and EPS estimates are $1 a share. Bulls will then say that the level of investment is elevated (which may be the case) so let's take a look at the company's price to sales ratio which is around 19. This again looks very expensive especially when you compare it to the S&P500 average which is a mere 1.8. Another bone of contention bears had was the share count. In November of this year, the float spiked past 2.8 billion but since then it has come down to current 2.27 billion, which has reassured the bulls.
FB stock chart

Source:Facebook Price To Earnings Ratio by amigobulls.com

After anlyzing Facebook's fundamentals, the only way we can conclude that Facebook stock is fairly valued is when you consider the growth potential the company hasn't tapped yet - especially in emerging markets. Writers and investors alike have been advising to short Facebook stock but now may not be the time. Besides the surging user growth number (1.55 billion reported last quarter - again ahead of expectations), this company has multiple growth avenues which it will likely tap in the near term.

Growth In Ad Revenues

Even with tepid user growth and engagement levels going forward, Facebook will undoubtedly increase revenues from its ads for the following reasons. Firstly out of the 40 million+ businesses currently on Facebook, only 2.5 million are availing of Facebook's ad service. Obviously many of these businesses are in the same industry which is going to create more competition which will lead to prices of ads rising. The big trend here will be local businesses advertising online which I see gaining big traction in the years to come.

Secondly Facebook is pushing videos as it increases engagement levels (time spent on the platform) which make video ads more remunerative. Facebook has been already been shifting its text and image ads to video and I suspect the shift will only intensify in the quarters to come.

Thirdly I believe marketers in the future will be able to bring their products to market more efficiently through enhanced technology. We already know that technology companies track everything we do through our internet searches and activity through apps. This is only going to advance more which will mean even more targeted prospects for marketers and businesses. What's the takeaway here? The more targeted the prospect, the more the advertiser will pay which again will boost ad prices.

Monetizing WhatsApp and Instagram

Speaking of WhatsApp and Instagram, Facebook is still in its infancy with relation to its advertising efforts. With relation to Instagram, Facebook has already started monetizing the program by placing ads into users feeds (400 million+ active engaged users) so expect sharp growth here over the forthcoming quarters.

WhatsApp on the other hand probably wont be as profitable as Instagram in terms of revenue per user but monetization potential is still very strong. The future of successful online sales is in getting businesses and customers to interact in a social setting which is why Facebook (social) will grow its advertising revenues faster than the likes of Alphabet Inc-C (NASDAQ:GOOG) (direct response) going forward.

Facebook's intent here on WhatsApp is to enable businesses interact with users through a chat function that has already been set up. I see this as extremely powerful tool as the user will have the possibility to interact with multiple businesses through the mobile app instead of visiting company websites and sending e-mails, etc. A prospect is always going to use the quickest option to get his or her query answered before deciding on a purchase. Furthermore you can see this trend gaining traction now as local companies are giving out their WhatsApp number (as it encourages interaction) because they know its a softer selling technique compared to other options.

Facebook Relative Valuation And Growth

Finally when you compare Facebook to Amazon (NASDAQ:AMZN) growth rates, Facebook doesn't look expensive across the main fundamental metrics. Amazon's stock has rallied hard this year and has easily outperformed Facebook stock YTD. (see chart)

FB stock chart

Source:Facebook Stockprice Data by amigobulls.com

However when we look at growth rates in revenue, operating income, operating margin and gross margin levels since 2012, Facebook is beating Amazon across all of these metrics with the exception of gross margin growth. These two companies are similar in that they are investing huge sums of capital back into their businesses to fuel growth. Which is why investors should ignore price to earnings ratios for the most part.

In fact, Facebook's balance sheet shows that its total operating costs metric which came in at $3.05 billion last quarter was only at $1.8 billion in the third quarter of 2014 which means investment in the business is now rising faster that revenue growth - something Amazon was well know for. Therefore ignore price to earnings ratios as in a company like Facebook they really don't matter as growth is the key - not earnings.

Nevertheless the one growth metric where Facebook is losing to Amazon is gross margin. Facebook's gross margins are far higher than Amazon's (83% compared to 32%) but Amazon's growth in its gross margin is 30% since 2012 compared to Facebook's 13.5%. If these two figures converge, I believe you are going to see astute investors slowly moving capital out of Amazon and into Facebook. Furthermore I believe there is less competition in Facebook's space which should enable it grow this metric faster than Amazon over time.


To sum up, Investors should not be overly deterred by Facebook's seemingly high valuation. Yes there are some variables (such as regulation risks or privacy fears) that could stifle Facebook stock's growth but these risks haven't affected the stock performance so far. On the main platform there is still huge upside potential when you consider the growth of video and the potential number of advertisers that could use this platform in the future. Instagram and WhatsApp are still virtually untapped and if gross margin growth could increase more robustly, I'm sure Wall Street would give Facebook stock an even higher valuation. This stock may have quite a long way to run up yet.

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  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
  • I am not an investment advisor, and my opinion should not be treated as investment advice.
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  • I do not have any business relationship with the companies mentioned in this post.
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Comments on this article and FB stock

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Jack, for ad sales, what impact will the upcoming election have?

A lot of money to be spend on ads next year.

Also you assume the businesses not advertising on Facebook will do so. What if they don't advertise due to the low performance of Facebook ads?
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