- There's a high opportunity cost of owning Facebook stock versus a consortium of large companies.
- The relatively lower income generation makes valuations risky.
- Continued equity dilution due to employee compensation and acquisitions is a risk as well.
For the past two years, Facebook (NASDAQ:FB) has outperformed the S&P 500 with a near 100% rise in its stock price. As a member of the FANG's (Facebook, Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) & Alphabet Inc-C (NASDAQ:GOOG), the world's leading social network became a favorite equity holding for technology bulls. With consistently increasing mobile revenue, a large and highly engaged user base and two of the most widely used mobile applications (Instagram & WhatsApp), investors may be tempted to purchase more Facebook shares. Long-term investors should, in fact, stay away from owning Facebook.
Cost Of Facebook Ownership
On March 11th, 2016, Facebook had a market capitalization of $310 Billion. Investors purchasing shares of a stock essentially purchase a portion of the underlying business. An individual seeking a long term investment can choose between buying shares of Facebook and buying shares of other companies or collections of companies.
For instance, to understand the opportunity cost, look at Facebook's market cap and see how that compares with a lot of other investment options, albeit not in a similar space. What does $310 Billion (Facebook's market cap) buy?
$310 Billion will buy an investor all of Facebook giving them the world's largest social network and two leading mobile applications (InstaGram and WhatsApp). $310 Billion will also buy an investor the largest grocer in the U.S. Kroger (NYSE:KR), two leading consumer products companies Kimberly-Clark (NYSE:KMB) & Clorox (NYSE:CLX), a top asset manager T. Rowe Price (NASDAQ:TROW), the second largest US automaker Ford Motor (NYSE:F), an investment bank Goldman Sachs (NYSE:GS), an energy company that Warren Buffet has recently purchased a stake in, Phillips 66 (NYSE:PSX), an agriculture machine manufacturer Deere & Co. (NYSE:DE) and $1 billion left over in cash.
Which option, the consortium or Facebook, should an investor purchase an ownership stake in? Which option has a moat and is likely to over perform for years to come?
Investors seeking a potential technology growth play can also find superior options over Facebook. As of March 11, 2016, $310 Billion would purchase all of Facebook or all of Amazon and Netflix; the "A" and the "N" in the FANG's. An investor with $x to invest can purchase either a portion of the world's largest social network (Facebook) or the world's largest e-tailer and cloud computing services provider (Amazon) combined with the world's largest streaming media service (NetFlix) and still have a portion left in cash.
Facebook can easily lose it's social networking throne to upstarts like SnapChat or whatever the newest social network will be, as other social networks have fallen behind in the past. Amazon has a large moat in retail with its warehouses and cloud services (AWS). NetFlix has it's award-winning original shows and licensing deals with TV and movie studios. Which investment is a better long term option? A portion of Facebook or a portion of Amazon and NetFlix combined?
Minimal And Future Income Generation
Once a company becomes large, income generation becomes a key measure of performance. A company can only be a growth stock for so long. By market capitalization, Facebook is the world's eight largest publicly traded company. How do Facebook's 2015 GAAP earnings compare to the consortium of companies used above?
In 2015, Facebook earned $3.6 Billion while the consortium earned over $24 Billion in net income. An investor can allocate a certain amount of dollars to Facebook or to a consortium that earns almost 7 times as much annually. The consortium pays dividends while Facebook does not. Which option is a better long term investment? Do note that this also shows how much more expensive Facebook is compared to all of these companies.
Facebook bulls often counter such an argument with the fact that the company is still in a growth stage and profits do not matter. For comparison, Apple, once a darling tech growth stock, is increasing net income faster than Facebook but is no longer treated like a growth stock with its earnings multiple of 10.
Facebook will need to dramatically increase its net income for it market valuation to continue increasing. It will take Facebook years if not more to match the income generation of the consortium of companies mentioned above. Facebook will eventually begin trading at a multiple similar to Apple (10) or Alphabet (34) versus the current 85. So even if earnings do grow, the stock price may or may not move to reflect the same.
In the past three years, Facebook has purchased WhatsApp ($19 B), Oculus VR ($2B), Live Rail ($500 M) and numerous smaller companies. All these acquisitions involved issuing of shares. Facebook, like other technology companies, also relies heavily on stock-based compensation for employees. Each acquisition Facebook has made and every stock option grant that is exercised dilutes the ownership of investors. Since going public in 2012, Facebook's total shares outstanding have consistently risen.
Investors who purchase shares in Facebook can expect continual dilution in their ownership. Unlike Apple and Alphabet (formerly Google), Facebook has not begun a share buyback program. Owning stock in a large company ($300 B in market cap) that continually dilutes ownership is not likely to be a wise long-term investment decision.
Facebook's performance the past two years along with its large active user base and ownership of Instagram and WhatsApp may lead investors to think it's a long-term opportunity. However Facebook's large market capitalization leads to a large opportunity cost in owning shares, the company earns a significantly lower amount of net income versus an equally sized consortium and the company continues to dilute ownership with new share issuances for acquisitions and employee compensation.
Additionally, Facebook can easily lose it's social marketing throne to new upstarts like SnapChat or some other app. The majority of high-income individuals are already on the social network; the remaining few billions are likely to be mostly lower income individuals from less developed economies. How much growth in advertising can those customers bring? Not all that much I'd imagine.