Where's the Bottom for Facebook?
Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Spoiler alert: it's at around $19 per share. In the era of Facebook and Words With Friends, I know I can't keep anybody's attention for too long, so I went ahead and gave you the goods right away. If you're interested in how I got this number, read on.
Right now, Facebook (NASDAQ: FB) is a speculative play. Most investors are expecting that the company will manage to monetize its user base in novel ways, and there are as many ideas for new revenue streams as there are Facebook investors. Charge to play games? Paid promotion of important messages? Release a Facebook phone? Sell personal data directly to marketers? Collect underpants? The list goes on. Proponents argue that speculation is warranted, since Facebook is a young innovator with many potential avenues for growth.
But what if it doesn't do any of those things, or doesn't do them well? What if you're interested in Facebook for the business it has now, rather than the business it might have? After all, Facebook isn't exactly a risky start-up burning through cash: it's a massive company with an entrenched user base of over 900 million, and at 8 years old, Facebook's a geezer compared to social media players like Groupon (NASDAQ: GRPN) or Zynga (NASDAQ: ZNGA). More importantly, unlike a lot of speculative plays, it actually makes money, pulling in $3.7 billion in revenue and turning $1 billion in profit last year. With sky-high valuation multiples based on what Facebook might do someday, I propose that a bottom for Facebook stock, in freefall since its IPO, would be the intrinsic value of its current business. To find out what that is, I performed a discounted cash flow analysis.
DCF models use projected revenue growth and profit margins, apply a discount rate to account for the time value of money and the perceived risk of an investment, and compute a net present value of a company based on earnings power. For Facebook, I used a discount value of 11%, reflecting Facebook's riskier prospects and higher valuation than its peers in the internet tech space, where the aggregate Weighted Average Cost of Capital is 9.5% I also applied a present value of cash flows of 3% to account for long-term inflation.
Projecting revenue is a bit trickier. If we're looking at the business Facebook has today, namely one that is built on advertising, then the two most relevant metrics are the number of users and the average revenue per user (ARPU). There are approximately 2.2 billion people with internet access, meaning Facebook's penetration is currently at 40%. User growth has been slowing from double digits only a few years ago to 5.6% at the end of 2011. I'll use a 6% user growth rate. Average revenue, however, has been increasing rapidly, particularly in Facebook's core market in North America where users bring in $9.51 on average compared to $4.34 for all users. I'll assume that as Facebook penetrates Europe and Asia, these users will generate revenue comparable to today's North American users. Let's also say that Facebook can address advertisers' concerns that Facebook campaigns offer a very poor return on investment, and so in North America ARPU will climb higher to rival the current user monetization of Google (NASDAQ: GOOG), the undisputed king of internet advertising, at $30/user. This scenario has Facebook sitting pretty in 2022, with over 1.7 billion users worldwide generating an average of $13.50 per user, yielding nearly $23 billion in revenue for Zuckerberg's dorm room project.
So, after accounting for cost of goods sold, debt service, and other expenses, I feed my assumptions into the DCF model, and we get a net present value per share of $19. This would yield a present P/E of 38.7. While that's still a richer valuation than peers like Google or Baidu (NASDAQ: BIDU), our conservative discount rate helps to price in downside risk. At around $19 per share, I would expect value investors to start to get interested in the stock, and begin buying on dips. At that point, investors are buying into the earnings Facebook is generating with its current business model, rather than the business model that Zuckerberg might dream up someday.
DCF models can give a strong impression of scientific accuracy due to their mathematical approach and precise results, but did you notice the key words about this method? “Projected,” “perceived,” “assume,” “trickier,” “approximately,” “stab in the dark” - OK, that last one isn't in there, but it's important to remember that DCF models are only as good as their assumptions. No matter how excellent the model, if you put garbage in, you get garbage out. So if you think my assumptions are garbage, let me know in the comments. We'll feed yours into the model and see what comes out.
Daniel Ferry owns shares of Google. The Motley Fool owns shares of Baidu, Facebook, and Google. Motley Fool newsletter services recommend Baidu and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
