How Wide is Facebook's Economic Moat
Jonathan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
No matter whether it is an individual or an institution, its greatest assets are also its greatest liabilities.
Before The Great Recession, Wall Street firms such as Goldman Sachs and Morgan Stanley soared on the strength of the highly leveraged trading operations: we all know how well that ended. At present, the most powerful assets of Facebook Inc (NASDAQ: FB) are how free and open it is, and its high profit margin.
Without question, these are also its most glaring liabilities.
When Warren Buffett invests, he searches for "...economic castles protected by unbreachable moats." That is why Buffett buys railroads (Burlington Northern Sante Fe), utilities (Mid-America Energy) and major chemical companies (Lubrizoil) for the portfolio of Berkshire Hathaway (NYSE: BRK-A). He also buys shares of Coca Cola and Kraft as each has formidable barriers-to-entry in its industry. There are no social media companies like Facebook in the portfolio of Berkshire Hathaway as there is neither an economc moat nor a barrier-to-entry in the business model. That is also why Buffett did not buy any dotcom stocks.
An economic moat or barrier-to-entry deters competitors, which results in high profit margins. As an example, Coca-Cola has a profit margin of 18.63%. Competitors such as Pepsico and Dr Pepper Snapple have profit margins right around 10%. These establish what the profit margin should be for established companies in the soft drink group of the beverage sector.
At present, Facebook has a profit margin of 26.95%. But other social media companies are losing money....big time. Zynga has a negative profit margin of 41.57%. Groupon has a negative profit margin of minus 10%. There is no congruity in the profit margins for Facebook and others in the social media industry. It is worthy of note that these stocks were up in the bullish period for social media stocks in the pre-IPO days for Facebook.
There is a saying in investment banking that 30% profit margins don't last. Facebook's high profit margin makes it a target: one of its greatest assets is also a liability.
Facebook is already competing with Google (NASDAQ: GOOG), Microsoft (NASDAQ: MSFT) and Apple (NASDAQ: AAPL). Google+ was launched by Google over a year ago as a social media site. Google also owns Youtube, Blogger and Orkut. iTunes Ping is touted by Apple as a "social network for music." Microsoft just bought Yammer, described as a "corporate social network" for $1.2 billion.
Not that long ago, just this spring, Nokia Corporation sold more mobile phones than anyone else on the planet. It was Research-in-Motion who introduced the smart phone to the world with the Blackberry. Previously trading around $40 a share in late 2007, Nokia is now about $2.00. At over $140 in 2008, Research-in-Motion is now at close to $7 a share.
Nokia Corporation and Research-in-Motion, unlike Facebook, actually sell products.
But the lack of an economic moat or effective barriers-to-entry doomed both Research-in-Motion and Nokia Corporation. Lured by the high profit margins of mobile phones and the attendant service contracts, an onslaught from Apple, Google, Microsoft and Samsung (SSNLF) descended. While the high profit margins for companies such as Apple (27.13%) and Microsoft (31.96%) still remain, the question is for how much longer will Nokia Corporation and Research-in-Motion.
Facebook can survive, but its profit margin of close to 30% will not. A good indicator for maintaining a high profit margin is the price-to-earnings growth ratio, which investing legend Peter Lynch considers to be one of the most important. The price-to-earnings growth ratio determines a stock's value while factoring in its earnings growth. The profits of a company come from its earnings. An adequate price-to-earnings growth ratio is 1: the lower the better. Apple has a price-to-earnings growth ratio of 0.71, which is very bullish. Google also has a robust price-to-earnings growth ratio of 0.95.
The price-to-earnings growth ratio for Facebook is 3.76.
Google and Apple are established companies in mature industries with a broad array of offerings that serve as formidable economic moats and barriers-to-entry to protect the profit margins of each. It is difficult to see what Facebook has to repel competition so as to maintain its profit margin well into the future.
jonathanyates13 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Facebook, Google, and Microsoft. Motley Fool newsletter services recommend Apple, Google, and Microsoft. 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.