Tech growth stocks were the darlings of 2020 and had a tremendous bull run, with the the Nasdaq gaining an incredible 128% from its March lows during the year. However, since January 2021, many of these stocks have been sliding downwards, and the Nasdaq even flirted with bear market territory in early January this year, falling 17% at one point.
This is in part thanks to rising inflation (+7% on the Consumer Price Index) climbing above the Federal Reserve's target and fears about rising interest rates. These rising interest rates disproportionally affect growth stocks as their value is based on cash flows estimated further into the future.
The good news is many of these stocks are now approaching what legendary investor Peter Lynch called "growth at a reasonable price," or GARP territory. Thus, in this article, we are going to take a look at the top three tech growth stocks that I believe are undervalued. Let's dive in.
1. Meta Platforms Inc.
Meta Platforms Inc. (FB, Financial), the company formerly known as Facebook, has seen a huge decline - a historic one, in fact, with the biggest single-day market cap loss in U.S. history.
Meta stock got hammered at the announcement of their fourth quarter and full-year earnings for 2021. User growth slowed down in 2021, where Facebook daily active users (DAUs) were 1.92 billion on average, an increase of just 5% year-over-year. For the first time ever, DAUs were down quarter-over-quarter by 0.05%!
Annual growth was less than the 2020 lockdown highs of 10.9% user growth. But more worryingly, this was also slower than the pre-pandemic growth rate of 8.56%. I have created a table below showing the user growth I have been tracking quarter over quarter.
The company also is seeing increased competition from platforms such as TikTok, which now has over 1 billion monthly active users (MAUs). This is fast approaching Instagram’s 1.4 billion MAUs. The MAUs for several popular platforms are as follows:
- Facebook - 2.9 billion
- YouTube - 2.2 billion
- Instagram – 1.4 billion
- TikTok – 1.0 billion
- Snapchat (SNAP, Financial) – 500 billion
- Pinterest (PINS) – 480 million
- Twitter (TWTR) – 397 million.
One reason you may want to consider Meta's long-term potential is that it is still led by its founder, Mark Zuckerberg. Zuckerberg has executed a very similar strategy to Microsoft (MSFT) in the late 90's, called the "Fast Follow." When a new competitor product starts to gain traction, Meta tries to acquire or copy it fast:
- Instagram (Acquisition)
- Snapchat (Instagram Stories)
- TikTok (Instagram Reels)
- YouTube (IGTV/Facebook Watch)
Zuckerberg has a large insider holding and owns approximately 12% of the company, which means he has skin in the game. For me, the future of Meta is a bet on the execution skills of Zuckerberg and his ability to continually pivot the company as he has done previously.
Zuckerberg’s latest pivot in true silicon valley style is a vast investment into the metaverse, which is set to be a cumulation of virtual reality, augmented reality and even 5G. Zuckerberg is putting his money where his mouth is and has invested a whopping $10 billion into the Metaverse.
I have completed a valuation model for Meta stock using my advanced discounted cash flow model. I have predicted a conservative revenue growth rate of 11% next year and then 15% for the next two to five years. In addition, I have predicted margins to decrease (due to increased investment) from 46% to 44%. From my valuation, Meta is 20% undervalued with a fair value of $408 per share.
Aside from the uncertainty of whether Meta will be able to catch up with and overtake competitors in the metaverse, one other major risk with investing into Meta is the implications on mental health. According to one leaked Whistleblower study, 13.5% of U.K. teen girls said Instagram worsens suicidal thoughts, while 17% of teen girls say their eating disorders got worse after Instagram use.
Thus, long term feelings of depression from social comparison may urge users to not be as active on the platform and this will affect Facebook’s bottom line.
2. Spotify
Spotify (SPOT, Financial) is the global market leader in music streaming with 408 million users and 180 million premium users as of the fourth quarter of 2021. The company even has a greater number of subscribers than the big tech giants such as Apple (AAPL, Financial) Music, which has 78 million paid subscribers, and Amazon (AMZN, Financial) music, which has approximately 60 million paid subscribers.
Now, although Spotify is still winning the music streaming battle against the tech giants, they have recently announced some poor guidance for 2022. The company guided for 1 million fewer subscriber additions for the first quarter of 2022, and they also refused to provide an annual forecast for Wall Street. Then there was the major controversy on the Joe Rogan podcast, where an uncredited doctor made some unsupported statements that spread misinformation and outraged the medical community.
These factors have kept the stock depressed, down 34% from highs in November 2021.
Despite these issues, Spotify still has the largest music subscription base in the world. Premium subscribers grew 16% year-over-year in the fourth quarter, a 4% increase compared to prior quarter.
In addition, Spotify has very low subscriber churn at less than 4% and strong network effects. Thus, this recent controversy could simply be noise, which is hiding the fundamentals of the business. As I like to say, volatility could equal a potential buying opportunity.
In the fourth quarter of 2021, revenue grew to 2.689 billion Euros ($3.070 billion), which is up 24% year-over-year (or 20% on a constant currency basis). For my valuation model, I have been conservative and estimated 16% growth next year and 15% for the next two to five years. Thus, I get a fair value of €207 per share, which means the stock is approximately 18% undervalued at the current stock price of €170.
3. Zillow
Zillow Group (Z, Financial)(ZG, Financial) is the most popular online real estate platform in the U.S. The company recently made headlines after their tumultuous exit from the house flipping business. The company failed to accurately predict home sale prices with its mathematical model and now is experiencing a large writedown of $544 million, in addition to slashing 25% of their workforce.
The good news is the wind down is going better than expected, according to a press report by Zillow on Dec. 2, 2021. Zillow has sold over 50% of the homes it needs to sell. The move to exit the house flipping business may not be all bad, as Zillow will be exiting a capital heavy business and can now focus more on their asset light online business model.
Zillow's core online business is fantastic with a high Ebitda margin of 40%+. Thus, focusing on improving their existing platform through technology could be a better strategy in the long term.
Plugging the numbers into my valuation model, I have predicted a conservative growth rate of 20% for next six years (previous years revenue growth was 51%) and 15% to 20% revenue growth moving forward. I have also predicted the operating margin to increase to 13% in five years, which is just over the industry average.
My valuation for Zillow from those estimates is $67 per share. The stock is currently trading at $47 per share, and thus the stock is more than 30% undervalued, giving a margin of safety.
The founder and CEO Rich Barton started the company 16 years ago and is an experienced veteran in running online businesses. He is the founder of Expedia (EXPE, Financial), Glassdoor and is also on the board of Netflix (NFLX, Financial).
Insiders own 8.93% of Zillow shares, with Barton owning around 4% of those shares and thus having skin in the game, which is great to see. Investing with great founders is an investment strategy that many successful hedge fund managers follow, such as the now retired Nick Sleep, whose fund earned an incredible 20.8% compounded returns for over 12 years.
Final thoughts
To conclude, some tech growth stocks are experiencing newsworthy troubles which have caused them to decline massively in the short term. Despite these troubles, many of these companies are still market leaders in their respective industries, led by exceptional founders and having strong financials and growth potential. Thus, a long-term investor may view some of these situations as temporary headwinds and the volatility as potential buying opportunities.
