Facebook (FB, Financial) is the world’s largest social network and the company has been expanding its reach across various platforms over the last few years. Facebook recently revealed that it had reached 1.5 billion monthly active users (MAUs) on its web platform, while mobile also continues to grow.
Just after going public in 2012, Facebook faced serious challenges about its chances of monetization in mobile as people continued to cut the amount of time spent on desktop platforms in favor of mobile. Facebook, however, has since proven many wrong, prompting a run in stock price that has seen it hit highs of $110 per share.
Facebook currently trades at about $104, which equates to a P/E ratio of about 104x, yet even at such a high earnings multiple, Facebook may not be getting the credit it deserves from investors. Currently, the stock has a price target of $123 for the next 12 months, which is the same figure expected for Netflix (NFLX, Financial) shares.
Netflix, the world’s leading online video streaming company, currently trades at a P/E ratio of about 296x based on its current stock price of $111. Why does Netflix have a P/E ratio of 296x versus Facebook’s multiple of 104x, but the same price target for the next 12 months? What’s happening here? Does this mean that Netflix is a better company than Facebook?
Investors appear to have completely bought into Netflix’s business model without leaving anything to chance. Netflix has an interesting business, which many are betting on to disrupt the television industry by rendering pay-TV services obsolete. Many consumers are shifting towards streaming services, and this is why investors are willing to pay a hefty premium in order to own a stake in the company.
Netflix has been reinvesting a majority of its money in the business as it seeks global expansion. This reinvestment has come at the detriment of profits, and perhaps this also explains why the stock trades at such high P/E.
This is similar to what Amazon.com (AMZN, Financial) has been doing over the last 20 years -- sacrificing profits for business growth. Amazon has hardly reported any profits when compared to the level of revenue the company has been raking in over the past few years.
Amazon currently trades at a P/E ratio of 928x. The company has been trading at high valuation multiples for years now, as investors optimistically bought into its rapid expansion business model, which has seen it diversify into several business units over the years. Again, investors have shown their preference for increasing revenues at the expense of earnings.
On the other hand, Facebook’s profitability margins have been impressive. The company currently has a profit margin of about 17% for the trailing 12-month period, while its operating margin stands at about 30%. This compares to Netflix’s profit and operating margins of about 2.5% and 4.8%, while Amazon’s figures stand at 0.33% and 1.7% in the same order.
However, when we look at the valuation metrics with respect to sales, there is some clarity as to why investors are willing to buy Netflix and Amazon at such high earnings multiples as compared to Facebook. The social media giant currently trades at P/S ratio of 18.44x, which is quite high compared to peers in the industry that trade at an average P/S of about 5.85x.
On the other hand, Netflix trades at a P/S ratio of 6.88x versus the industry average of 2.55x, while Amazon is priced at just 3x in P/S and it operates in the same industry with Netflix. The point here is not just about looking at what multiples each of these companies trade relative to industry averages, but also to establish why investors are willing to pay the current premiums on the stock prices.
Why investors are comfortable with Netflix and Amazon pricing
Netflix is focused on market dominance, the same strategy that Amazon uses as its business model in order to drive future growth.
The company’s revenues are based on user subscriptions, and the more paying users the company brings, the higher the revenue growth. Netflix has been on a campaign to expand its online streaming service globally and Europe already seems to have bought into the company’s streaming business offerings.
The company expects to spend a $6 billion next year on feature films, television series, documentaries and other content, which is approximately a 62% increase from $3.7 billion spent in 2014. Netflix is literally building a library of global rights to stream various shows and feature films, and this could pay off big time in the future as paid subscriptions grow across the globe.
As such, investors are looking at the stock in terms of potential, rather than what is already recorded on its bottom line.
On the other hand, Amazon has been expanding rapidly over the years, and this expansion appears to have picked up some momentum as it continues to diversify across various business units.
The company began as an online book seller, but has since diversified into household electronics, music and videos, apparels and computing devices, among other products. It also has its own video streaming service dubbed Amazon Studios, which already released three new shows in Q3 and announced 12 new pilots. Amazon’s venture into online video streaming services has made many to believe that it could be an ideal rival to Netflix in the future given its massive subscriber base.
In addition, Amazon has already surpassed Wal-Mart (WMT, Financial) as the world’s largest retailer and it continues to dominate the online retail market in North America. Amazon has a wide business moat and it is constantly reinvesting in the business, which can only serve to strengthen its position in the future.
The company has had a couple of failed projects including Amazon Fire Phone, which led to $170 million write-down and Amazon Destinations, a hotel booking website that was shut down after operating for a year.
Regardless of these picky misfortunes, the company has enjoyed success in several other projects and investors continue to show faith in its ability to reinvest in the business.
Does Facebook possess similar strengths?
One thing that both Netflix and Amazon possess is that they have unassailable lead in their respective markets. They both are very good at what they do, and investors are willing to bet on their continuous dominance despite thin profit margins.
On the other hand, a lot can also be said with regard to Facebook being the leading social networking company, but the question has always been on monetizing its vast user base. As such, turning users into sources of revenue is not as easy as the case of Netflix and Amazon.
Nonetheless, in a similar campaign to Amazon’s, Facebook has been expanding its business offering to other sections including video advertising, virtual reality, ecommerce and now satellite connectivity among others. Some of these projects have yet to bring in revenue, but they are surely bound to boost top line in the next few years, if not quarters.
So why aren’t investors showing enough faith in Facebook’s projects that clearly help it monetize its massive user base? The company already has good profitability margins, which should help it weather the storm in the case of a project that fails to pay off, while its addressable market could be as big as its user base if it can find a way of effectively relating spending to social behaviors.
Because of this, Facebook has the potential to trade at higher P/E multiples than it already is, and this means that investors may not be giving it the credit it deserves.
Conclusion
The bottom line is that all these companies are leaders in their respective markets and their business models indicate that their potential for growth is far from over. Investors seem unbothered by Netflix and Amazon’s thin profitability margin, while Facebook enjoys reasonable margins.
It makes sense for investors to be as optimistic on Facebook as they are when analyzing Netflix and Amazon, which means the social media giant’s run is far from over and that the recent decline in price (from $110 to about $104) makes the opportunity to invest even better for now.
Disclosure: I have no position in any stock mentioned.
