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John Kinsellagh
John Kinsellagh
Articles (107) 

Are Traditional Valuations of Facebook Reasonable?

Traditional valuation techniques don't factor in the problems facing Facebook due to the uncertainty of the new regulatory environment that will likely adversely affect its future earnings

April 11, 2018 | About:

Facebook Inc. (NASDAQ:FB) CEO Mark Zuckerberg faced hostile questions from lawmakers yesterday during his appearance before a joint session of the Senate Commerce and Judiciary Committees. Although he may have assuaged investor concerns for the moment, questions still remain about how the Cambridge Analytica scandal and subsequent revelations about misuse of customers' private data will affect the long-term financial health of the company.

Despite the cascade of bad news, some analysts and fund managers remain undaunted. In their view, the fundamentals of the company remain strong and the current crisis will abate over time. Indeed, many of the company’s bellwether financial benchmarks are enviable.

The stock’s current price-earnings ratio is 30.6; earnings per share are $5.39; return on equity is 23.88% and its net margin is 39.2%. Facebook’s earnings growth over the last five years has been explosive. The company earned $1.5 billion in 2013. At the end of 2017, its earnings had skyrocketed tenfold to $16 billion. These numbers are not indicative of a company in peril.

Yet, ominous signs are emerging that do not bode well for the company.

First, Fakebook’s entire revenue stream from operations was predicated on unfettered access to its customers private data that it sold to advertisers and other undisclosed third parties, in some cases, without its users’ consent or knowledge. Stripped bare of its idealistic claims of being a platform for spawning online communities, Facebook was nothing more than a giant — and highly profitable — advertising clearinghouse.

Second, the significance and unprecedented nature of Zuckerberg’s appearance before the Senate Commerce Committee should not be lost on analysts. How often has a CEO of a Fortune 500 company been compelled to testify before Congress about their company’s ordinary and every day business practices?

Zuckerberg’s interrogation before legislators is a seminal event because it signifies unequivocally that the era of laissez-faire is over, not just for Facebook, but for every other major internet company. The specter of certain regulation is especially acute for Facebook because of all the members of the FAANG group, it is clearly the most vulnerable. Any anticipated changes or legislative responses to address privacy concerns will fundamentally alter the manner in which Facebook conducts its core business.

Traditional valuation techniques do not, and perhaps cannot, acknowledge or address these imponderable variables that, however indeterminate, will have a substantial impact on earnings. Give present uncertainties, any discounted internal rate of return projection for Facebook would be speculative.

Facebook’s unorthodox business practices have upended traditional fundamental analysis. The company is perhaps singularly unique among corporations in the Dow Jones Industrial Index in that its sole product is its users. For purposes of security analysis, can the same be said of Monsanto Co. (NYSE:MON) of The Boeing Co. (NYSE:BA)?

Facebook’s most substantial asset is private information extracted from its users. This is reflected in the company’s book value of $25.59 per share versus Tuesday’s closing price of $165.04. How does one ascribe a present value to an asset that will now be depleted over time? Its current operating margin of 50% doesn’t reflect the “true” cost of doing business. Given recent scrutiny by lawmakers and consumers alike, those who think these hefty operating margins will continue are wishing upon a star.

Moving forward, Facebook will not be conducting business as usual. In light of the public furor precipitated by callous disregard for its users’ privacy, regulations are a certainty. Facebook’s very business model is under assault and will not survive intact. Since data harvesting has been the bedrock of Facebook’s business, there is no viable solution to remedy the problems that created the public backlash without impacting adversely the company’s profitability.

Some have argued new rights to privacy should be legally recognized that would prohibit companies like Facebook from using private information without an individual’s consent. New models for user interaction with Facebook would entail revenue sharing that would additionally crimp the company’s growth rate.

Because the greatest risks facing Facebook are cultural, legal and political, its current predicament presents difficulties that are insurmountable. The company will not be able to sustain its present rate of growth while operating in a regulatory environment that curtails its ability to harvest and manipulate customer data.

Given these new and inexorable realities, is a Piotroski F-Score of 8 for the company truly warranted? How about a three-year revenue growth rate of 43.20%?

Despite all that is unknown, one thing is certain: Facebook will no longer be conducting its business as usual. Those who believe Facebook is currently undervalued might want to give pause and reassess their assumptions.

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Disclosure: I have no positions in the stocks mentioned in this article.

About the author:

John Kinsellagh
John Kinsellagh is a freelance writer, former financial advisor and attorney specializing in civil litigation and securities law. He completed the Boston Security Analysts’ Society course on "Investment Analysis and Portfolio Management."
He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community and personal finance.
He is the author of "Election 2016" and "The Mainstream Media-Democratic Party-Complex," both available on Amazon. Follow him on Twitter @jkinsellagh

Rating: 3.9/5 (7 votes)

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Comments

crafool
Crafool - 8 months ago    Report SPAM
I disagree with the statement that Facebooks asset is the data it can extract from its users. Facebook is much more than that. There is an old expression that Warren Buffett (Trades, Portfolio) likes to use regarding advertising. It goes something like this, “we know that 50% of our advertising dollars are wasted and we would gladly. It it out, but you have to tell us, which 50%”. Facebook is the single greatest advertising medium in the world for it allows companies to dial down and into their target market with unmatched precision and the ability to make it interactive and the audience size and pool is unmatched.

It is a superior and dynamic business and business model. I don’t know if you can come up with an accurate or definitive intrinsic value, and in my opinion, I look at the initial price that I pay for it using traditional measures like earnings yield and plan to monitor the company paying attention to subscriber retention, balance sheet, and advertising revenue and since I have no idea of when or what will replace it, I use no terminal data and will compare to 30-year Treasury yield, and for margin of safety will double the 30 yield.

Lastly, I disagree with with the characterization of Washington politicians beating up on Zuckerberg. In fact, I saw it most prominently with the Senators, but I saw politicians that were basically in a near “awe” of him. There was a few like smarmy Dick Durbin that has a way of trying to get some theatrics in for his constituents, but mostly I saw politicians that looked to not want to cross this guy, because he controls the biggest media platform company since William Randolph Hurst.

Iam a buyer and am long FB. I bought under $160, and in this decline.



DLAAdvisors
DLAAdvisors premium member - 8 months ago

Good article John. While I am not a bear of FB, it would be foolish not to think that FB business model is in jeopardy. How much so is anyone's guess. To begin Zuckerberg stated several times in the hearings that they will be conducting audits of all apps on FB etc. He could not give a timeline of how long it will take, but he did say it will be expensive. I have heard figures of +$1 billion for this. Zuckerberg did about as good a job as one could expect, hence the slight relief rally. However what seems clear to me is that Zuckerberg and FB are running fast trying to catch up with their neglect and hope nothing bad happens again. They do not appear to have clear knowledge let alone control of the situation. In addition, it's clear post hearings that some type of regulation will be coming forward. Until some clarity comes in terms of extent of damage, and potential regulation I would at best have a hold on the stock. As an investor there are too many moving parts that FB cannot control for me to be comfortable.

Barthold
Barthold - 8 months ago    Report SPAM

Facebook could stop harvesting data from users and still earn money from advertising. A lot of people, including myself, like the fact that the advertisements are more relevant. It could also provide a paid version. I see a bright future ahead for Facebook and I'm long I bought on this dip average about 153 dollar

John Kinsellagh
John Kinsellagh premium member - 8 months ago

Thanks for your insightful comments.

I don't disagree with the proposition that FB is the greatest advertising platform to date. While that may be it's strength, it is also its weakness. It generated a significant part of its revenue by failing to disclose to its users that thieir private data was being manipulated and sold to third parties. Many people who use, or have been using FB, never expected, beyond seeing a targeted advertisement on thier page, that the company would profit by continuing to collect and disseminate to advertisers additional personal info.

Many users in this regard were perhaps naive, but legal recognition of individual rights to privacy as a person's property or statutory provisions protecting privacy are going to be enacted. That is a reality. And, there is no possible way that a company whose entire core business model was data mining with impunity is going to have the same profits when its business processes are going to be forced to change.

I'm not saying this makes FB a bad investment or that the company is doomed, only that in light of the realities noted above, those who think FB is fairly or rationally priced at present, may want to take a hard look at their present valuation models.

Applied_Image
Applied_Image - 7 months ago    Report SPAM

Interesting article that gave me pause for thought..

However, as both an investor who bought the dip (albeit tentatively), and someone who uses Facebook to advertise, the information advertisers use to target customers is very available – it's age, gender and location, and things people have publicly clicked Like on .. The value is really in the reach.

I'm not aware of this more detailed, convolutional data playing a role in paid advertising campaigns. The data in question was obtained from a survey, and as far as I'm aware, this is something entirely separate from Facebook's advertising infrastructure. I wouldn't envisage an impact on functionality if they stopped parsing message data and using predictive algorithms.

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